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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.


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