Amend-extend-pretend revealed: Banks carry $57B of delinquent FHA loans
I have written about amend-extend-pretend since early 2009 when government regulators relaxed accounting rules and ushered in the era of mark-to-model accounting (AKA mark-to-fantasy). This accounting rule change allowed banks to report the value of a loan based on statistical modelling rather than on current market prices. Since the banks can use whatever bogus assumptions they want in their accounting models, it quickly devolved into a way for banks to disguise losses they will inevitably take.
Mark-to-model accounting allows banks to report higher book values than the free market would pay for their assets. This in turn allows them to report capital reserves in excess of what they really hold. This puts them in compliance with capital reserve ratios and relieves any pressure on lenders to resolve their bad loans through foreclosure and put that money to work in more productive loans. This policy of delaying bank write-offs is what propped up the Japanese banking system during the 90s, and it’s also what caused their lost decade.
In my opinion, the main reason our economy has not recovered from the Great Recession is because we failed to force the banks to write down their bad loans and liquidate their assets. This would have lowered asset prices and freed up capital for more productive uses. It also would have caused investors in bank stocks and bonds to lose trillions of dollars and forced the nationalization of our banking system. That sounds scary mostly because the oligarchs that would have been impacted by this set out to scare the populace into agreeing to a massive bailout to preserve their wealth and power. The countries that recently nationalized their banks, Sweden in the 1990s and Iceland after the 2008 bust, both recovered quickly from nationalization and experienced robust economic growth. Countries that need nationalization, but don’t do it, experience years and decades of weak economic growth like we have.
Most people understand that we have too-big-to-fail banks, but most don’t realize the extent to which we have gone to stop these institutions from going under. Many don’t understand why bank regulators allowed mark-to-fantasy accounting and why we continue to operate under this emergency measure four and a half years later. The reality is scary. Banks are holding billions in worthless assets on their books as if these loans have real value. The scale of this deception leaks out occasionally, and people who understand it are rightfully scared and angered by the special favors these too-big-to-fail institutions receive.
The nation’s four largest banks are holding $57 billion of seriously delinquent loans that they’ve been slow to move into foreclosure over concerns that the Federal Housing Administration, the government mortgage insurer, will refuse to cover the losses and hit them with damages, according to industry sources.
The banks — Bank of America (BAC), Citigroup (NYSE:C), JPMorgan Chase (JPM), and Wells Fargo (WFC) — have assured investors in the footnotes of quarterly filings that the loans are government-insured and therefore pose no threat to their bottom lines, even if they end up in foreclosure. What’s more, the banks have used these supposedly iron-clad government guarantees as a pretext for continuing to classify the loans as performing and for holding no reserves against them.
No reserves? If these loans were not performing, and if the the banks truly had no worries about being reimbursed by the FHA, why are they still holding these on their books at all? Let’s look at the possible scenarios:
1. Politicians told the banks not to process these bad loans because it would force a bailout of the FHA which would make the politicians look bad. While this is possible, and I imagine politicians are happy about the FHA not needing billions more to pay claims, I rather doubt any such deal was made. It would be too hard to conceal, and some banks would send in their claims anyway.
2. The banks are holding these loans in cloud inventory believing they can recover their collateral at a future sale of the property, probably a foreclosure. While this is possible, the bank has no incentive to wait. They can turn over the loan and get all their money back from the FHA now, so this doesn’t seem like a compelling reason to hold these bad loans.
3. Banks are withholding these claims due to pending litigation. The GSEs and the FHA have both been suing the banks for shoddy underwriting, and settlements are on the horizon. The banks may be withholding these claims until they have a blanket assurance from the FHA that they will not be held liable for their own bad behavior.
4. The banks don’t believe they will get their money back from the FHA, but since they are allowed to kick the can, they will do so for as long as necessary for prices to come back so they can get their money through a sale as mentioned in #2 above. This really is the only plausible explanation as to why they would wait to process these bad loans.
The FHA insures home loans issued by banks and other mortgage lenders to low-income and first-time home buyers. Those buyers pay the FHA insurance premiums to cover potential losses. In the event that an FHA-backed loan goes into foreclosure, the lender has the right to file a claim for reimbursement of losses.
However, the FHA’s guarantee does not apply if lenders are found to have violated underwriting or servicing standards, or to have engaged in misconduct. Banks can also be held liable for treble damages under the False Claims Act if they are found to have “falsely certified” that mortgages met all FHA requirements.
As a result, the banks face hefty losses if the loans go into foreclosure because there is no guarantee that the FHA will cover them, asserts Rebel Cole, a former Federal Reserve Board economist who is now a professor of finance and real estate at DePaul University in Chicago.
In the last year, the Department of Housing and Urban Development, which oversees the FHA, has forced four banks to pay a total of $1.5 billion under the False Claims Act on FHA loans that defaulted. More settlements are expected soon.
“The banks say they are certain of repayment on these distressed assets, but that’s simply not true,” says Cole.
Let’s assume this is true, which it probably is. What is the proper response? We’ve already decided not to nationalize the banks, so we are stuck with whatever bullshit bankers and regulators want to do to cover up their insolvency. Other than be outraged, what else should we do?
To be sure, even if all $57 billion of loans went into foreclosure, losses to the FHA and banks would likely be substantially less, thanks to recoveries on the properties. The FHA’s overall recovery rate was 42% of the principal value in the second quarter.
Wow! That is an remarkably low number. If the banks only recover a similar 42% of principal value on the $57B in bad loans on their books, the total losses would be $32.5B spread among the four major banks. There’s no way they can absorb those kind of losses.
Do you see why the federal reserve is so intent on reflating the housing bubble?
The only way to recover more money on these loans is for house prices to be higher. Without higher house prices, our major banks are all bankrupt.
Some lenders acknowledge that they will likely end up eating losses on defaulted loans held on their balance sheets and settlements related to past claims. They are also likely to try to avoid the risk of getting hit with damages by forgoing the FHA claims process and absorbing some losses themselves.
“There’s a distinct possibility that they [banks] do not file all claims and just self-insure [absorb losses] on those loans,” says Melissa Klimkiewicz, an attorney at BuckleySandler. “Lenders may err on the side of not filing claims where there is uncertainty because of the potential for HUD action or treble damages.” …
They can’t afford to write down these losses. Realistically, the policy of witholding these properties from the market by suspending them in cloud inventory is the only option they banks have.
Moreover, it is not as if the FHA — whose own financial health is in question — is pressuring the banks to file claims. Like any insurer, the FHA wants to avoid paying claims, so it is providing incentives to mortgage servicers when they modify loans, offer a forbearance of past due mortgage payments or provide other alternatives to foreclosure. The FHA’s goal is “to reduce the number of full claims against the insurance fund,” a 2012 Government Accountability Office report on its finances said.
The FHA certainly isn’t going to pressure the banks to file more claims, and with their triple-damages clause in effect, the banks are in no hurry to do so.
Some observers suggest that the loans could sit on the four banks’ balance sheets until they settle existing disputes with the FHA over their underwriting. B of A and Citibank have already negotiated settlements over False Claims Act violations with the FHA or are in the midst of doing so.
The settlements are to resolve claims involving an unknown amount of previously filed FHA claims that could date back a decade or more. After the legal claims involving these mortgages are cleared up, the banks will be able to file new claims for loans still on their balance sheets.
“At some point there is going to be a settlement and it will include the loans held on their balance sheets, and at that point they will be able to file claims,” said one attorney who represents a bank currently in settlement talks.
In all, 10 FHA lenders are currently in negotiations with HUD and the Justice Department, David A. Montoya, HUD’s Inspector General, told legislators last month. The FHA’s servicing review teams have found widespread violations of servicing practices, and the expectation is that the FHA will be reimbursed for claims it has already paid, Montoya said.
“Given the sheer volume of loans involved and high error rates identified in underwriting, settlements and favorable court actions may result in significant recoveries by the government from each of the 10 lenders,” Montoya told a House subcommittee on Sept. 10.
Any recoveries, of course, would help the FHA bolster its own finances. Though the FHA says it has already set aside reserves to cover losses, the agency remains undercapitalized and had to tap the Treasury Department for a bailout last month.
“There’s no question that HUD is stepping up its enforcement efforts and that’s a euphemism for collection efforts,” says Schulman, the K&L Gates attorney.
So not just are lenders facing huge losses on loans they are storing on their balance sheets, they are going to have to pay billions more for bad loans they’ve already processed. This is a lose-lose for the banks.
The FHA has more than $32 billion in reserves, but it faces an estimated $70 billion in future payouts on loans originated just from 2007 through 2009, according to the 2012t from the Government Accountability Office. In all, the FHA has roughly 686,000 seriously delinquent loans, representing $106 billion in total principal balances for all lenders. These distressed assets continue to be a major drag on the housing market, distorting the supply of homes for sale because so many remain stuck in the foreclosure process.
All the stories in the mainstream media discuss how the housing market is on the mend and shadow inventory is no longer a problem. Market analysts like Keith Jurow are right to point out that these so-called legacy loans are a major problem that isn’t going away by waiving a magic wand. These loans have yet to be dealt with, and when they are, they will be distressed sales that would not otherwise be on the market. It’s the price lenders and homeowners must pay for the depleted inventory rally they enjoy today.
$145,000 ………. Gross Gain (Loss)
($22,000) ………… Commissions and Costs at 8%
$123,000 ………. Net Gain (Loss)
111.5% ………. Gross Percent Change
94.6% ………. Net Percent Change
3.8% ………… Annual Appreciation
Cost of Home Ownership
$275,000 …….. Asking Price
$9,625 ………… 3.5% Down FHA Financing
4.25% …………. Mortgage Interest Rate
30 ……………… Number of Years
$265,375 …….. Mortgage
$73,535 ………. Income Requirement
$1,305 ………… Monthly Mortgage Payment
$238 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$57 ………… Homeowners Insurance at 0.25%
$299 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$1,900 ………. Monthly Cash Outlays
($165) ………. Tax Savings
($366) ………. Principal Amortization
$15 ………….. Opportunity Cost of Down Payment
$89 ………….. Maintenance and Replacement Reserves
$1,472 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$4,250 ………… Furnishing and Move-In Costs at 1% + $1,500
$4,250 ………… Closing Costs at 1% + $1,500
$2,654 ………… Interest Points at 1%
$9,625 ………… Down Payment
$20,779 ………. Total Cash Costs
$22,500 ………. Emergency Cash Reserves
$43,279 ………. Total Savings Needed