billddrummer (43.68)

Let's Play a Game--Hide the Losses Until Someone Notices

July 21, 2009 – Comments (8)

This was originally a response to a fellow CAPs player regarding bank accounting for losses in a loan portfolio, but upon further review, I felt that it warranted a separate post.  For clarification, comments added to my original response are in bold italics.

"Many pundits point to the 'lack of skin in the game' as a primary cause for many foreclosures.  Many of the loans now in default were written at 90% LTV or greater.  Clearly, this isn't proper underwriting by normal standards, and banks are reaping the pain resulting from weak underwriting limits during the boom times.

Weak underwriting operated under the assumption that 'real estate always goes up.' 

As we've seen, that isn't true.  Now, with one-third of local (Northern NV) homeowners underwater, lenders are fearful that more homeowners will simply walk away rather than continue paying the mortgage.

And as far as a bank's accounting, a bank will carry a loan on its books for as long as it can before it's forced to recognize a loss, either through an examination or through repossession and subsequent resale of the underlying property.  A loss remains unstated until either of those two events occurs. 

Bank examiners have the power to force a bank to immediately recognize losses.  If a bank is continuously negotiating with a borrower, remaining in constant contact, and working with the borrower for resolution of a troubled credit, the bank may feel safe.  But when examiners look at the facts of the deal, they may decide on their own that the risk of loss is too great, and mandate an immediate chargeoff of the full loan balance. 

A surprise chargeoff during an examination is never a good thing.  And examiners may then call the entire underwriting and approval process into question, casting doubt on bank management and the lending officers responsible for handling the deals.

But that's not the worst that can happen.  When a bank decides to repossess a property, its bid (called a Trustee's Sale in NV) becomes the value that is recorded on the books.  The difference between the bid and the original loan amount is booked as a loss at the time the repossession takes place, when the property is classified REO, or Real Estate Owned.  The bank has to keep this value on its books until the property sells.  In the meantime, the bank has to maintain the property, pay property taxes, insurance, perhaps security patrols to prevent squatters and looting, HOA dues and assessments, and the power bill to maintain utilities.  All these costs are added to the REO balance, where they remain until the property sells.  When the sale takes place, any additional loss residing on the balance sheet is recognized against earnings at the time of sale.

I know of a property that was repossessed by a mortgage lender who neglected to pay the utility bill.  Because the utilities were cut off, the property's water pipes froze and burst.  The leaks warped the floors and soaked the drywall, which caused luxuriant mold growth throughout the house.  This dropped the value of the property by $300,000, including the cost for repairing the damage.  The bank in question, that repossesed the property, had to cut its sale price by $300,000, which it recognized as an additional loss when the property (finally) sold.  Most of the loss could have been averted if only the lender had paid the power bill.

Unwinding deals is never as simple as you think."

I believe that nearly all banks in the US have unrecognized losses that would wipe out their capital if taken.  And the worst part about it is that no one really knows how much the losses will be, or whether the banks would survive if they indeed swallowed hard and took the losses.

I've worked in commercial lending for the past 25 years, and this is the first time I've noticed that banks as a whole are purposely ignoring losses that are accruing on their balance sheets.  Instead, profits are good--if you just look at the bottom line.  A cursory analysis shows that many loan portfolios are rotting from the inside--plagued by higher delinquency rates, relcalcitrant borrowers, looming losses and massive chargeoffs to come.

But at least US banks aren't as leveraged as those in Europe.  Irish banks are broke, Spanish banks are on life support, and even Swiss banks have leveraged their balance sheets far beyond even the most aggressive of their US counterparts.

Let's hope people running things have ideas about how to restore stability to the system.  Otherwise, we'll be facing an even tougher credit climate this fall.

Fool On!

Bill