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Where is Wall Street Hiding Hundred Plus Billion in Lo$$es?

Posted by Larry Doyle on March 8, 2010 11:24 AM |

U.S. Rep. Barney Frank (D-MA)

Banks are increasingly healthy, right? Our nation’s accounting rules promote real transparency and integrity in our financial reporting, right? Housing is bottoming, right? No, no, and no!

Why so pessimistic, you may ask? I am not pessimistic at all. I am merely searching for the truth in the midst of the smoke and mirrors on Wall Street and in Washington.

Thank you to our friends at 12th Street Capital for sharing a recently released letter from Congressman Barney Frank imploring the four largest banks involved in mortgage originations to write off second liens they are holding on their books at inflated values.

Why does Congressman Frank believe these loans need to be written off? The liens must be largely written off so that Washington can then compel banks to engage in writing down principal on first liens in an attempt to keep people in their homes. Keeping people and families in homes is certainly a worthy cause, but the process is fraught with all kinds of violations of moral hazards and assorted unintended consequences. When you hear that your neighbor receives a principal reduction, how long will it take you to go to your bank and demand the same?

Let’s review Frank’s brief, two-page letter (click on image below to access pdf document). Focus on Frank’s comment that the second liens have no real value but accounting rules allow the banks to carry them at artificially high values. Can you say, “cooking the books”?

What are the projected losses in these second liens? Well, how much of this paper is outstanding? The Wall Street Journal provides a bar graph in an article this morning, Home-Savings Moves Afoot:

So, with $1 trillion in outstanding second liens on the books, the question begs as to how much of this indebtedness is current, how much is delinquent, and how much is truly worthless but not yet acknowledged. In discussions with those in the industry, suffice it to say, the most optimistic assessment is that the industry has at least a few hundred billion in losses yet to be acknowledged.

The larger banks addressed by Congressman Frank are the largest holders of these second liens. These banks do have earnings power given the free flow of liquidity provided by the Fed and accompanying capital markets activities. That is not the case with smaller institutions. How many of those institutions are already dead, but not yet buried?

Wonder why banks are reluctant to provide credit? They need to increase capital knowing these second liens are truly an ongoing sinkhole. Don’t even start to ask about setting aside capital for those big bonuses.

LD

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  • Mike

    LOL @ at a housing turnaround before 2015.

    I once interviewed for a commission based position with a company that installs thermal windows, siding, and other home editions. The guy kept telling me that “This is a buyers market and people are looking to upgrade!” Meanwhile there were about 3 – 5 other people my age waiting outside the interview room by the time we finished…

    Needless to say, I did not call him back.

  • Bill

    When Barney Fraud talks, Wall St. listens. Not because he knows what he is talking about, but because he wields political power due to the nitwit electorate in his MA district who keep foisting him on the rest of us. So far as these second liens, I’m sure the Obama administration can conjure up another version of its Chrysler plan to deal with that.

  • coe

    This issue sits squarely at the crossroads of many intersecting problems in our financial crises – first, banks are saddled with an asymmetrical accounting system – sort of imperfectly marking their bonds and derivatives to market, mercurially marking some loans for sale, but booking others at historical cost, and not benefiting by marking their deposits to market at all – all the while as their regulators apply equally dysfunctional examination and regulatory prescriptives against these companies…for example, it is against this flawed background that their capital ratios are calculated and, in fact, behavior is driven; second, the congressional urge to surge in loan modifications to “keep mom and pop in their houses” is yet another political subsidy at the expense of taxpayers, and in my opinion, fraught with the moral hazard you have been consistently pointing out – not only are the neighbors of those modifying unprotected and adversely selected for struggling to honor their financial commitments while others get the free pass, but so also are the holders of securities in which these “modified” loans sit – and whether we like it or not, for the housing market and the economy to reignite, I believe we need to rescue the securitization process from the ashes – if only in plain vanilla flavor; and lastly, over time the consolidation of the industry has indeed created a sort of oligopoly of the “haves and have nots” – a mere handful of mega-institutions with dominant market share that clearly are “too big to fail”, but more importantly, these few are the very same banks that are most involved with the leverage, off-balance sheet smoke and mirrors, and capital markets activities that have been proven to be at the heart of the crises. Time to look more closely at implementing the Volker solution, don’t you think!

    • LD

      Coe,

      Yes, I think so as well. Insightful …as always.






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