The Giant Elephant in the Room

Guest Author:  Larry Doyle is President and Chief Operating Officer of Greenwich Investment Management, a privately held registered investment adviser in Greenwich, CT.  He writes at his blog Sense on Cents and is a contributor at several financial web sites including Seeking Alpha and Wall Street Pit.  He has had many appearances on financial TV and has been quoted in and contributed to leading media sources in the U.S. and elsewhere.  A full bio is available here.

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.  A 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 write downs,” 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 write downs 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.

5 replies on “The Giant Elephant in the Room”

  1. Larry, you make some interesting points, but are you missing the biggest point of all by saying that “taxpayers” get stuck with the bill? Does that simply capitulate to the fear deficit hawks promote in order to delay rational action? If private debt is the elephant in the room, what do you call fear of public deficits? The Blue Whale in the aquarium?

    Is the real issue maintaining high monetary income disparity, while using “deficit” fears to both stoke unemployment and defer write downs of nominal holdings? All simply because the primary effect of those write downs – for banks, bankers & high net-wealth holders – would fall on groups currently spending the most on political lobbies?

    In military terms, this would be called starving the soldiers in order to keep them in line, to guarantee that generals are much better off than soldiers. The problem is that net capability – of either armies or populations – is obviously declining in such circumstances.

    Does the conclusion of this article also just kick the can down the road, by describing part of the problem while failing to explore solution options?

    ps: the actual methods bank lobbies use to avoid exploring options sure sound like complicit fraud;

    ps: ps: if we’re so fearful of currency creation (aka public deficits) …
    why so little fear of proportional amounts of fraud creation (aka regulatory complicity)
    is there such a thing as a National Fraud Debt? Is it bigger than the supposed National Fiat Currency Debt?

  2. Roger, until such time that i see true sovereign debt evaporation – then the taxpayers are stuck with this debt. As we have discussed many times, the central bankers are treating their currencies like we exist under a gold standard. This article was on target based on these rules.

    You raise interesting points on the deficit hawks, but the thrust of this article was down different lines. you know my position on reckless spending of money to promote the dream of jobs expansion. I challenge anyone to provide data (not opinion) that shows after the year 2000 that there is a reasonable correlation between government spending or GDP growth and jobs growth. Under the current environment, monetary policy can only cause jobs contraction – and is unable to create jobs growth.

    I totally agree with you, however, that this fascination with balancing the budget in the short term will lead to anything good with jobs. The government needs to focus on the structural defects preventing jobs growth before focusing on fiscal responsibility.

  3. Roger,

    To be perfectly frank, I think you are going well beyond my commentary in bringing the topic of the deficit into play here. The simple fact is I am trying to highlight two points:

    1. The fact that the banks themselves and their regulators are disingenuous in not addressing the credit quality and valuations of these loans.

    2. The creditors of the banks are NOT bearing the brunt of these embedded losses but those costs are very effectively being passed along to the taxpayers via a number of mechanisms.

    Those two points are all I am trying to highlight. I would like to think I did just that. I think you are taking my points to a further extreme.

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