Los Angeles Times - Picture this nightmare financial scenario: You’ve taken out a $150,000 home-equity credit line to remodel your house, you’ve already pulled out thousands of dollars to pay contractors and owe thousands more, when suddenly you get a curt letter from the bank.

Effective yesterday, it says, we’ve shut down access to your credit line. Although we haven’t physically appraised your property, an automated valuation indicates it is worth significantly less than when we approved your application. If you wish to hire an appraiser, chosen by us but at your own expense, you can appeal our decision.

You’re in shock. You can’t pay bills you’ve already contracted for. You can’t touch the money you confidently believed you had. Plus you know that house prices in your area have been relatively stable since you took out the credit line. How could a bank effectively devalue your real estate using nothing more than a computer program?

Welcome to the world of what class-action attorneys estimate to be massive numbers of homeowners — 1 million customers at one national bank alone — who had their credit lines reduced, frozen or canceled without appraisals during 2009 in the tense months following the near-collapse of the capital marketplace.

Now a federal district court in Chicago has given the green light to clients of JPMorgan Chase Bank to proceed with a consolidated suit alleging that their equity lines were yanked or reduced illegally, costing them billions of dollars in lost borrowing power. Judge Rebecca Pallmeyer rejected the bank’s motion to dismiss the case, clearing the way for a possible giant class action.

The litigation pulls together eight separate suits seeking class certification filed by homeowners in California, Minnesota, Illinois, Texas, Arizona and Ohio. It is considered a bellwether test of the rights homeowners enjoy under the Truth in Lending Act and state consumer protection statutes when they take out equity lines of credit.

But it also shines light on the controversial computerized tools many lenders use to make quick, inexpensive assessments of property values in lieu of more costly professional appraisals. Suits on similar grounds are pending against other major lenders, including Wells Fargo & Co., GMAC Mortgage and Citibank, according to attorneys.

The plaintiffs’ lawyers not only are challenging JPMorgan Chase’s legal right to rescind or limit credit lines without adequate documentation that property values have dropped “significantly” — as required by the truth in lending law — but are also mounting a side attack against automated valuation models that they contend are frequently inaccurate and unreliable.

The computer valuations used by JPMorgan Chase were found to be “grossly in error,” based on subsequent physical appraisals, said Steven Lezell Woodrow, a partner with Edelson McGuire, the Chicago law firm representing the plaintiffs.

JPMorgan Chase does not comment on ongoing litigation, said spokesman Tom Kelly. However, the bank’s filings in court argued that federal law does not specify the type of valuation technique lenders may use in reviewing equity line collateral, and that the homeowners did not demonstrate that the automated valuation models values were incorrect.

The allegations in the consolidated suit include a credit line suspension on a house in Mountain View, Calif. Originally valued at $1 million and devalued to $826,000, a subsequent physical appraisal found that the house had actually increased in value to $1.07 million. The bank later reinstated the owner’s credit line.

On a house in Arlington, Texas, originally valued at $172,000, an automated valuation model lowered the amount to $151,000. On appeal, the owner presented a physical appraisal completed 10 days before the bank’s action that put its market value at $165,000. Nonetheless, the bank refused to reinstate the credit line, based on a revised requirement lowering maximum loan-to-value ratios on total debt to 70% from the previous 80%.

Though the litigation will be contested primarily on the grounds of alleged violations of truth in lending procedures and state consumer protection laws, the accuracy and use of automated valuations will be hovering in the background. Leaders in the automated valuation model field such as Tim Grace, senior vice president of CoreLogic, say “commercial-grade AVMs have proven over decades of testing to provide accurate, independent and consistently reliable estimations of property value.”

But lawyers for the homeowners say nothing should distract attention from the context surrounding JPMorgan Chase’s mass freezing of credit lines shortly after accepting $25 billion in emergency liquidity funds from the Treasury, which the bank has since repaid.

“They took the government’s money, which was supposed to help them to lend to people who needed credit,” Woodrow said. “But instead they cut them back.”

Wall Street Journal – Almost 40% of homeowners who took out second mortgages—extracting cash from their residences to cover everything from vacations to medical bills—are underwater on their loans, more than twice the rate of owners who didn’t take out such loans.

WSJ’s Robbie Whelan reports nearly 40% of homeowners who have a second mortgage–that is, they owe more than their home is worth. The finding, in a report to be released Tuesday by real-estate data firm CoreLogic Inc., illustrates the consequences of easy borrowing amid the housing boom’s inflated prices. The report says 38% of borrowers who took cash out of their residences using home-equity loans are underwater, or owe more than their home is worth. By contrast, 18% of borrowers who don’t have these loans were underwater.

It’s not clear how much cash withdrawn from homes during the boom was used to acquire luxuries such as expensive automobiles, and how much went to basic necessities, including tuition expenses, or renovations intended to raise a property’s value.

What is clear is that home-equity loans, which account for about 10% of the U.S. mortgage market, have been a headache for homeowners and lenders alike. Second mortgages refer to any loan taken out on a property that is subordinate to the first mortgage, and include home-equity loans or lines of credit.

Second mortgages are weighing on a fitful recovery, in which housing has figured as particularly weak spot. The S&P/Case-Shiller National Index last week showed that home prices tumbled 4.2% nationwide in the first quarter, its third straight quarter of price declines after a modest recovery in early 2010. Nationwide, prices have fallen 34% since their peak in 2006. The inventory of unsold homes will take 9.2 months to sell, the National Association of Realtors said recently, about 50% higher than what is considered a healthy level.

“When a homeowner’s house is underwater, “it’s harder to get a credit card or a car loan, you can’t put your home up for a small business loan,” said Mark Zandi, chief economist at Moody’s Analytics. “There are all sorts of little, pernicious effects that you don’t necessarily think about.”

CoreLogic found that borrowers with second mortgages had deeper levels of negative equity—an average of $83,000 compared with $52,000—than borrowers without second mortgages. In many cases, borrowers withdrew cash from their properties using home-equity loans or lines of credit, a type of second mortgage. The CoreLogic report doesn’t include cash-out refinancing, a common practice during the boom, where borrowers opted to extract cash while refinancing their first mortgage.

According to Federal Reserve Board data, homeowners took out a total of $2.69 trillion from their homes at the height of the housing boom between 2004 and 2006. That tally includes cash-out refinancings.

“Easy access to home equity loans during the housing boom put borrowers who extracted home equity at more risk,” said Mark Fleming, CoreLogic’s chief economist. “The price declines were felt more severely by people who took out home-equity loans.”

Overall, the CoreLogic report found that the percentage of underwater homeowners declined slightly in the first quarter. About 10.9 million Americans who borrowed to buy their homes, or 22.7% of all homeowners with a mortgage nationwide, were underwater in the first quarter, down from 11.1 million, or 23.1%, in the fourth quarter of 2010.

The modest decline wasn’t a sign of an improving market. Rather, the change reflected completed foreclosures, which reduced the total number of homeowners in the market, CoreLogic said.

“The implication is that there are still a lot of people who are at risk of default, so delinquency and default rates are going to reflect that large amount of negative equity for some time to come,” said Jan Hatzius, chief U.S. economist for Goldman Sachs Group.

The risks extend beyond the borrowers to banks. While the majority of first mortgages were bundled into pools and resold to investors as securities, second-lien mortgages are heavily concentrated on bank balance sheets.

Nearly three-quarters of roughly $950 billion in home-equity loans outstanding were held by commercial banks at the end of last year, according to Federal Reserve data. More than 40% of that debt is on the books of the nation’s four largest banks: Wells Fargo & Co., Bank of America Corp., J.P. Morgan Chase & Co., and Citigroup Inc. Requiring big writedowns on those loans could burn through banks’ capital.

Second mortgages have made it more difficult for troubled borrowers to negotiate loan modifications with lenders. Economists say borrowers with second mortgages on homes that are underwater are far more likely to walk away from their homes.

Homeowners seeking a “short sale,” in which they sell their property for less than the value of the outstanding mortgage, have a much harder time doing so when they have a second loan, because all the lenders involved must agree to take losses on the sale, and second-lien holders take the first losses in such a situation.

In 2005, Matt Facchini, took out a $200,000 home-equity loan on his home in Toms River, N.J., and used it to pay his divorce settlement, pay down some credit card debt and make home renovations, including installing new fences and restoring the swimming pool.

Two years ago, after price declines put him approximately $190,000 underwater, he walked away from the home, and is currently trying to negotiate a short sale. But Mr. Facchini, who works installing insulation for pipes, worries that the lender on his second mortgage will demand that he pay the approximately $70,000 deficiency on the second loan.

“I’m sweating. I have a broken car sitting in my driveway that I can’t afford to fix. I can’t get a loan to buy a new car because my credit is ruined,” Mr. Facchini said. “I’m hoping they don’t come after me for the money I owe them. That would be, for me, the end of it all.”

Nevada, which has seen homes lose half their value on average in some markets, had the highest rate of negative equity, with 63% of its mortgaged properties underwater, followed by Arizona (50%), Florida (46%) and Michigan (36%). Two-thirds of homeowners with a mortgage in Las Vegas are underwater, while 56% of homeowners in Stockton, Calif., and 55% of Phoenix mortgage-borrowers have negative equity.