Principal Writedowns and the Fake Stress Test
Tuesday, 03/9/2010 - 1:17 pm by Mike Konczal | 11 Comments
Roosevelt Institute Fellow Mike Konczal explains why stress tests for the major banks have been all show and no substance.
Three things happened in a row yesterday: (1) Two positive profiles of Timothy Geithner (New Yorker, and The Atlantic) came out, both working under the assumption that the stress tests of last year worked. (2) Shahien Nasiripour had a comment about principal write-downs walked back on him by Treasury: “Treasury is NOT poised to roll out a major principal write-down program. As the [official] said, we are looking at a number of tweaks to existing programs to help reach more borrowers.”
(Are you reading Shahien’s work? You should, he’s doing great work on financial issues; he was the one who caught the modifcations -> 70% more underwater issue. Here’s a little secret about Huffington Post – you can rss feed specific reporters off their page. So if you find the page itself a little overwhelming, or think you are missing most of the better financial reporting as it gets buried quickly, your rss feed reader will catch it for you.)
(3) And Barney Frank released a letter to the four largest banks, centered around this language (my bold):
Many investors in first-lien mortgages have indicated that they are willing to accept the fact of significant losses on those investments in order to move on and use their money for other purposes, rather than having it locked in underwater mortgages with a high and growing likelihood of foreclosure. With the interests of homeowners and investors aligned in this way, it should follow that large numbers of principal-reduction modifications could be made relatively quickly. That is not happening. According to investors, Administration officials, and other experts I have consulted, holders of second-lien mortgages are now a principal obstacle to many modifications. The problem of second-lien mortgages standing in the way of successful principal reduction modifications has reached a critical stage and requires immediate attention from your institutions.
Large numbers of these second liens have no real economic value – the first liens are well underwater, and the prospect for any real return on the seconds is negligible. Yet because accounting rules allow holders of these seconds to carry the loans at artificially high values, many refuse to acknowledge the losses and write down the loans, which would allow willing first lien holders to reduce principal and keep borrowers in their homes.
I want to connect these three things around a simple premise: writing down those second liens, which would allow principal writedowns of underwater mortgages, would expose the stress tests of last year as a lie.
Those Stress Tests
Read Barney Frank’s letter again. In order to write down the first principal of a mortgage, the second needs to be destroyed. However the second mortgages are on the books of the largest banks, and they are on their books for a high value even though they are worthless.
Let’s talk specifics: Last June I made a DIY Stress Test, using values reversed-engineered from the public documents, where you could play around with the values online or download an excel spreadsheet yourself (it’s still one of my favorite blogging items). The backbone of the overview of results, page 9 from the Federal Reserve’s document, looks like this:
I’m going to isolate the four largest banks Frank questioned about second-liens, along with their loses as they’ve legally sworn to being accurate during the stress test:
Again, this is data as reported to the government by the major banks during the stress test of 2009. So what’s going on here? The four major banks have about $477 billion in junior liens, either in the form of a second mortgage or a home equity line of credit. If you go to the Fed Funds data online, you’d see that there’s about a trillion dollars of 2nd/Juniors out there, so the four major players have about half the market.
The four major players each report that they expect to have a 13-14% loss on these items under an “adverse scenario”, with Citi reporting a 20% loss under an adverse scenario. That means of the $477bn, $68.4 bn is junk that’ll never be collected on. This, combined with all the other expected losses (see the link to the stress test for the rest) meant that the four biggest players needed around $53bn to be raised.
Notice how Frank’s letter, and pretty much anyone you’d speak to who isn’t working for the four largest banks, assume that second liens in the country aren’t worth 86% of their value (for a 14% loss). You see in Frank’s letter “no economic value.” Huh. Well, that’s a problem.
Let’s look at these values again, assuming that the expected total loss would be 40%, and then 60%.
So the original loss from second-liens, as reported by the stress tests, was $68.4 billion for the four largest banks. If you look at those numbers again, and assume a loss of 40% to 60%, numbers that are not absurd by any means, you suddenly are talking a loss of between $190 billion and $285 billion. Which means if the stress tests were done with terrible 2nd lien performance in mind, there would have been an extra $150 billion dollar hole in the balance sheet of the four largest banks. Major action would have been taken against the four largest banks if this was the case.
Tradeoffs
Notice the tradeoff – with this valuation of 2nd liens locked into the stress test, it meant that a huge chunk of homeowners wouldn’t be able to renegotiate their mortgages. So you have a decade of people underwater in their homes, unable to move to pursue new jobs, with the 1st mortgage owner willing to negotiate new terms but being blocked by the second mortgage owner, in order to pretend that the stress tests weren’t completely invalid.
And the endgame? I’ve heard anecdotally from enough credible people that there’s extra pressure on underwater homeowners to pay off the small second lien first. This is in part because the servicers, who will be nudging (or “sweat boxing”) homeowners in desperate situations on how to act, work for the major banks, and in part because the second liens are usually smaller and easier to pay. This is what happens when servicers don’t have a fiduciary responsibility to investors. Between that and playing the gruesome (for regular people) spread on interest rates, the major players should be able to drag themselves to solvency.
Perhaps 40% is too bad, or 60% is too kind. This is where regulators should be stepping in and demanding that the books are updated with new values. Notice how Barney Frank has to ask politely that these 2nd liens are recorded correctly, playing a game of chicken with a quarter of all homeowners in the cross-fires. You had people like myself calling for additional stress tests on the largest banks over the course of the following year, specifically to watch for huge incorrect estimates in any of the categories. I’ve done many stress tests in my day, and the most important part is being able to update them as new information comes down the line. By the end of last summer, when it was clear that the value of the 2nd liens were never coming back, there should have been a mechanism for re-estimating the balance sheets of the banks. You could tell that wasn’t going to happen – they’ve already unrolled the “Mission Accomplished” banner when it comes to these tests.
Mike Konczal is a Fellow at the Roosevelt Institute. He blogs here and at rortybomb.
First, I am no accounting or economics expert, but I think you have done some critical thinking and make a complelling case. Obvisouly you have done some hard work and deep analysis.
Thank you for your efforts on this very important subject.
Posted by fresno dan | March 11th, 2010 at 5:39 am
Dear Mike- Thanks for this back-of-the-envelope work. While it has been obvious since last summer that the ‘books were cooked’ systematically due to our dire condition, shouting it from the rooftops has done no good. If the govt strong arms the auditors and makes everyone ‘believe’ the (industry) emperor has clothes, what are the consequences ex. a bunch of stupefied, curmudgeonly, reasoned types becoming more so? After all, the pols, senior mgmt teams and administrators lying to the public will be retired and onto new personal successes while the citizens of this republic continue to pay the bill for profligate ways and the deepest dishonesty at all levels of society.
Posted by Vincent C. Fulco, CFA, CAIA | March 11th, 2010 at 7:10 am
Anybody who believes valuing large pools of second lien mortgages at $.86 on the dollar is realistic should look into what private label mortgage backed securities trade for. My understanding is that senior securities backed by first lien mortgages on pools of prime and Alt-A mortgages, and with some level of subordination from junior securities, are now mostly trading in the 60’s and 70’s. How can second lien mortgages, which theoretically are wiped out before the first lien takes one dollar of loss in a default, be worth more than that? I would think they’re worth much less in terms of a percentage of par.
There should be greater levels of disclosure required on the second lien mortgages. What percentage of them are backing various types of first lien mortgages, i.e. option ARM, interest only, subprime and Alt-A? What is the geographical background, i.e. how much exposure to the big bubble states of Florida, California, Arizona and Nevada? What is the estimated current loan to value on the underlying first mortgages for these classifications and what is the estimated combined loan to value of the first and second lien mortgages. The major banks and their regulators must have this type of information and investors can’t intelligently estimate the real exposure from second lien mortgages without much more detailed disclosure. But it doesn’t take much analysis to realize that $.86 on the dollar is a fantasy.
Posted by DP | March 11th, 2010 at 11:01 am
Report from the RE shopper side of the house. I’ve been looking at properties in Oregon and California and have found many properties which have been held-up for two years waiting to work out a deal on the second lien. There are literally thousands of properties sitting empty because of this. Something needs to be done to break up this logjam.
Posted by Jim Twamley | March 11th, 2010 at 3:32 pm
Damn, this is almost as scary as the Fed announcing it was going to start buying up $900B in treasury notes almost one year ago today (51 weeks ago). Numbers don’t tattle, but they don’t lie either, and they ultimately point to something very nice, or something very nefarious and evil. I wonder if the average economist has ponder the simple truth that a first underwater means a worthless second, not just a reduced value. Jim Twamley’s comment above is telling of the “reality on the ground” of what’s really happening.
Posted by Seismedia | March 12th, 2010 at 12:29 am
You’re telling us what we already know, and what the entire public already knows. The entire *system* is insolvent.
It will go on being ignored until either: 1) unemployment insurance stops being extended; 2) food shortages, rolling blackouts or the cancellation of American Idol.
Posted by Thisson | March 12th, 2010 at 11:26 am
Wow, am I glad I found this site. Got linked through the New Yorker blog and this is some of the most refreshing writing I’ve come across so far this year. Thank you for putting in the work to create some original content and rigorous criticism! Much appreciated.
Posted by Justin Boland | March 15th, 2010 at 11:09 am
So basically we’ve got 5 lbs. of crap in a 2 lb. bag. No wonder everyone is pushing the meme that it’s a moral imperative, and not a business decision, that people honor their contracts. Someone go get Rick Santelli over here so he can dump tea bags on something and fix this whole darn thing! After all, “you can’t cheat an honest man.”
Posted by Gf | March 16th, 2010 at 5:30 am
Looking at Total 2nd Lien/Junior Lien mortgages in one bucket is not a productive way to analyze things. Closed-end 2nd liens have performed very differently from home equity lines of credit (HELOCs) and your analysis does not reflect that.
There are $762 billion of junior lien loans in U.S. commercial banks, but 79% of those, or $604 billion, are actually HELOCs, while only 21% are closed-end 2nds.
Closed-end 2nds are performing generally how you would expect — 11% net charge-offs (i.e., losses) in 2009, with 8.6% delinquent at the end of the year.
HELOCs, on the other hand, have performed much better — only 3% losses in 2009, and only 2.6% delinquent at the end of the year (a number which actually declined from year-end 2008).
There are a number of possible reasons for this discrepancy — I believe HELOCs are generally issued to higher quality borrowers, customers who do other business with the bank, and don’t always have a first lien in front of them. Comparing bank-underwritten HELOCs to the securitized product out there is an erroneous comparison, as the stuff on bank balance sheets has performed much better.
You can criticize the SCAP for taking too short-term a view of things, but 1 year into their 2-year horizon, the actual realized losses on this overall pool of loans is 5%, and the percentage that are behind on their payments is only 3.8%. You should consider the possibility that your 40-60% projection is not going to materialize, and perhaps update your assumptions just as you ask the Fed to update its tests.
Posted by Dave in NYC | March 16th, 2010 at 10:19 am
What a detailed and well - written article.
That said: aren’t these balances and “holes” only based on current home valuations? If the housing market rebounds, even slightly, it’s going to greatly reduce the pressure on these numbers. It’s not like banks have or will be expected to write off all the 2nd loans, it’s only those loans that are attached to properties where the borrower is unable to make payment anymore and a foreclosure is imminent. That’s certainly a portion of those loans, but not all (or even most?) of them.
That said, fiscally on the balance sheet it doesn’t matter where it will be in 5 years, it matters where it is today, and that asset today is worth $0, so from a bank stress test perspective it’s completely accurate that it is a gaping hole for lenders, although in reality no one is going to “cash that check” for all 2nd loans tomorrow or the next day.
Great post, great commentary. I need to sorely brush up on my economics!
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