Saturday 9 October 2010

Resolution Trust Corporation II - the unavoidable Sequel

How to fix the US Commercial Real Estate Mess:

The US need a Resolution Trust Corporation similar to the one put in place during the Saving and Loans Crisis. The RTC was established in 1989 until mid 1995 and closed or otherwise resolved 747 thrifts with total assets of 394 billion USD.

"The Resolution Trust Corporation pioneered the use of so-called “equity partnerships” to help liquidate real estate and financial assets which it inherited from insolvent thrift institutions. While a number of different structures were used, all of the equity partnerships involved a private sector partner acquiring a partial interest in a pool of assets, controlling the management and sale of the assets in the pool, and making distributions to the RTC reflective of the RTC’s retained interest."

Between 1986 and 1991, the number of new homes constructed per year dropped from 1.8 million to 1 million, which was at the time the lowest rate since World War II.

Where are we now? In a worse situation than anytime between 1986 and 1991.

The hole is much deeper. We have beaten the record since the Saving and Loans crisis. Desperate times need decisive action and setting up a new RTC would definitely be the right move in the right direction.

We have a lot to learn from the Saving and Loans crisis:

"Between 1980 and 1994 more than 1,600 banks insured by the Federal Deposit Insurance Corporation (FDIC) were closed or received FDIC financial assistance."

How many banks failure have we had so far this year? 129 banks went under and the year is not over yet.

In 2009, 140 banks failed.

Because the situation is worse than during the Savings and Loan Crisis, where 1600 closed down or received help, you can expect more bank failures in this ongoing crisis.

"If you look at the most recent FDIC statistics on problem banks, you would see that there were 829 problem banks at the end of the last quarter."

Don't believe the situation is improving in the CMBS space:

This is what the banks are in fact doing with their damaged Commercial Real Estate Exposure:

B notes are comparable to Sub debt where the coupon payment is deferred (similar to Upper Tier 2 financial paper).

But it isn't only happening in the Commercial Real Estate space. Many large banks have recently suspended foreclosures, kicking the can down the road:

"As of August, there were more than 4.4 million home loans that were either in the foreclosure process or 90 days past due, according to mortgage research firm LPS Analytics. Since 2006, about 6.4 million homes have been lost through the foreclosure process."

According to the article, it is due to documentation issues...I don't believe it is the real reason.

"Bank of America services 14 million mortgages, or one out of every five in the U.S., and its loan-servicing portfolio exceeds $2.1 trillion in size. Of its mortgages, 10 million came from its 2008 acquisition of troubled California lender Countrywide Financial Corp. More than 80% of its delinquent loans were acquired through Countrywide."

Given that 1 out of 4 US Household is already in negative equity, you can do the math.

The Mortgage mess:

In addition to the rising delinquencies in Mortgages, the Unsecured Home Equity Loans exposures of large US banks have not been resolved (the HELOC time bomb).

"In an interview with Bloomberg, CreditSights' senior bank analyst Baylor Lancaster said: "While a lot of people are looking for dramatic improvement in the short term, one area that still has to be worked through in a material way is home equity." The writedowns from HELOCs are not likely to show up in earnings reports until later this year, Lancaster said."

"Together with Citigroup the banks hold about 42 percent of the $1.1 trillion in second-home liens. Unlike first mortgages, they are typically not bundled and sold off to investors but kept on the banks' books. The biggest home-equity lender in the U.S. is Bank of America, holding some $138 billion in such loans. Wells Fargo has about $123.8 billion of home-equity loans."

In addition to these unresolved issues:

"Fannie and Freddie are "actively exercising their right to put back to the original lenders a considerable amount of the troubled mortgages in their portfolios," write analysts Tom Abruzzo and Christopher Wolfe. The agencies have a right to require lenders to buyback delinquent mortgages, if it is determined the mortgage loan did not meet GSE investor underwriting or eligibility standards."

"Under a moderate loss scenario, in which the banks buyback 35% of delinquent loans and recover 55% of the money, Fitch expects losses around $27bn."

"“Home equity is the giant elephant in the room and everybody knows it,” said Anthony Sanders, a finance professor and director of the Center for Real Estate Entrepreneurship at George Mason University."

"“If 25% of mortgages are underwater, [the second liens on those homes] should be classified as nonperforming loans, which would require a 50% reserve,” said Rebel Cole, a finance and real estate professor at DePaul University in Chicago and a former Federal Reserve Board economist."

"The four institutions now hold at least $423 billion of home equity loans, including $151 billion of loans to borrowers who are either underwater or close to it, according to data provided to the House Financial Services Committee in April."

You need to watch very closely the delinquency rate for second liens loans.

"Banks are required by regulators to charge off loans after 180 days of nonperformance, according to the Fed and the Office of the Comptroller of the Currency, which supervises large banks that service 65% of all mortgages.

A bank does not have to classify a home equity loan if the value of the property has dropped, said Bryan Hubbard, an OCC spokesman.

But Cole and others argue that banks ought to reassess the underlying credit quality of loans and account for problem credits if the collateral has changed. “Regulators have the power to force the banks to reserve against these loans, but choose not to do so,” he said."

"Gerald Hanweck Sr., a finance professor at George Mason and a former visiting scholar at the Federal Deposit Insurance Corp., agreed that banks are loath to take losses on performing loans even if the value of the home has dropped 30% or more and a default is likely."

"“The banks have been accounting for [home equity loans] at par and the reason is that supervisors won't force the writedowns,” Hanweck said. “If the loan is performing, that's their fallback, but the underlying value of the property is still less and is insufficient to support the valuation.”

But forcing writedowns would have negative consequences for capital positions, which banks have spent the last few years rebuilding and will have to further buttress in coming years under the new Basel III standards."

Allowing banks to repay TARP money early was not a smart move:

"Lenders Balk at Buying Back $11 Billion in Bad Loans from Fannie Mae and Freddie Mac"

"Banks that sold bad mortgages to Fannie Mae and Freddie Mac promised to buy the loans back, according to their regulator. But many of the nation's largest institutions aren't living up to their end of that commitment, reports"

"Miller's assumptions for a "base case" scenario show that Bank of America stands to lose $9.1 billion, or 34 cents per share, on both Fannie-Freddie and private-label buyback demands. JPMorgan Chase stands to lose $8.7 billion, or 27 cents per share; Citigroup stands to lose $3 billion, or 5 cents per share; Wells Fargo $2 billion, with no per-share loss estimate provided; SunTrust $1.05 billion, or 31 cents per share; Morgan Stanley $948 million, or 44 cents per share; and other lenders less than $500 million."

Setting up a new RTC would alleviate the burden face by banks. Until all the toxic assests have been dealt with, the crippled financial sector will not function properly. The banks are hoarding cash due to these issues and cannot participate in a sustained recovery through lending and enabling investment. It will take a very long time to clean up all the mess. By not appropriately dealing with these toxic assets issues today via a new RTC means it will take a much longer period for the economy to heal. We will see more bank failures in the process.

Hemingway: Kicking a can down the road illustrated...

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