How changing loss recognition rules could restore lender solvency
Changing the timing of loss recognition for lenders could enable them to process their latent foreclosures, recover their capital, and regain true solvency again.
Why have lenders permitted millions of delinquent borrowers to squat for years? Why haven’t they processed foreclosures in a timely manner and recycled much-needed supply back into the housing market? The short answer is because processing foreclosures forces them to recognize losses they can’t afford to take, but what if that wasn’t their only alternative?
In April of 2009, lenders convinced government regulators to allow them to value loans on their balance sheets based on financial models rather than current market value for those securities, thus beginning the era of “mark-to-fantasy” accounting. By allowing lenders to do this, they were able to avoid recognizing losses with the implicit assumption that they could hold these loans on their books until collateral value was restored and they would again have the option to foreclose and recover their original loan capital if the borrower was delinquent.
This set up circumstances where underwater borrowers had tremendous leverage to negotiate loan modifications because they knew lenders were powerless to foreclose. Lenders cut borrowers many good deals, often lowering their payments below comparable rental rates, thus creating the cloud inventory of underwater borrowers trapped in their homes. It also set in motion the big waiting game for prices to recover to peak valuations where the lender could get their money back and borrowers could enjoy reduced housing costs while they waited. It was an imperfect solution to a daunting problem.
But was that their only alternative? Under the current regulatory and accounting regime, yes, it was; however, changing one more arcane accounting practice could have provided yet another alternative, an alternative that would have allowed lenders to more quickly recover their capital, recycled the bad loans and removed the bad debts from the system, and eliminated cloud inventory.
Changed loss recognition rules
The current regulatory and accounting rules allow lenders to report loans at face value based on the assumption they will hold the loan on their books until it’s paid off, either by a sale or a foreclosure once prices of the underlying collateral reach the outstanding balance of the loan. If the lender forecloses, the current rules force them to value the newly acquired house at fair-market value rather than the fantasy value they carried on the loan. By simply allowing lenders to value the real estate using the same fantasy modeling, they could avoid loss recognition until the house itself was sold, thus they could avoid loss recognition at the time of foreclosure.
But does that really solve anything? Aren’t they still holding an asset on their books at a fantasy value waiting for prices to recover? Yes and no. Such a rule change would provide lenders with two other alternatives to waiting for a full market recovery to recoup their capital:
1. They could treat the rental income as if it were an amortizing loan payment.
2. They could package these REO into a Special Home Investment Trust, and sell it off to Wall Street for a premium value.
The first option reduces their waiting time somewhat due to the reduced book value due to amortization, and the second option reduces their waiting time significantly as they can convert the real estate asset into either a share of a REIT or by obtaining a direct cash payment.
Keeping the loan alive by treating rent as a loan payment
There are millions of borrowers who aren’t paying their loans, even a modified payment offered to them. This is a completely non-performing asset tying up lender capital. Many lenders are accruing these missed payments and actually increasing the book values they pretend they will obtain some day. If that continues, they may be increasing their fictitious book values at a rate greater than the rate properties go up in value. In short, they will never recover their capital this way.
Foreclosing on these delinquent mortgage squatters would stop this runaway loan loss, eliminate the undeserved subsidy these squatters obtain, and restore faith in our property system of lending with threat of foreclosure for non-payment. It would also return a non-productive asset to productive use either as a for-sale home with a new loan or a rental property with a paying tenant.
On an accounting basis, lenders can keep the value of the loan on their books at par value, convert the income stream from rental into a mock “payment” on the loan. If they reduce the interest rate enough, nearly any rental income can be used to amortize even very large loans to zero over 30 years. Basically, they can take the rent, pretend it was a loan payment, and ignore the real value of the collateral. If they hold it as a rental long enough, they will pay off the amortizing loan.
Since the value shown on their books is declining, lenders don’t have to wait as long before they can sell and regain their capital to put into another loan. If the property is not severely underwater, the lender can book the rent as interest income and wait until prices reach full book value. This opens up new options for lenders to recover their capital or increase their profits.
Special Home Investment Trust
By far the fastest and most efficient way to recover lender capital is to foreclose on their non-performing loans, rent the properties (perhaps even to the former owners), package the properties into a REIT, and sell this REIT for enough to recover all their capital.
As banks convert more and more of their non-performing loans into real estate, they become less of a bank and more of a real estate investment trust (REIT). If they take all of their bad loans and create a special home investment trust (SHIT), they can dump their SHIT on Wall Street. We already know Wall Street is willing to buy this stuff; in fact, REO-to-rental companies are buying non-performing loans from banks specifically to foreclose, rent the properties, and securitize the income stream. By failing to do the same, lenders are making the same mistake that made the REO-to-rental business model work in the first place.
Investors buying shares in these new REITs are paying more than the liquidation value of the portfolios. In fact, they are paying premiums of 20% or more betting on continued rent growth. Rather than having to wait for the actual liquidation of the assets to regain their lost capital, the banks can get the capital from investors as they sell their SHIT in a REIT.
Look at this from an accounting standpoint:
First, lenders had a non-performing loan with a book value in excess of the collateral value of the property. That’s where we are today.
Second, they foreclose on the property and transfer this fictitious book value to the house which was the collateral. That’s where we could go if the loss recognition rules were changed.
Third, they rent the property and put the property into a REIT, so now they hold shares in a REIT on their books — but with one major difference. The REIT shares really are worth the original fictitious loan value because REIT investors will pay a premium equal to the lost value of the underlying real estate; thus lenders could sell off shares of the REIT and regain the full cash value they show on their books today.
If this premium didn’t exist, REO-to-rental companies wouldn’t be buying these non-performing loans and going through steps two and three above. That’s how they make money — at the expense of the banks.
In practice, this isn’t as clean and easy as I describe, but the basic business model works. The only reason banks can’t or won’t do this is because of the loss recognition rules imposed on them. Changing that rule would provide lenders with other options for recovering their capital. It would work to quickly eliminate much of the bad mortgage debt in the system that continues to burden borrowers, lenders, and the whole economy.
Is it time for a change?