Big Banks in Trouble: Huge Mortgage Write-Downs Seem Inevitable

Are The Banks Paying Back TARP Money Too Soon?

Since the beginning of the year, major banks have raised over $200 billion in capital, far in excess of the $75 billion of new capital that the government stress tests had called for. The market prices of major bank stocks have recovered dramatically since March, indicating that Wall Street investors see a recovery in the banking industry.

In addition, the banking industry is enjoying one of the largest net interest margins in history due to a very low cost of funds. Wells Fargo (WFC), for example, in the fourth quarter saw its average cost of funds decline to 1.5% while its net interest margin exceeded 4%. With banks able to access cheap funding thanks to the super low rate money policy of the Federal Reserve, banks almost have a license to print money.

The big question is will the banks be able to earn enough to offset the huge amount of future write downs that will be needed on their troubled loans? Earlier this year, Bloomberg reported that the International Monetary Fund (IMF) estimated U.S. banking losses through 2010 at $1.06 trillion. To date, the banking industry has taken write-downs of only half that amount, indicating further write-downs of an additional $500 billion will be necessary.

In addition, delinquency rates on $1 trillion of commercial real estate loans held by banks have been increasing at a higher rate than anticipated. Credit card losses for the banks have also been rapidly mounting from previous estimates.

Mortgage Default Surge Could Wipe Out Banking Capital

Total Estimated Losses

Courtesy: T2 Partners LLC

The banking industry’s mortgage portfolio is the real wild card and may result in the need for huge additional write-downs to cover the cost of mounting defaults. The banking industry is facing a potential nightmare surge in mortgage loan defaults, even if real estate prices stabilize at current levels due to the large negative equity positions of many homeowners. (The above chart shows the total estimated banking losses of which only a fraction has been realized to date.)

There is no historical model to predict the correlation of mortgage defaults to equity position, but one would expect that being deeply underwater on the mortgage will result in a strong economic motive to stop paying or simply walk away. How many homeowners, for example, will continue to make a mortgage payment on a $200,000 mortgage when the home is valued at $100,000? The greater the negative equity, the greater the odds of a mortgage default, especially if the homeowner is under financial stress.

Unfortunately, the problem of negative equity is not theoretical. In the latest overview of housing and the credit crisis, T2 Partners LLC assembled an in depth, excellently documented case on why the pain in housing is not about to end quickly. One eye opener in the report is the estimate, by type of mortgage borrower, of negative equity. T2 shows the following stats: 73% of OptionARMs, 50% of subprime, 45% of Alt A and 25% of prime mortgage loans are underwater. Combine this with a weak economy, job losses and negative income growth and the potential for additional huge write-downs on residential mortgages seems inevitable.

The impact of a poor economy and huge negative equity is already being reflected in default rates never experienced in modern economic history. Almost 10% of all mortgages are in some stage of delinquency or default. The delinquency rate on prime mortgages, never expected to exceed historical delinquency rates of approximately 1%, are now over 4.5%. Note that prime mortgage loans are the loans that were never expected to have more than a minimal default rate based on the borrower’s credit and income characteristics.

The banking industry is likely to need every dollar of newly raised capital and then some to cover future loan losses. If future banking industry profits are overwhelmed by additional loan losses, it will be years before banks can be solidly classified as well capitalized. A capital-constrained banking industry will survive in some form, but it may not be able to provide the new lending necessary to foster future economic growth.

Comments

[Milkweed]

The vast majority of people buy a home to live in it not as an investment and the ones that did buy as an investment have pretty much been wiped out by now. You academdic types need to get out in the real world once in a while, you're thinking about this too much. Most people don't even know what the "current" value of their house is. There will certainly be more foreclosures due to job losses but the idea that significant numbers of people are walking away from their houses because the current value is less than they paid for it is idiotic. Where are they going to go?

2009 Jun 22 07:46 AM

[Ishortyou]

to mon and pop to live in their garage?

2009 Jun 22 08:06 AM

[Gill]

Say what you want Milkweed (first comment), but I owe over $2M in mortgage debt and my homes (7) are worth about half that now. My "commission only" income is down substantially. I am seriously considering walking away from all of it and renting for the next 5 years just so I can get a good night's sleep. I don't believe I am alone.

2009 Jun 22 08:20 AM

[Houston]

I think that there is truth in what milkweed says...albeit caustically.

I sufferered through the oil patch bust in the 80's. Out of school I bought a cheap condo and watched its value plummet to 30% of what I paid for it. I couldn't afford a credit hit. I lived in it for 11 years and rented and paid on it for another ten...taking a loss every month... until the value came up to what I owed.
I think a lot of people will do this. I think the major implications will be a diminished move up market.

2009 Jun 22 09:02 AM

[tipalia]

Milkweed read Gill s comment, I am behind it 100%. We just walked away of our house and the result is : a rent of 700$ instead of a mortgage payment of 1250$. Lots of houses for rent and cheap .
A smaller home but at least the fridge isn t empty like it was a couple months ago. You can t eat a house and with a family of 5 one must do what s best for his family. I bet you Milkweed lives a free stress life.

2009 Jun 22 09:22 AM

[doubleguns]

I think Milkweed and Gill are the two sides of the coin and we will probably get a 50-50 toss on this situation. Personal factors will dictate each persons outcome to a large part but often it will simply come down to how important a person views thier credit rating directly linked to how much pain they will tolerate.

2009 Jun 22 09:24 AM

[buoy]

I agree with Milkweed, most people don't just walk away. And if you do, you're probably a loser.

2009 Jun 22 09:42 AM

[JAlexGomez]

It seems to me that if these banks had greater, more open policies for truly modifying mortgages for people in trouble, they may be able to recoup their losses on a futures basis. Over 4 million homes were in default in Q1'09 and only half a million loans were modified in the same period according to the Hope Now non-profit setup to help troubled homeowners. Yet, as more lawyer-based mod companies spring up on Main Street, the very banks who testify in front of Congress saying they are modifying loans are doing so at a snails pace. Meanwhile, California has to have a law passed to place a 90-day moratorium on foreclosures, giving banks a chance to work out with homeowners. And yet, many are not helping the situation out. The bottom line is that banks need to be willing to post-pone profits for today, modify all troubled mortgages now by reducing payments, convert their adjustable mortgages to fixed rate affordable loans and push profits off to 2-3 years down the line. At that point, we may have recovered and they can begin to refi loans and start making money again.

2009 Jun 22 10:25 AM

[rm]

Most people don't even know what the "current" value of their house is. ]

Maybe not... while they're current. But they take a KEEN interest in how much they owe once they do fall behind on payments. Don't think for a minute that people aren't doing the math to see if the LTV is within their tolerance level.

Many borrowers were stupid enough to take the loan they were given. But they're not stupid enough to keep it.

2009 Jun 22 10:46 AM

[Milkweed]

O.K. I'll try to hit a few in one post: $2M on (7) homes does not represent the average homeowner out there and while you can always come up with anecdotal evidence like the person claiming to be walking away from a $1,250 mortgage for a $700 rent three years into the housing downturn but that doesn't make it commonplace.

I agree with the gentleman that mentioned once someone gets to the point where they are considering defaulting on their loan they start looking into the "current" value of their house but I don't agree that "current" value of the house is what is causing people to consider defaulting at this point in the game. A couple of years ago when housing first started crashing the speculators and flippers were bailing based on market value however common sense tells you anyone who has been current on their loan this late in the game is looking to keep the house and only defaulting due to personal finances.

You can give me all the anecdotal evidence you want I'm sticking with common sense.

2009 Jun 22 11:55 AM

[jackooo]

rm:
Have to disagree. Most people are stupid.
I told my friend 5 months ago he was stupid to keep the condo when he way over $100,000 under and he still has it.
Americans are not very smart. It is a wonder where we are today.

2009 Jun 22 11:57 AM

[jackooo]

way should be was.sorry.

2009 Jun 22 12:00 PM

[SAH]

I am sad to see virtually every comment, here and elsewhere, focusing on credit scores and what people think their loan to value is all the while vilifying the banks. "People were stupid enough to take the loans, but not stupid enough to stay in them" what kind of sentiment is that. People are stupid to take a loan that is more than they can comfortably pay back. Sometimes circumstances change and what you can comfortably pay back become a significantly different number but the fact remains that the loan was taken and that there is a moral obligation to do everything humanly possible to return what you borrowed under the terms of the agreement, whatever those terms may be. If you speculated that the value of your 7 properties was going to go up and you borrowed money to obtain those properties then you gambled and lost. Gill your efforts are worthy, and it sucks that you can't sleep. Do the best you possibly can to meet the obligations that you agreed to and be disappointed in yourself if you fail. Don't just walk away. America's strength is in our morality not our diversity. We shouldn't let those values go. Now, on the issue of evil banks. Greedy foolishness that made millions for a few and caused pain for many more. We shouldn't be spending tax money to "fix" the problem. If banks had the option to go out of business or to adjust the terms on existing loans you can bet they would be scrambling to adjust some terms. As it stands today they just hold out a hand to the Feds and drag their collective feet on modifying loans. Some of those banks didn't need TARP money to begin with but they took it to make a little money with it. When they were told that the money came with strings they couldn't pay it back fast enough....anyone remember that part? This current down-turn may have lasted longer had poorly positioned banks been allowed to fail and it would have had world wide consequences but when we regained our footing, and we would regain it, we would have been so much stronger. By printing money to prop up a broken system we simply become more dependent on the Federal Government and weaker because of it. Living through pain and hardship will make us stronger. Ask your grandparents.

Disclosure: Lost my ass in the market over the last year, (i.e. Washington Mutual, 401K and IRA). Bought a second property one year ago that is worth significantly less than I paid for it, I can't raise the rent on the other one because the market won't stand for it and my damn property taxes are up again this year.

2009 Jun 22 12:15 PM

[Houston]

I largely agree with Milkweed on the points he makes. As far as "where will they go?,"...they will leave Chicago for a job in Dallas and quit paying on the house in Chicago that they could not sell.
People are coming to Houston and doing exactly that.

I don't think that this will be most people. Most people will want to stay in their home and will want to maintain their credit. I also think that the "this late in the game comment" is accurate. I know someone who is interest only on his mtg...and he has lost his job, but if he can find a job he is going to hang on to the house. He has a back up plan to move in his girlfriend to help out. (I know..bad plan)

The point is that he is 40 years old now and doesn't want his credit destroyed if he can help it and he doesn't want to leave his home.

2009 Jun 22 12:40 PM

[everyothercatstaken]

A couple of points on point to the article:

1) It would be helpful if the author could provide some stats from the T2 report which segment "how far" under water each of the product segments is. For example, if X% of the estimated 25% of prime mortgages were !0% under water, the liklihood of a foreclosure is far less(probably quite small) than the segment which might be 40% underwater.

I tried the T2 website for its report, but was undable to access the report without a paid subscription. Perhaps the author can answer my question, but I'd be very surprised if there's any segmentation.

2. Given the IMF, T2, Roubini, and GS(Which I consider most accurate) projections, what is the relationship between the estimated "losses to come" and the bank's loan loss reserve accounts which are targeted to the various product segments. To assume that estimated losses are competely uncovered by reserves---and that seems to be what the author is assuming----is highly misleading.

3. IMF financial institution estimates have been notoriously off the mark in the past. GS projections have been historically.....conse...

4. Mr. or Ms. Milweed has an excellent and realistic point: When time passes and the real estate market even starts to improve, most of the borrowers who were going to turn in their keys have already done so. The obvious question, then, becomes "Where are we in this cycle?". If real estate were to continue to decline markedly, the author's assertions could become partly true. I say partly because their are a few questions to be cleared up first, namesly Nos. 1 and 2.

By the way, I don't work for any financial institution---or Wall Street, or consultancy outfit: I'm just a retired dope who's trying to get a few simple answers so I can objectively analyze risks to my portfolio. Easier said than done.

2009 Jun 22 01:09 PM

[eveski77]

r 2nd paragraph "There is no historical model to predict the correlation of mortgage defaults to equity position, but one would expect that being deeply underwater on the mortgage will result in a strong economic motive to stop paying or simply walk away." I agree with Milkweed instead. The realty is, there might be incidence of people walking from their homes simply because it is underwater but majority of the reason is because they simply cannot afford to pay it anymore simply because they cannot afford anymore. Why? The most diot man knows why..either he lost his job, lost his business, death, health problems, or because his was a victim of predatory lending practices from all of these lenders that we bailed out. Go back to history and see where it all started...The mortgage crisis started from this people who offered these stupid loans for their gain even to the extent of giving extra benefits to brokers just to get even people who does not have documents to present to validate their income (stated income) or those whose credit score is above 620 to sign up for a loan. Did'nt you know that it was their fault...You call that Anti-predatory practices, because these lenders were obliged to see to it that borrowers could sustain to pay the loan in the duration of the 30 years and not for 2 to 3 years only. They made the borrowers believe that " oh, don't worry, you can just ask for refinancing after the "pre-penalty period"..What is that? that if you refinance earlier, you get a penalty...so they have to suffer paying for 3 years negative amortization...what is that? your monthly payment does not cover your interest for the month and is added to your principal...borrower says, what if I can't afford when I start paying the all interest? (level 2, higher monthly)..lender/brokers says, "oh, at that time, your house value is high to cover for your unpaid interest....Do you see the picture now?...these banks/lenders ruined our economy and stupic we "bailed them out"..It 's sad the government was enjoying the robust economy brought by the mortgage industry that they overlooked regulating these brillian lenders...Well they have our money now to buy all these houses..The truth is, they don't like to modify...They will push you to short sales or give back the keys. They have a lot investors who are dying to do the flipping....at a higher price of course...

2009 Jun 22 01:14 PM

[Mad Hedge Fund Trader]

You betcha! Since I have been pelted daily with predictions that residential real estate has bottomed for the last 18 months, I feel a public duty to tell that is just not the case. Now that the state and federal moratoriums are off, foreclosures are accelerating. There are over a million Alt-A loan resets about to hit the fan. Since many owners will not see positive equity in their homes in their lifetimes, banks are seeing more walk always. The run up in mortgage rates from 4.5% to 5.5% has yet to hit the market. Some 18 million homeowners divert 50% of their incomes to pay for housing, double the 25% that is considered healthy, and many of them are losing jobs. While the volume of units sold has rebounded, the action is dominated by speculators, flippers, and bottom feeders bidding for properties at 10-40 cents on the dollar, not exactly a sign of health. Call me when Ozzie & Harriet Nelson come back to the market. I listen to industry insiders call the bottom of the Japanese real estate market for 15 years, until they finally died, and the market is still a fraction of its 1990 high. I thing we are closer to the bottom than the top in terms of price, but closer to the top than the bottom in terms of time. You can take that to the bank.

2009 Jun 22 02:14 PM

[tipalia]

Milkweed is a dreamer, wake up , open your eyes and if you still think we are at the end of this real estate cycle you are joking yourself.In a year from now we ll hear the same individual singing the same song and it s going to be even worse than today. Plus I am not talking about investment I am just talking about a roof you can afford. When one loses his job you may be able to keep what you have but when your spouse is sick on top of that you don t think about yourself any more . The real question is what s best for the kids. Buoy Iam glad we are not all brainless like you are, that s all Ihave to say about you.

2009 Jun 22 02:39 PM

[Milkweed]

I suggest you take reading comprehension lessons tipalia I did not argue we are at a bottom in housing, in fact I acknowledge the job market is going to be a drag on housing. The author of the article is suggesting however that there is a mass of homeowners out there that three years into the housing downturn are just now discovering that their houses are worth less than they paid for them and are going to be walking away from their house based solely on it's "current" market value in the near future. My argument is that shoe has already dropped.

The housing market will bottom when people stop losing their jobs which should be coming in the not too distant future.

2009 Jun 22 02:56 PM

[User 296044]

I think that anyone who just walks away from their home and responsibilities is a loser. If you have to walk away from your home within a few years of buying it because you can no longer afford it, you deserve to be homeless. Everyone is looking for a handout. I am tired of everyone whining. Stand up and take some responsibility.

2009 Jun 22 03:29 PM