As this is written the stock market is around 13,000, a remarkably high level powered in some measure by renewed strength in the financial sector.
Total industry profits for the fourth quarter were $26.3 billion — but that's a number which may be far less certain than it seems.
For instance, under the government's housing recovery plan it's okay for banks to skip traditional appraisals or actual acquisition costs. Instead, they can use general “mark-to-market” estimates to figure real estate values.
But if mark-to-market accounting reflects today's home and mortgage values — and if today's values are lower than in the past — haven't lender assets shrunk? Maybe what we need is a “debt valuation adjustment” or DVA.
William Frey, author of Way Too Big To Fail, says current accounting practices may over-estimate lender assets.
“The big four banks have over $400 billion of second lien mortgages on their balance sheets. Even though real estate prices have collapsed and many of these loans would not be paid back in the normal course, they are still held at nearly full value on bank balance sheets.”
Now it appears that federal regulators have begun to catch up. Bloomberg News reports that “Wells Fargo & Co. (WFC) and JPMorgan Chase & Co. (JPM) labeled $3.3 billion of junior liens as bad assets after regulators pushed the nation’s biggest banks to rethink the value of second mortgages whose collateral has vanished.”
Like Frey, Bloomberg says “U.S. regulators last year were examining whether lenders were accurately valuing $845 billion of home-equity and other second-lien mortgages and setting aside enough reserves, according to people with knowledge of the matter.” (See: Wells Fargo, JPMorgan Label More Junior Liens as Bad Assets, April 13, 2012)
The New Marketplace
“The new look now being given to second liens and distressed properties is not surprising,” said RealtyTrac vice president Daren Blomquist. “It comes at a time when the financial system is more stable and lenders are preparing for a different marketplace with new regulations and requirements.”
Why are second lien assets tricky to value?
Imagine that a home was bought for $300,000 with 10 percent down, an 80 percent first loan and a 10 percent second lien. This is a classic 80-10-10 deal and means the borrower put up $30,000 in cash, the lender provided a first mortgage worth $240,000 and a second lien for $30,000.
We now have a house purchase that uses a “simultaneous second” to accomplish several goals.
First, the borrower avoided mortgage insurance because the first lien is equal to 80 percent of the purchase price. A bigger first loan would have set off the need for insurance and an additional monthly cost.
Second, the lender has a conventional loan to sell in the secondary market to mortgage buyers. Most likely the loan will be combined with other mortgages to create a mortgage-backed security.
Third, the borrower was able to get a conventional loan with a low rate and less than 20 percent down.
The value issue arises if the deal goes sour.
Foreclosure Sale Proceeds
Imagine that the property price drops 19.4 percent — the average loss of value nationwide since April 2007. Now the home is worth $241,800.
If there's a foreclosure the owner of the first loan will receive all the proceeds from a foreclosure real estate auction until the entire $240,000 debt is satisfied. Only then will the second lender get anything from the foreclosure.
In the best-possible case the second lienholder will receive $1,800 from the foreclosure sale in this example. In practice that won't happen because foreclosures in virtually all markets today sell at discount. There won't be enough money from the sale to pay off the first lien so the value of the second lien will be zero.
If you're a lender and hold both the first and second liens then a very good reason to modify the first mortgage is to avoid a total loss on the second. Another option is to accept a short sale if the projected loss on the property will be less than disposing of the property via a foreclosure home auction.
The exact size of second lien losses is arguably lower today than it would have been a few years ago because some local markets — though certainly not all — have begun to strengthen. Still, there's plenty of room for additional second lien losses.
Fitch Ratings explains that the “increased regulatory scrutiny of second liens may continue to affect the way banks account for potential losses on these portfolios.” Fitch says new valuations could produce an additional $55 billion in bank losses during the next three years.
No doubt another $55 billion is a huge amount of money. But over a period of three years and with a resurgent financial sector, $55 billion is a lot more manageable than it was a few years ago. No less important, lenders have been socking away reserves to cushion future write-offs, something which can be seen with the success of most lenders under federal stress tests.
Foreclosures Less Favorable
If regulators are going to force more realistic loss accounting, then what's a lender to do?
The smart strategy — and perhaps a model for the financial sector — has been outlined by BB&T, a major bank which never offered toxic mortgages. For the first quarter, BB&T said:
“Foreclosed property expense decreased $254 million largely due to write-downs and losses in the fourth quarter of 2011 as management accelerated a more aggressive approach to reduce foreclosed real estate.”
In other words, let's move forward, let's not take on additional REOs if we can help it and let's try short sales when practical.
The new attitude is beginning to show up in local sale figures.
“Short sales have finally exceeded the number of foreclosure sales in South Florida,” reports the Fort Lauderdale Sun Sentinel.
“Banks are clearing out distressed properties and approving the deals that force them to take a loss. It also means that sellers and their real estate agents are getting better at completing the required paperwork.”
So, the wait is over. Lenders are now doing deals with short sales, foreclosures and distressed properties which may not have been possible a few years ago. For homebuyers and investors, it means deals are out there and unlike a few years ago lenders want to see offers.
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Peter G. Miller is syndicated in newspapers nationwide and operates the consumer real estate site, OurBroker.com.