Forcing second mortgage loss recognition brings reality back to bank reporting
For the last four years the health of the American banking system has been an illusion. In 2008 our insolvent banks were deemed too-big-to-fail, and regulators began allowing banks to market their assets to a fantasy valuation rather than fair-market value. Once insulated from loss recognition, lenders embarked on a policy of amend-extend-pretend with delinquent borrowers. Never before have so many been allowed to squat in luxury for so long.
The policy of mark-to-fantasy bank accounting was necessary to make our banks look solvent. The hope was that banks would earn their way back to health as the federal reserve took the interest it used to pay retirees and instead diverted it to its member banks. The ongoing bailout of the banking system has largely been paid by retirees on fixed incomes. With zero percent interest from the federal reserve, lenders bought government treasuries to earn a riskless return. If given enough time and enough money to buy treasuries, lenders would eventually make up the losses they incurred from their unconscionably stupid lending practices of the housing bubble era.
So far this policy has largely worked. Seniors have been screwed, and although lenders drove the yields on treasuries down to near 2%, our big banks have earned considerable income from this riskless trade. Each quarter, they write down a certain amount of their bad debts, report a small profit, and everyone pretends everything is copacetic in the world of high finance.
Eventually banking regulators will bring reality back to reporting on bank balance sheets — I hope. Recently, the first steps were taken as regulators forced lenders to acknowledge the obvious: second mortgages behind delinquent first mortgages have no value. Believe it or not, lenders have been allowed to carry these assets on their books at 100% value even though they are a total loss in a foreclosure or short sale. This is one of those complex issues few really understand — and lenders and regulators are happy to keep it that way. If the general public realized banks are holding billions of worthless assets on their balance sheets at full value, their confidence in the banking system would be shaken because they would realize our banks are still insolvent today.
Concern that banks were not properly accounting for potential losses on second liens in foreclosure proceedings led regulators to issue a January 31 guidance that effectively requires banks to treat a second lien as nonperforming if it is subordinate to a first lien that is nonperforming. The result was that J.P. Morgan, Wells Fargo, and Citi combined to classify over $4.1 billion of second liens as nonperforming during the quarter. The largest holder of second liens is Bank of America, which is likely to report a large increase in nonperforming second lien loans when its data are released next week.
In total, more than $10 billion of second liens may be classified as nonperforming during the quarter.
This is just 1.4% of the $723 billion of second liens held by insured depository institutions at the end of 2011, according to the FDIC.
$723 billion! OMG! There is no way our banks can absorb the losses that are coming. This is the primary reason the federal reserve, the Treasury Department, and the entire US government is throwing all its resources into papering over these losses and making house prices go back up. Our banking system simply cannot afford for house prices to remain low indefinitely, yet they have been unable to move the market higher. With so many on the wrong side of the trade, it’s unlikely prices will go up. Distressed sales will continue to dominate the market and squelch every recovery as it begins.
It is also not clear what loss severity is used for loan loss reserves. In many cases, the loss severity is likely to be 100% when the homeowner is underwater on the first mortgage. Yet, in the recent stress test the Fed estimated only $56 billion in potential losses on second liens, which suggests a maximum default rate of about 8% or recovery rates that are far above what is implied by house prices.
This is clear evidence the stress tests for banks were bogus. Only $56 billion in losses on $723 billion in worthless second mortgages? If everyone stays in their houses and pays these mortgage until values return to the peak, then maybe, but realistically, it will take a long time for values to rise enough to give borrowers equity again. In the meantime, people will want to move, and they will either default or short-sell their house. When they do, the second mortgage is a total loss. It doesn’t seem likely this will only effect 8% of these mortgages.
The graph below compares the nonperforming rate on first lien and second line closed-end mortgages (mortgages with a fixed principal balance). These data (from the FDIC), show that borrowers are 2.75-times more likely to go delinquent on their first mortgage than on their home equity loan, as delinquencies on the first liens are 9.61% relative to 3.49% for second liens. The share of HELOCs that are nonperforming is even lower, at 1.83% of all loans, according to the FDIC. This is anomalous because the second liens are subordinate to the first mortgage and should therefore be riskier and have a higher default rate. Instead, many households continue paying their home equity loans even as they stop making payments on their mortgage.
There are many hypotheses for why a homeowner would continue to pay his second lien even after going delinquent on his mortgage. The payment is lower, the loan is fully recourse to the borrower in 39 states, and revolving home equity lines provide the household with access to credit. However, it is also important to note that the servicer of the first loan is often the owner of the second lien. Given that the servicer has much greater exposure to the second lien, it makes sense to think the servicer would work harder to ensure the second lien is current. Part of the anomaly could therefore be explained by servicers exerting greater pressure on borrowers to pay their second liens. The new regulatory guidance seems to recognize this conflict of interest.
… Also, home-equity payments are smaller, meaning homeowners are likely to keep paying after a default on their primary mortgage — at least for awhile.“When we analyzed it, it was pretty obvious it was just a timing difference,” JPMorgan CEO Jamie Dimon said. “In almost all cases when the first went delinquent, the second eventually went delinquent. And in all cases where the first went into foreclosure, the second was a loss, basically a total loss.”
I first reported on this strange phenomenon back in 2010: Borrowers default on first mortgage and keep second mortgage current. There are few good explanations for why people would remain current on the second while not paying on the first. What Jamie Dimon noted makes more sense. It’s only a matter of time.
While this new rule requiring banks to recognize these losses is a step in the right direction, we are still far from having a transparent banking systems with accurately reported book values. Only the implied promise of solvency through the too-bid-to-fail policy of the government keeps investors buying bank stocks and bonds. The write offs on second mortgage liens will continue for years, and unless house prices go back up strongly — a very unlikely scenario given the level of distressed debt — then these second loans losses will mount as people leave their underwater homes through strategic default and short sale.
Beach properties also benefit from amend-extend-pretend
Property near the beach is intrinsically more desirable than inland properties. The narrow strip of land within a few miles of the ocean gets the ocean air which is clean and cool. It’s the perfect climate all year. Because this area is so desirable, it always has higher house prices. High wage earners porting equity from previous sales bid up prices on homes beyond rental parity. These are a classic move-up destination market. During the housing bubble, these areas were even more desirable because prices went up so much. The Ponzis particularly coveted these properties because they provided so much free spending money. Further, since prices have crashed elsewhere, lenders elected to let these people squat in luxury rather than foreclose on them and endure massive losses. These losses are coming, perhaps when lenders can finally afford them.
Today’s featured property shows just how bad these losses will be. This condo a few miles from the ocean sold for $985,000 in 2004. Today, eight years later, it is selling for 27.5% off its 2004 purchase price. The beach communities are not immune to the crash, and when lenders finally get around to foreclosing here, we will see many more properties selling for 30% to 40% off their bubble-era prices. Corona Del Mar is still grossly inflated. This market always trades at a premium to rental parity, but the current premium is nearly 60% over its historic norm. I remain very bearish about Orange County’s high end. Today’s featured property is still considered an anomaly. If not for amend-extend-pretend, it would be the norm.