Dec162009

Lenders Can Hold Real Estate Indefinitely

Today I briefly want to again Revisit Option ARMs, and I want to address a common misperception about REO; lenders do not have to sell REO due to regulatory pressure. Shareholders may dissuade lenders from becoming real estate investors, but the banking regulators will not.

The Option ARM Kingpins: Who Holds the Elusive Option ARMs?

$189 Billion Securitized and Outstanding and big Three of Wells Fargo, JP Morgan, and Bank of America Playing with Time.

There have been many charts … and much of the confusion is around a few key points:

-1.  Banks have been circumspect given the actual number of option ARMs

-2.  Many option ARMs are in California (roughly 60 percent of the market)

-3.  Many of those behind on payments are now simply not paying their mortgage but banks are not moving

It is hard to quantify the above data since this is something banks would like to hide.  Nearly 60 percent of all current outstanding option ARMs are in the hard hit state of California.  As many of you know, the median price of a home in California has fallen by 50 percent.  The peak in home prices was reached in 2007, the last year option ARMs were made in mass.  Since that time, option ARMs were merely ticking financial bombs.

But what if homeowners balk?  Many in California are strategically defaulting.  In many cases, unless their mortgage meets with market rents many will walk away.  Also, the California unemployment and underemployment rate is at 23 percent so no amount of modifying can help out with a loss of income.

So  let us sum up the option ARM market:

option arm market data

$750 billion in option ARMs were originated between 2004 and 2007.  The top 10 option ARM originators cornered over 60 percent of the market.  Of these, many are now part of the too big to fail banks.  We know that $189 billion is still securitized in investor portfolios while many billions are still on the banks books (i.e., $107 billion with Wells Fargo and $50 billion with Chase).  The bottom line is the option ARM issue is still here and we will be contending with this for the next couple of years.

That doesn’t sound very good, does it?

From yesterday’s discussion about Shadow Inventory, matt138, said, “Shadow Shadow inventory – the people who are currently thinking, “why the hell am I still paying if nobody else is?” I did some calculations and my result was: A LOT.”

What I find interesting is how much of the Option ARM problem has already been resolved (probably through foreclosure). If $750B was issued, and only $200B remains, only 20%-25% of the Option ARM problem remains — at least in the form of Option ARMs. Many of these original borrowers already went through short sale, foreclosure or walked away. The Option ARMs didn’t go away due to market sale because the homedebtors were all underwater, and these loans did not go away through successful loan modification because cure rates are very low.

The good news is 75% of the Option ARM holders appear to have defaulted early. The bad news is most of the homes of these borrowers will end up as REO sold on the open market, it is only a matter of when. This problem is going to be stretched out as long as possible, and the abundance of overhead supply will prevent appreciation from saving the market for many years.

Lender’s Options for REO

The lenders I have spoken with are genuinely concerned about the auditors forcing them to reclassify loans. Many lenders are not properly categorizing their loans for accounting purposes — the still have it on their books as if it is a good loan and the borrower is making their payments. Many, many non-performing residential loans are still classified as performing while lenders have the shield of government loan modification programs. The reality is many of these loans are not performing, they are never going to, and lenders are not being forced to recognize this fact until their balance sheet ratios support it.

Regulators are not concerned with what a lender does with the REO it picks up through the foreclosure process as long as the losses are accurately accounted for — in theory. Once the REO department gets a property, the only pressure they get to sell property comes from through management from shareholders.

Shareholder Pressure

People who invest in banks are investing in a business that writes loans and carries loans on its balance sheet. If a balance sheet becomes polluted in the eyes of investors with real estate assets, it starts to look less like a bank and more like a real estate investment trust or a hedge fund. When banks cease to be banks, investors bail out and stock prices crumble — at least that is the belief of bankers, so the management does not want to hold real estate. Also, REO is lingering evidence of prior poor lending practices, and nobody wants to keep that around.

The implication for the market is simple, there will be no forced dump of REO instigated by bank regulators. That isn’t to say we don’t have a huge pig to send through the snake, but it can be digested in smaller pieces rather than one massive chunk. We may (probably will) see a cartel arrangement evolve, but the large amount of supply and the competition to dispose of it will serve as a drag on prices until the inventory is exhausted. In some markets that will take decades.

Direct from an Asset Manager

As part of my work, I go to Building Industry Association meetings on a regular basis. As a courtesy to them, I am keeping my sources anonymous, but should any of you wish to attend a BIA meeting, you can see and here these people yourself. The meetings are open to the public for a fee.

At a recent meeting I listened to asset managers from two major West Coast banks. I asked one of these asset managers to detail his banks policy toward REO based on market conditions. He said that in markets where they do not see recovery in a longer-term horizon (think Lancaster), they may sell at reduced prices to clean up the mess; however, if they do see the market recovering in a reasonable time, they will hold the property, and perhaps even rent it out while values improved. In short, the REO departments of these banks are empowered to act as responsible asset managers trying to obtain the greatest recovery for the bank. This also means there will be no massive inventory dump forced by a government regulator.

Each bank will evaluate its own financial circumstances, its exposure to the market and other factors and pursue a policy of maximizing recovery while disposing of these assets. Certain banks will dump in some markets and hold in others. It will be the chaotic collapse of a cartel with much volatility, and most likely slowly declining prices for several years as lenders slowly release their inventory to obtain price recovery.

Blue skies are not here yet.