You’ve probably heard that the nation’s banks had a $21.6 billion profit during the second quarter, reason enough to celebrate with big executive bonuses for our financial leaders. But before we break out the champagne it might be good to mention that the profits enjoyed by our bankers are no more believable than Bernie Madoff’s sworn testimony.
To untangle what’s going on we have to start with the idea that a sound financial system is crucial to the economy and thus to everyone. If that means a few rules must be bent to create the fiction of bank stability, so be it. Unfortunately, the financial system remains painfully and deeply unsettled, a reality which impacts home prices and foreclosure practices nationwide.
In The Beginning
In 2008 the government created the TARP program, $700 billion largely set aside to prop up big lenders. Happily, most of the money was unneeded, “only” $190 billion remains outstanding and much of what’s unpaid is related to non-banks such as GM and AIG.
However, less visible and perhaps equally important was a quiet accounting change.
“Rule 157” used to say that assets on lender books should be appraised as if they were being sold today, the “mark-to-market” valuation method. This was a great rule when values were increasing, but if left in place during down times it would force banks and others to show huge mortgage and property losses. So, of course, the rule was changed, replaced by what the Wall Street Journal calls the “mark to wish” standard.
Bankers certainly knew what was going on. As Sheila Blair, head of the Federal Deposit Insurance Corporation explains, “the difficulty in determining the value of mortgage-related assets and, therefore, the balance-sheet strength of large banks and non-bank financial institutions ultimately led these institutions to become wary of lending to one another, even on a short-term basis.”
Almost 435,000 homes have been saved from foreclosure under the government’s Making Home Affordable program. This is certainly good news for legions of borrowers and there’s another beneficiary as well: Lenders have been helped because nearly 435,000 once-distressed loans are now performing.
Under the Making Home Affordable program lenders cut rates, stretch loan terms and sometime forgive principal so that monthly mortgage payments will total no more than 38 percent of a borrower’s monthly income. Uncle Sam then chips in with a subsidy so that borrowers only make payments equal to 31 percent of their monthly income. The result: Lower monthly costs for borrowers, fewer foreclosures, better-looking lender books, and higher stock prices.
The Profit Illusion
Given the unprecedented level of federal assistance, it’s hardly a surprise that the fortunes of the lender community have begun to improve, even if much of the “improvement” does not reflect marketplace realities.
Here’s an example: Smith took out an option ARM loan in 2006 which allowed negative amortization. The interest not paid each month was added to the loan amount. For accounting purposes such interest was treated as taxable “income” even though it was not actually collected. With “higher” income lenders could also report “higher” profits.
Now we have the reverse situation. When an option ARM is foreclosed the principal balance is likely to be larger than the original loan amount, meaning the loss is magnified. This is a major problem because Fitch Ratings reports that “start” periods for option ARMs worth $134 billion will end in 2010 and 2011. Fitch also reports that the average monthly payment will rise 63 percent, an increase many borrowers will be unable to afford. The result is that the value of such loans on lender books is now greatly overstated.
When a home is sold at foreclosure the loan is retired at the value the lender is able to get from the transaction. For example, a home with a $200,000 mortgage balance might be sold at foreclosure with the lender getting $150,000 from the sale. In today’s market foreclosure losses can be substantial, especially in major foreclosure centers such as Nevada, Arizona and Florida.
If a borrower is delinquent but not foreclosed then there’s no lower value to report, a $50,000 “savings” in our example. Lenders thus have a financial incentive to carry delinquent borrowers and support state rules which delay foreclosures.
If you look at the latest numbers for the Making Home Affordable program you can see that there were 1.5 million eligible borrowers. That compares with 3.1 eligible million mortgages — or better than two per borrower. In other words, many of the homeowners now in trouble purchased real estate with “piggyback” financing. This meant they could buy with less down and also avoid the cost and bother of mortgage insurance — good news, as it turns out, for the mortgage insurance companies.
Laurie Goodman, a leading analyst with the Amherst Securities Group, tells us that second liens worth $1.01 trillion are outstanding according to Federal Reserve data. Of these liens, says Goodman, $751 billion are held by commercial banks and $435 billion are owned by the top four commercial banks.
In a foreclosure situation the rule is that the first lender must be paid off entirely before a dime is paid to second lien holders such as those who own second mortgages or home equity lines of credit (HELOCs).
Given that the value of many homes is less than the balance of the first mortgage, just how many second-lien holders will get paid in the event of foreclosure? Or, to put this another way, is the $751 billion in second liens held by the nation’s banks really worth reported values?
Many of the largest banks are also the largest servicers, an arrangement which can create a considerable conflict.
“Often,” says Gretchen Morgenson, writing in The New York Times, “the same bank that services a primary mortgage owned by another institution also owns a second mortgage or home equity line of credit on the same property. When that borrower has trouble meeting both payments, the servicer has an interest in making sure that amounts owed on the second lien, which it owns, continue to be paid even if the first loan, which it has no interest in, slides into delinquency.” (See: In This Play, One Role Is Enough, August 14, 2010)
How does a servicer protect the second lien holder? According to Naked Capitalism, servicers don’t foreclose on borrowers with second liens at the same rate as they foreclose on borrowers without a second lien. If all borrowers were foreclosed equally, lenders would be forced to immediately write off large numbers of second liens.
Lenders are required to set aside money for loss reserves. How much to set aside is a matter of discretion, there’s no absolute rule. Curiously, in the second quarter when lenders had profits of $21.6 billion they also reduced loan reserve contributions by $27.1 billion when compared with a year earlier.
Lenders might argue that credit quality has improved and thus less money should be set aside for losses, but the reality is that foreclosure filings have been above 300,000 per month for nearly a year and a half according to Jim Saccacio, Chairman and CEO at RealtyTrac.com.
“Like an iceberg, a large portion of the foreclosure problem is hidden from view,” says Saccacio. “But the problems are there, they’re real, and everyone has to understand that they have yet to go away.”
The Bottom Line
Despite glowing profit reports, the lending system remains troubled. At best, what we have is a holding operation which has prevented the financial system from appearing significantly worse. That’s a victory — consider the alternative. Unfortunately at some point real values will have to be shown on lender books and those values are not what we see today.
The hope is that the national fudging process can continue until property values increase for real, raising the value of lender loan portfolios no matter what accounting system is used. The good news is that some increases in home values have begun to be reported. The National Association of Realtors says July home prices were 0.9 percent higher than a year ago. TheCase-Shiller Index shows that home prices across the country rose 4.4% in the second quarter. The Federal Housing Finance Agency says home prices increased .9% in the second quarter when compared with the first three months of the year.
So the race is on: Will higher real estate values take hold before lender accountants have to fess up? Stay tuned.
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