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“The Giant Elephant in The Room”

Posted by Larry Doyle on September 21, 2010 12:02 PM |

What is holding back our economy? Why isn’t there more credit available in our banking system?

I have answered these questions numerous times over the last two years BUT many in Washington pretend not to know the answer and pander to their constituencies in the process. Regular readers of Sense on Cents are well aware that the books of our banks–especially our largest money center banks–remain chock-filled with loans that are being valued far in excess of what they are truly worth. Let’s navigate.   

I first addressed issues within the second mortgage and HELOC (home equity line of credit) space in Fall of 2008 (Sense on Cents/Second Mortgages). Here we are a full two years later and America still has not received a straight answer and a full accounting by the banks or their regulators as to this “sinkhole” on their books and in our economy. 

Let’s dive into this hole, get a little dirty, and again expose the issues within this sector.

While there are many issues holding back our economy, in my opinion, there are none greater than the issues surrounding these embedded losses. High five to American Banker for highlighting these issues and to 12th Street Capital for bringing the commentary to my attention. AB writes, Why Writedowns on Second Mortgages Are So Scarce,   

If a home is underwater but the borrower keeps paying the second mortgage (though maybe not the first), can that junior lien be worth anywhere near face value?

The question is more than academic. If the answer is “yes,” as banks have indicated in their valuations, government attempts to help distressed borrowers may be destined to flounder as second liens continue to stymie loan modifications and short sales.

If the answer is “no” — as many critics contend — and banks were forced to acknowledge it by writing down more of their second liens, their capital could take a serious hit.

“Home equity is the giant elephant in the room and everybody knows it,” said Anthony Sanders, a finance professor and director of the Center for Real Estate Entrepreneurship at George Mason University.

Observers say fallen home prices and evaporated equity mean that those borrowers who today are still paying their second mortgages on underwater properties may soon join the ranks of those who aren’t.

And if house prices fall further — as many economists are predicting — more borrowers will slip into negative equity, making defaults even more likely, all other things being equal.

Roughly 23% of mortgage borrowers owed more than their homes were worth in the second quarter, and another 28% had “near negative equity” in their homes of 5% or less, according to CoreLogic, an analytics firm.

“If 25% of mortgages are underwater, [the second liens on those homes] should be classified as nonperforming loans, which would require a 50% reserve,” said Rebel Cole, a finance and real estate professor at DePaul University in Chicago and a former Federal Reserve Board economist.

Yet losses taken to date have not been as severe.

Since 2008 the top four banking companies — Bank of America Corp., Citigroup Inc., JPMorgan Chase & Co., and Wells Fargo & Co. — have charged off 19.9% of $79.7 billion in junior liens, and 8% of $353.9 billion in home equity lines, according to call report data.

The four institutions now hold at least $423 billion of home equity loans, including $151 billion of loans to borrowers who are either underwater or close to it, according to data provided to the House Financial Services Committee in April.

Banks point out that a good chunk of borrowers who have already defaulted on their first mortgage are still paying their second mortgage or home equity line.

One reason, bankers say, is that the balances, and therefore the monthly payments, tend to be small.

“In half of all cases where the first is in default, the home equity is still paying,” Michael Cavanagh, JPMorgan Chase’s chief executive of treasury and security services, said on its second quarter conference call.

“It is a shocking number. … [but] remember the home equity is a loan secured by real estate. It is supposed to pay. You are not supposed to walk away from a loan because the collateral is worth less.”

Did he actually say that? Then perhaps Mr. Cavanagh can explain that concept and inform all those homeowners who have strategically defaulted on their first mortgages.

In the second quarter the delinquency rate on second liens with combined loan-to-value ratios above 100 was just 6% for B of A, and 5.04% for Wells.

Citigroup’s overall delinquency rate was 2.4% in the second quarter and 47% of its second liens were “underwater,” with loan-to-value ratios above 100% in the quarter. JPMorgan Chase did not break out delinquency data on second liens apart from Cavanagh’s remarks.

Bank of America, which has $40.6 billion of second liens with loan-to-value ratios above 100%, estimated in its second-quarter report that it would be able to collect 85 cents for every dollar loaned, even if all such loans defaulted. It based this estimate on current housing market prices, a spokesman, Jerry Dubrowski, said.

Banks are required by regulators to charge off loans after 180 days of nonperformance, according to the Fed and the Office of the Comptroller of the Currency, which supervises large banks that service 65% of all mortgages.

A bank does not have to classify a home equity loan if the value of the property has dropped, said Bryan Hubbard, an OCC spokesman.

But Cole and others argue that banks ought to reassess the underlying credit quality of loans and account for problem credits if the collateral has changed. “Regulators have the power to force the banks to reserve against these loans, but choose not to do so,” he said.

In layman’s terms, that is known as “kicking the can down the road..!!”

Gerald Hanweck Sr., a finance professor at George Mason and a former visiting scholar at the Federal Deposit Insurance Corp., agreed that banks are loath to take losses on performing loans even if the value of the home has dropped 30% or more and a default is likely.

Regulators are complicit in looking the other way, he said.

We have learned that regulators have been complicit on a variety of financial charades over the years!!

“The banks have been accounting for [home equity loans] at par and the reason is that supervisors won’t force the writedowns,” Hanweck said. “If the loan is performing, that’s their fallback, but the underlying value of the property is still less and is insufficient to support the valuation.”

But forcing writedowns would have negative consequences for capital positions, which banks have spent the last few years rebuilding and will have to further buttress in coming years under the new Basel III standards.

We don’t have the money in the economy to successfully write down these loans,” Sanders said. “If we force the banks to write them down, the banks will become insolvent and come back to the federal government for additional bailout money, which means the taxpayers get stuck.” (all highlights applied by LD)

Ultimate Catch-22 you say? Perhaps. If the banks have such serious capital issues, then how is it that they have been able to pay such enormous bonuses recently? Think the banks have the regulators and Washington over a barrel? Just because nobody is acknowledging the elephant, does not mean it is not casting a VERY LARGE shadow.    

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. As President of Greenwich Investment Management, an SEC regulated privately held registered investment adviser, I am merely a proponent of real transparency within our markets so that investor confidence and investor protection can be achieved.

  • fred


    Most of recent bank earnings are due to loan loss reserve writedowns, so bonuses are being paid on phantom income.

    I agree with you, rather than reducing reserves, reserves should be increasing to more accurately reflect the real risk of default. Rather than being paid bonuses bankers should be paying fines from civil prosecutions from the biggest fraud ever perpetuated on Main St since this country was founded.

    These types of shenanigans are what is still haunting the Japanese banking system over 20 years later!

  • LD

    Knowing the Wall Street mentality, I know for a fact that management would promote that we did not get paid in 2008 so everything now is catch-up. That said, compensation will be forced to come down.

    Mewrrill Lynch just releases a report that 20% of hedge funds will shut in 2011. One of the largest hedge funds, Citadel, has already indicated that they will be cutting fees.

    Lower volumes and a deleveraging throughout the industry are trends not likely to change anytime soon.

    Wall Street managers are probably trying to grab what they can while they can.

  • PJ

    Anybody in business knows your first loss is ALWAYS your best loss. Spreading this loss out over a number of years will assuredly only worsen the entire situation. Can’t afford to take the loss BUT can’t NOT afford to take the loss. What a mess.

    Stick it to the taxpayer.

  • coe

    LD – Yet another perverse irony in this whole capital markets psychodrama is the fact that BASEL III is upping the capital ante for our favorite large banks that dominate the housing origination/servicing/second lien equation precisely because of the risks that have surfaced based on the last two decades of poor underwriting, excessive leverage, and accounting shenanigans! Yet, at the same time the legislators are also trying to tackle the “too big to fail” implied safety net, while curiously, the regulators keep pouring the deposits and assets of the “weak”-ly bank failures onto their troubled and still unresolved balance sheets – all while the private equity firms with real pools of capital stand behind the forbidden gates of 24.9% limitations and a combatitive regulatory approval process to invest in the mess! You can’t make this stuff up…

    Maybe the second lien issue is the largest elephant in the room, but he has the pleasure of the company of the rest of the herd – the still to be played out commercial loan performance problems, the liabilities related to pushback from the GSEs to repurchase loans at par that violated the reps and warranties of the P&S agreements, the hidden costs of compliance to HERA, Dodd-Frank, the new consumer protection agency and the rest of the kitchen sink that is being thrown at the banks, and, let’s never forget the relentless onslaught of new accounting demands that remain asymmetrical and never quite get to the heart of the matter.
    With this backdrop of future shock, it’s really not surprising that the management teams want to take the money and run. I’m no fan of an administered roll-down in coupon for the housing market either – it raises all kinds of issues – and ultimately will not solve the problems anyway.

    Your fight for transparency is essential, LD. The problems, though large, can be addressed by strong leadership and collective will. There will be collateral damage. But it’s time to take our medicine now and avoid the self-preservation instinct of kicking the can down the road…the economy of the next generation, and our children should not have to inherit these problems as the legacy we leave behind.

    just one man’s opinion…

  • wt

    what is the normal level of “near negative equity” in a housing market (ie, the number of houses bought in a six month period as a percent of total houses)?

  • jh

    What do you believe causes someone to default on a first mortgage and continue to pay on a second?

  • We’ve come full circle to the issue of, where are the auditors and the rating agencies?

  • There are two aspects to this problem – one is the lack of accounting reality presently in vogue and practice to not price these assets at what they are worth.
    But, how can we really know what they are worth?

    The second part of this illusion is contained in the GIANT BUBBLE of non-foreclosed mortgages.
    This less-mentioned bubble is completely supporting the CDO-MBS-SIV “superstructure” of financial exotica, that which, if it tumbles, pushes us over the edge, into the abyss.
    Reportedly most of these underlying mortgage assets are about 9 months in arrears, meaning they would ordinarily already be written off, the losses incurred, and, again, the assets revalued at today’s reality.

    The operating financial fiction of the lapse of proper accounting, coupled with the fraud of avoiding the necessary and appropriate mortgage foreclosures, is what allows the dead-men-walking, a.k.a. investment bankers, to keep up the multi-million CEO bonuses we will soon be paying.
    It is a national fraud against good business practice and our national economy.
    Soon coming to an end.

  • Opinionated Bloviator

    The official policy of Extend/Pretend/(Stealth)Bailout, designed to hide the total insolvency of the United States Financial system since Lehams implosion is starting to break down as the slow motion economic collapse of the United States, ~20%+ real unemployment, begins to accelerate. There will be a second Wall Street financial meltdown soon, when this happens it will be Game Over for Wall Street and possibly the United States as well. The United States of Argentina or PANEM, change your getting soon…

  • Bail Me Out

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