Monday, 7 March 2011

"Extend and Pretend" - Banks bloated balance sheets and the Impact of Real Estate crisis

Extend and Pretend. Welcome to the "new normal".

In a previous post "Resolution Trust Corporation II - the unavoidable Sequel", I argued that in order to fix the difficult situation relating to Real Estate in the US, the set up of a new RTC, was necessary. I also discussed how Banks were "extending and pretending" in relation to their Commercial Real Estate exposure. The suspension of foreclosures is also a strategy to kick the can down the road and gain some time to resolve the hangover linked to the burst of the mega housing bubble.

In my post relating to the RTC, I reviewed the current mortgage mess plaguing the recovery of the US Economy in general and the US banking sector in particular.

I highly recommend you purchase this week's "The Economist" latest issue where you will find a very interesting 14 page special report relating to Property.

I came accross Barry Ritholtz's excellent recent post relating to the game being played by banks in relation to their ongoing Housing issues and exposure which is a subject I discussed previously on various posts. Barry sums it up accurately in his post:

"Rather than go Swedish, and force a shorter painful pre-packaged bankruptcy process, we have opted to take the long slow route:

1) Banks are slowly rebuilding their capital by borrowing from one branch of government and lending to another. This is a slow process, but its less well unerstood (and hence more politically acceptable) than merely giving Banks capital outright.

2) FASB 157 allows banks to carry all of these structured products made of bad mortgages on their books indefinitely.

3) Banks are carrying lots of housing inventory waiting for a better residential market to emerge 5 or 10 years down the road.

Under normal circumstances, the bad mortgage process goes Delinquency (late payments) Default (90 days behind), Foreclosure (legal proceedings to enforce the note).

Once a home goes into foreclosure, the accounting changes: It is now a loss that must be written down immediately. That hits the banks capital levels. Consider what the next 3-5 million foreclosures will do to banks’s capital cushions.

Once a foreclosure occurs, not only does the capital write down take place, but the local property tax liability accrues to the bank; prior to foreclosure, the liability is to the nominal home owner and/or property. Once the bank takes possession, its on them.

Hence, you can see why “Extend & Pretend” is so attractive to the large institutions sitting on massive REO inventory, enormous bad loans and CDOs, and huge future local tax obligations."

Now it is getting more official, the SEC has launched an investigation relating to the "Extend and Pretend" practice as per this link to a WSJ article published recently.

"Banks sometimes break up a troubled loan in order to place a portion of it on "performing" status, a sleight of hand that reduces the reserves needed to be set aside."

In October 2010, when I wrote about the need for a new RTC, I highlighted the restructuring game being played in the CMBS space.

As a reminder:

The slice and dice game runs unabated.

The WSJ article indicates some sobering facts:

"U.S. banks hold an estimated $156 billion of souring commercial real-estate loans, according to research firm Trepp LLC. About two-thirds of commercial real-estate loans maturing at banks from now to 2015 are underwater, meaning the property is worth less than the amount owed.

As of Dec. 31, 7.8% of commercial-property loans held by banks were delinquent, down from 8.6% a year earlier, according to Trepp."

The recovery in the US is very fragile:

Little is beeing charged off:

For more on the subject of the US Commercial Real Estate mess:

CRE Primer On CRE Pretending- I Mean Lending

A wall of maturities needing refinancing...

As The Economist put it bluntly in its special report on property:

"Property is widely seen as a safe asset. It is arguably the most dangerous of all, says Andrew Palmer"

It can be argued that the most toxic of all bubbles is a housing/property bubble. They also always generate a financial crisis when they burst due to the leverage at play. How the risk can be mitigated? By forcing players to have more skin in the game.
Recently Sweden passed a law limitating the maximum Loan to Value (LTV) to 85%. In effect, Swedish people will need to put down a minimum of 15% of deposits to borrow 85% of the remainder.

I was shocked to read recently that Northern Rock, which became infamous for lending people up to 125% of the value of their home before the credit crunch (the product was called "Together Mortgage") has launched a range of riskier 90% mortgages. This is coming only three years after the collapse of Northern Rock! Northern Rock made an underlying loss of 140 millions GBP in the first six months of 2010. It looks like the British Government is eager to cut corners to boost its revenues by selling early its stake and is ok with Northern Rock taking on more risk.
For more on Northern Rock, see my post "Solid...Solid as a Rock..."
On the 9th of March we will have a clearer picture on Northern Rock when they will publish their latest results for the whole of 2010.

Following closely Northern Rock, Skipton Building Society has launched a 95% LTV product especially aimed at first-time buyers.

Why? Because buyers are struggling to raise large deposits required to secure a mortgage. If they are struggling to save, is it prudent to lend to them in the first place?

"Both mortgages have an application fee of £195. The 95% deal has no completion fee, but the 90% deal has a completion fee of £995."

And the icing on the cake:
"At the end of the two years, both revert to bank base rate plus 4.45%."

It seems to me that some of the lessons of the recent financial crisis were never taken on board at all.

As The Economist special report put it nicely:
"Given the state of residential property around the rich world, perhaps the victims are suffering from post-traumatic amnesia."

Anterograde Amnesia or Retrograde Amnesia? Or both?
As per my post from May 2010:
Anterograde amnesia refers to the inability to remember recent events in the aftermath of a trauma, but recollection of events in the distant past in unaltered.

Retrograde amnesia is the inability to remember events preceding a trauma, but recall of events afterwards is possible.

For an intereractive experience on Property prices around the globe, you can play with their very interesting tool using the following link:

The Economist house-price indicators

Using the above tool, and having a look at Real Estate Prices against rent, a few interesting points come up:
Germany is cheap using 2003 as a reference point, relative to rent, so is Italy and Netherlands and Denmark. (For more on Denmark's mortgage market: "Are Fannie Mae and Freddie Mac on the path to a crash à la Thelma and Louise?").
UK appears to be still overpriced, prices relative to rent taken into account, as well as taking into account prices against average income, using 1996 as a start date and 2000 as well.

Prices against average income from 1999 to 2010, for Britain, Ireland, Spain, and USA (in Black):

A matter of Gravity: Ratio of House prices to Rent

The Special Property report from The Economist comments:
"PROPERTY can cause huge problems, but the sector also traditionally leads economies out of recession. Housing is far bigger and more important than commercial property. Residential investment, which is driven by new housing starts, makes up a large chunk of the volatile bit of the economy. That means changes in residential investment have a disproportionate impact on rates of GDP growth. It has played a big part in driving previous post-war American recoveries, and many assumed the same would happen this time round. Things have not worked out that way."

We are still in a deflationary environment.

In this report The Economist also make a very important point:
"Work on the relationship between housing supply and bubbles by Edward Glaeser of Harvard University and Joseph Gyourko and Alberto Saiz of the Wharton School suggests that places with relatively elastic supply have fewer bubbles, of shorter duration, than those where the supply is more restricted."

Two-thirds of the outstanding mortgages in Britain are adjustable-rate mortgages that move in step with changes in official interest rates.
This is why the rise inflation is such a nightmare for the Bank of England. The impact of rising interest rates in the UK could have serious implications on already stretched household's balance sheet, putting additional pressure on the downside for housing prices in the UK.

Property remains the biggest financial purchase people ever make during their lifetime.
A quarter of US mortgage holders are in negative equity but, at least in the US, prices are back to their long term average compared with rents as displayed above.

The more exposed an economy is to housing, the more dangerous the burst in a housing bubble and serious the consequences for the banks. We have seen the dramatic results of the burst in the US, Ireland, Spain and others. The political rationale for encouraging home ownership is a dangerous game which can have dire consequences. The mortgage lending business should be very conservative, as it is the case in Denmark, as well as in Germany. Renting is not always a waste of money after all.

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