Toxic Assets, Short Sales, and Mark-to-Market

Here are answers to a few questions I’ve received recently………

What is a “toxic asset”?

This generally refers to either mortgage-related derivatives (see previous posts “Subprime Primer I & II for more about derivatives) or loans related to land, lots, and houses that are in foreclosure and held on bank’s balance sheets – see previous post “Why Banks Aren’t Lending” for information about how these ended up on their balance sheets.

What is a “Short Sale”?

A short sale occurs when a bank allows a residential builder to sell a house or condominium at less than the amount the builder owes the bank for that particular unit. Simplified example: a bank lends a builder $200,000 to construct a house. The builder completes the house but cannot sell it, at least not for an amount that would net the builder enough to pay off the bank loan. If the builder gets into financial difficulties and cannot afford to make the payment to the bank on the $200,000 loan the property often goes into foreclosure, meaning the bank takes ownership of the home. Banks don’t like to do this because they typically recover much less than is outstanding on the loan and they also incur legal and administrative expenses. Alternatively, the bank may consider a short sale which would net them a higher recovery on this house. Here is how it would work…….a potential buyer offers $190,000 for the house in the example above. The builder then goes to the bank and asks to have the house released for less than the $200,000 loan amount which is typically required. If the bank agrees, the sale takes place and the bank realizes a $10,000 loss vs. what would likely be a much higher loss if it went into foreclosure. The $10,000 is not typically forgiven but instead remains as a debt of the builder who would much prefer to pay interest on $10,000 than on $200,000.

What is “Mark-to-Market”?

Here is a link that will tell you about this concept: http://en.wikipedia.org/wiki/Mark-to-market

In short it simply means listing assets (“marking” them) on your balance sheet at their current market value. The alternative is to hold them at cost or a previously appraised value. There are arguments on both sides but very few argue with the logic of mark-to-market in general…….how can you argue that companies should list assets at anything other than their market value? This is not the real question though…….. the real question is how strict to get with the application of this principle. Those against a strict application of MTM would say that if you have what is likely a short-term downward blip in the real estate market and you force banks to mark their assets down this will punish banks in an unnecessarily punitive fashion and one that does not reflect reality, at least for many banks. This argument is very logical too.  The challenge is in finding a new standard (modified MTM) that can be applied across all banks that is both fair and reasonably reflects the reality of their particular situation.  This is a very high bar to clear so the default is to maintain the status quo which is a strict adherence to MTM.

Why Aren’t Banks Lending???

One of the questions I hear a lot these days relates to why banks are not lending, especially when there are plenty of qualified borrowers out there who need loans (which there are). For most banks the reason is a capital shortfall driven by the ailing residential real estate market. Below is a simple example to explain this. As with my other posts this is an over-simplified example that is only designed to explain a concept and not qualify you for an advanced degree of some sort.

The fictional bank I will use as an example is called “Startup Bank” that opened its doors in 2005. I don’t think there are actually any banks that have that name but if there are this is not intended to describe that bank or any other bank; it is just a random name I picked.

Startup Bank raised $10M in equity capital from various investors. Generally, the regulations allow banks to lend 10 times the amount of capital they hold so, in this case, Startup Bank could lend up to $100 Million. In order to keep this simple, assume capital remains exactly the same throughout this entire example at $10 Million and that the maximum amount Startup can have in outstanding loans is $100 Million.

Startup Bank had a great first year in 2005 and loaned $50 Million, or half of its maximum amount. Startup generated another $50 Million of loans in 2006 to reach $100 million in total. At this point the bank could not make new loans unless existing loans paid off or unless they raised additional capital but they were pleased because they made so many new loans so quickly.

50% of Startup’s $100 million in loans were to businesses & individuals and the other 50% of their loans were related to the residential real estate market which includes land acquisition, lot development (streets, curbs, water, sewer, etc.), and construction of new homes. As of late 2006, all loans were paying as agreed and Startup Bank felt well secured, especially on their residential real estate loans because house values had continued to rise for so many years in a row.

By early 2007 Startup started seeing some trouble developing in their residential loans – small at first but getting much more troublesome as 2007 wore on. Houses were selling much less quickly which, in turn, meant developed lots weren’t selling and, of course, that meant sales of undeveloped land stagnated too. All of this was caused by the collapse of the securitized debt market which I covered in previous posts (Sub-Prime Primer Parts I and II).

Without sufficient levels of sales in land, lots, and houses, Startup Bank’s borrowers started to face financial difficulties. At first, some of the borrowers tried laying off part of their staff and started using savings they had been able to accumulate during the residential boom years………but for many the slowdown lasted too long and they allowed their assets to go into foreclosure. As more and more borrowers did so Startup Bank began realizing losses on these loans.

By late 2007, $90 million of Startup’s loans were still paying as agreed but $10 million had gone into foreclosure.  Startup was afraid that the market would continue dropping (which it did) and decided to sell the foreclosed assets for a deeply discounted price of $6 million and booked a loss on these loans of $4 million ($10 million loaned out minus $6 million received from the sale of assets).

This loss of $4 million was deducted directly from capital which was then reduced from $10 million to $6 million. As a result, the maximum amount of outstanding loans was decreased from $100 million down to $60 million. The problem was that they still had $90 million in outstanding loans ($30 million more than allowed) and Startup was then classified as severely “undercapitalized”, a classification that bears many problems including dramatically increased funding costs, intense regulatory scrutiny, and bad PR that can lead to many depositors withdrawing their funds. Startup Bank needed to return to a status of “adequately capitalized” or “well capitalized” in order to have any chance of survival. In order to do so they had two choices:

1) Raise additional capital of $3 million. Probability: Low. It is very difficult to raise equity capital from individuals that either don’t have funds to invest (due to other investment losses at that time) or, if they have the funds, don’t want to invest in a highly uncertain banking market without some significant return – a return so high that the bank is unwilling to pay it.

2) Reduce loans from $90 million down to $60 million. Probability: Extremely Low (at least in the short-term). The average borrowing client would respond very poorly if the bank approached them and asked them to pay their loan off early. It is simply not feasible for most borrowers.

[Note: there is a third way to improve equity which is through retained earnings, meaning that the bank keeps profits in-house vs. paying them out in dividends.  The problem is that very few banks are making profits right now because of the current interest rate environment, which I'll write about later.  So earning your way back to health is not likely for banks these days.]

With a $3 million capital shortfall and very poor prospects for quickly returning to an acceptable level of capitalization, Startup Bank was in a very precarious situation. The FDIC (which insures Startup’s deposits) took a keen interest in the bank because they believed Startup’s problems were even deeper than reported. Compounding the drama, the rate at which Startup borrowed from other banks to support operations skyrocketed since they were undercapitalized. Additionally, borrowers started pulling deposits at an alarming rate as word got out that the bank was facing financial difficulties. Startup was forced to increase depository rates in an attempt to save the deposits they had but this further reduced the bank’s profitability (or created a larger loss).

The problems with the FDIC, increased borrowing rates, and loss of deposits all stemmed from Startup’s deficient capital position. At this point, they realized that attempting to make additional loans would only compound the problem, like tossing gasoline on a fire, and Startup’s leadership decided to at least temporarily stop making new loans.

That, in a nutshell, is why banks are not lending. Startup is an example of a very small bank but the same concepts apply to the largest financial institutions too. Simply multiply the numbers above by a few thousand and replace “residential real estate” with “derivatives” (See Sub-Prime Primer I & II).

So what were the TARP funds used for if not to allow/encourage banks to lend again? In the case of some banks lending has restarted but in others, even billions of TARP funding hasn’t returned certain banks back to an adequately capitalized position……..yes, really. Additionally, most banks have not received TARP funding for one reason or another (e.g. in Georgia only 7 banks have received TARP funds to date). That does not mean that these banks will necessarily fail.  Likewise, all banks that have received TARP funding don’t necessarily have bright futures.

Until a bank’s capital position is restored to at least “adequate”, if not “well capitalized”, they are unlikely to begin lending again.  And it will be a long road for banks for the foreseeable future with only the three ways mentioned above to improve their capital position, none of which seem very likely right now.

Sub-Prime Primer (Part II)

[Read previous post "Subprime Primer I" below first]

OK, so where did we leave off in Part I………lots of factors contributing the “fertile soil” into which the seeds of the credit crisis were planted; mortgages being bundled into MBOs…………that’s a good place to pick back up.

After the bundling process creates an MBO these securities are sold to various large institutional buyers including pension funds, mutual funds, sovereign funds (owned by countries that have excess cash flow, unlike the U.S.), and municipalities that are looking for safe investments.  And they did appear to be safe because they had solid ratings from the rating agencies like S&P.

With more and more pressure to encourage the huge money-making machine that the securitized debt market had become, two important changes occurred that heavily contributed to the Credit Crisis that began in 2007 and the collapse of Wall Street in 2008………

Change #1:  Sub-Prime Mortgages

When mortgage securitizations were first introduced (late 60’s/early 70’s) investors bought generally homogeneous portfolios of mortgages…….similar credit profile, income, liquidity.  The homogeneous portfolios would be rated by S&P just like they were being rated at the height of the sub-prime mortgage market.

The HUGE difference was that the early portfolios contained only borrowers with reasonably strong (and documented) credit, liquidity, and income.  Sub-Prime and no-doc mortgages had not been invented and investors experienced a very predictable and consistent return on these portfolios of relatively homogeneous mortgages.  MBOs built a strong reputation as safe havens, especially for investors concerned first and foremost with safety-of-principle.

For the sake of argument assume S&P rated one of these portfolios an “A+” and that this rating correlated to an expected loss of investment only one out of ten thousand times — almost risk-less.  People very rarely missed their mortgage payments because didn’t want to lose their home, especially since home equity was the primary method of “saving” for most people.  And home prices had gone up relatively consistently for many years with few exceptions.  Seemingly, almost everyone agreed that for all these reasons MBOs were indeed almost risk-less investments, until…………the introduction of sub-prime (SP) mortgages.

The original sub-prime mortgages offered were actually considered a success……..Fannie & Freddie took a baby step out of the risk continuum by slightly lowering credit standards and increasing borrowing rates by a small amount for sub-prime mortgages.

[Side Note:  If Fannie Mae charged an extra 1% for a sub-prime loan they would get far more than an additional 1% in revenues.  Here's why in an overly-simplified example..........Assume Fannie and Freddie received a margin of 1% for packaging and selling MBOs.  If they then increased rates by 1% for sub-prime mortgages, to account for the additional risk, they would increase their margin from 1% to 2% -- increasing revenues by 100% (again, this is a very over-simplified example).  Don't worry about the math -- just focus on the fact that a small increase in rate can lead to a huge increase in revenues.]

Initial payment records were strong as were margins.  Fannie & Freddie were happy, investors were happy, mortgage companies & banks were happy, and the new mortgagees were glad to be approved, even at a higher rate.  So what happened????????

What happened next will be the focus of many books in years to come.  Many explanations will be offered but here is what everyone will likely agree on………..everyone got greedy from Fannie & Freddie to banks & mortgage companies to Wall Street giants.  The only way to feed this insatiable greed was to continue to increase the pool of mortgagees and the only way to do that was to lower approval standards again and again.  Eventually, terms like “no-doc”, “low-doc”, and “stated income” were part of our everyday language.  Borrowers with little or no income could say they had strong income and the mortgage originator would put that on the application without being required to verify it, as they would have been in the past.

Note on size of SP market:  Experts differ on the actual size of the sub-prime market at the peak but most estimate it around $1 Trillion +/- $300 Billion.  For the purposes of this post just focus on the scale in comparison to the estimated worldwide assets values and don’t get too caught up on whether it was $800 Billion or $1 Trillion.  For the purposes of this post I’m using $1 Trillion, which is probably not an exaggeration since there were over $600 Billion of SP mortgages originated in 2006 alone (various sources………type “size of subprime market” into your web browser to find more information).

And so the sub-prime mortgage market ballooned to an estimated $1 Trillion by 2007.  However, even a 100% failure of every single SP mortgage would not have been enough to trigger the worldwide credit crisis and the death of Wall Street.  Even though $1 Trillion is a huge number, at the same point in time, worldwide asset values were estimated at well over $100 Trillion – over $50 Trillion in the U.S. alone (again, various sources…….Google the key words).  Sub-Prime represented less than one percent of world-wide assets and even if every single SP mortgage was worthless it would not have been a catastrophe in and of itself.  But here is where it gets really interesting…………… 

Change #2:  Derivatives (MBOs, CDOs, CDS, synthetics) and Leverage

Again, many books will be written on this topic in coming years but I’ll try to keep this as simple as possible………….

It turns out that there was MUCH more demand for sub-prime MBOs than there was supply because the return on investment (ROI) for subprime MBOs was higher than traditional MBOs because the risk was higher.  For you statisticians & MBA’s out there, you are probably screaming at your monitor that the risk-adjusted ROI was much more modest……..and you are 100% correct but the concept of adjusting for risk seemed to be thrown out the window somewhere in the mid-2000’s, in large part because so many people believed that “real estate always increases in value” (how many times did you hear that?).

So the risk-ignoring MBO investors demanded ever-increasing amounts of these higher-yielding subprime MBOs but there was a limiting factor………the number of MBOs you can sell is (or was) limited to the number of actual mortgages  that were available to be bundled.  And everyone knows that you can’t just artificially create new mortgages or new MBOs……..or can you?  The answer is actually yes and no……..No, you can’t generate a new MBO out of thin air but, yes, you can synthesize all of an MBO’s characteristics and that is exactly what happened.  Here’s how………..

Around 2004/2005, some very creative individuals on Wall Street invented a security with the same profile (risk & return) of other MBO portfolios that were in such high demand.  This new derivative was known as a Synthetic Collateralized Debt Obligation and, as the name implies, it synthesizes or mimics the risk profile of something else — in this case an MBO.  There was only one problem……….taking on the risk is only half of the equation.  The party taking on that risk wants to be compensated for doing so but who would pay them to take this risk and what would they require in return for this payment?  It turns out that there were actually two groups who were willing to do so……..

Around 2005 certain people started believing that the mortgage market, especially sub-prime, was a house of cards, which it turned out to be.  These individuals wanted to, in effect, bet against what they thought were bad MBO’s (we’ll call these the “doubters”).  Additionally, some who owned MBOs wanted to hedge against default risk in their own portfolios of mortgages (we’ll call these “investors”).

 

So the doubters and the investors both needed a mechanism that would provide what each was seeking (one wanted to place a bet and the other needed a hedge) and they both found it in the form of a derivative known as a Credit Default Swap (CDS).  In simple terms, a CDS is an insurance policy offered by a Synthetic CDO in exchange for premiums that compensate them for taking on the risk of that insurance.  The buyer of the CDS is betting against a “reference” asset (a real MBO with a risk profile & yield attractive to the Synthetic CDO investors).  They pay a premium to place this bet and if the underlying MBO portfolio fails they receive a large payoff.  If the MBO succeeds, the Synthetic CDO keeps all of the premiums and the CDS contract expires.

Don’t worry if that last paragraph sounded like Greek to you – it does upon first reading to many.  You can read up on Credit Default Swaps and Synthetic CDOs later but for now just think of it this way………a CDS is essentially a bet against an MBO (betting that it will default beyond some level) and a Synthetic CDO is then a bet against that bet.

You’ve probably figured out by now that there is not really anything backing up a Synthetic CDO.  Its success or failure is tied directly to a reference MBO which has actual assets (houses) backing it up but the Synthetic CDO does not have anything directly supporting it.  The problem of course is that if the underlying assets in the MBO fail (e.g. sub-prime mortgage meltdown) then both the MBO and the Synthetic CDO fail — the MBO would experience far greater than expected losses and the Synthetic CDO would have to make a large payout to the Credit Default Swap buyer.

At first this was still a relatively small percentage of the debt market but then it got out of hand and the death knell of Wall Street was sounded……the betting continued until the machine overheated and blew up.  At the same point in 2007 when there were an estimated $1 Trillion in sub-prime mortgages there were $60 Trillion in synthetic CDOs– all betting that the underlying mortgages were stable & solid (at least to a certain degree).  When the sub-prime market crashed so did the synthetic CDOs (the associated bets for them to succeed) – TIMES 60!

As the reference MBOs started defaulting so did the associated Synthetic CDOs, resulting in Credit Default Swap claims in numbers far greater than virtually anyone expected.  And who was liable for paying off the Credit Default Swaps?……….In large part, it was the big brokerage firms and insurers like AIG, Bear Stearns, Lehman Brothers, Merrill Lynch and others.  None of these firms had (or have) anywhere near the capital necessary to pay off the trillions of dollars in bad bets and so the collapse of Wall Street ensued.

Now you know what caused the credit crisis.  So what’s next?  Honestly, there are many more questions that answers but, in my opinion, we’re headed for a completely changed economic paradigm — how can we not be?  I’m not 100% sure what that paradigm will look like but there will likely be much less leverage overall and we are likely to see lower levels of both economic growth and profit as a result.  The new “normal” will likely feel much different and that is an important starting point.  Those who thrive in this changed world will be those who first recognize that things are different and make their decisions based on this new paradigm — not those who bet on returning to the old “normal” of the past decade.  Stay tuned…………

If you have another 30-45 mins to kill click on the link below and read something that will make your head spin:

http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom

Sub-Prime Primer (Part I)

The following is a surface-level explanation of  several key market and political forces that conspired to create the fertile soil into which the seeds of the sub-prime mortgage market and subsequent credit crisis were planted.   Several links to other articles/wikis are provided if you would like to learn more.

 

[Note: Wikipedia is provided as a reference source for three of the items below.  The content of Wikipedia is provided by various individuals that collaborate on a given entry.  The site attempts to limit inaccurate or politically-motivated entries but is not always successful at doing so.]

 

1) Going back to the early part of the 20^th century banks were engaging in a practice known as “red-lining”, which was the practice of denying or increasing the cost of certain services including banking to certain geographic areas, often on the basis of the racial makeup of those areas.  This limited the capital flowing into these areas, often keeping them in a blighted situation.  http://en.wikipedia.org/wiki/Redlining.

 

2) In the late 1960’s, Fannie Mae and Freddie Mac were created by Congress to help provide liquidity for the mortgage market.  Prior to this time, banks primarily kept mortgages and other loan on their own books and they were limited by the amount of deposits available to lend.  As a result banks were often unable to fill all of the demand for credit in their markets, even for well qualified borrowers.  Fannie and Freddie provided liquidity to these banks by buying these mortgages, bundling them, and selling them.  These bundles of mortgages are known as Mortgage Backed Obligations (MBOs).  An MBO is one large security made up of thousands of mortgages that is typically purchased by an institutional buyer – for example, pension funds or mutual funds.  The buyer acquires the stream of cash flow generated by all of the monthly mortgage payments associated with the individual mortgages in a particular bundle.  With the new liquidity that was provided by Fannie and Freddie, banks could then continue to originate new loans.  http://en.wikipedia.org/wiki/Fannie

 

3) In an effort to end redlining and provide certain geographic areas with better access to credit, the Community Reinvestment Act was passed by Congress and signed into law in 1977 by Jimmy Carter.  Six major legislative changes were enacted over the next three decades.  The original intent of the act was to prohibit lenders from denying loans to creditworthy borrowers just because they lived in a certain part of a city (the previously redlined areas).  The legislative changes that followed increasingly put pressure on lenders to proactively attempt to lend into these areas — literally to go into these markets and find the opportunities.  Banks that didn’t comply were hit with penalties including a prohibition against opening new branches until they were deemed to be in compliance.  http://en.wikipedia.org/wiki/Community_reinvestment

 

4) In the late 1990’s the Clinton Administration, banks, mortgage companies, and stockholders were all pressuring Fannie Mae to “ease credit”, meaning to lower their lending standards – all for different reasons but all self-serving.  Very few were opposed to doing so, although there were some clear warning signs in the following article going back as far as 1999:

http://query.nytimes.com/gst/fullpage.html?res=9C0DE7DB153EF933A0575AC0A96F958260

 

All of these factors and many more combined to create the fertile soil into which the seeds of the credit crisis were planted.  I will follow up in Part II to describe what came next in more detail but the following is a simplified version of how it started unraveling.

 

As Fannie and Freddie eased their credit standards slightly (at first) an entirely new group of individuals qualified for mortgages.  This increased the demand for housing, primarily at the lower end of the market which in turn drove prices higher.  With newly found equity, many owners of these houses, selling to newly-qualified mortgagees, took this increased equity and bought houses in the next price range higher.  This process continued right up the line and drove housing prices higher in every price range.

 

The result:  a historic level of new mortgage activity……..newly qualified mortgagees plus all of the new mortgages for upgraders.  Everyone was ecstatic and everyone was a big winner – new home buyers, mortgage companies, banks, stockholders, politicians, real estate attorneys, and every household that now had surprisingly high levels of equity.

 

The mortgage market (everyone involved in the process from origination to MBO packaging to selling in the secondary market) was addicted to this huge level of activity and did everything it could to keep the good times rolling.  At a certain point it became obvious that it couldn’t keep rolling forever, unless…………unless we lower the credit standards even more.  Who needs income verification?  For that matter who needs any documentation at all?  Home prices will always keep rising, right?  So what is the real risk?  This type of thinking attracted even more borrowers to the market and artificially kept the party going well past what should have been its rightful end.

 

So what did cause the party to come to an end???  Again, I’ll go into more detail in a later in Part II but the simplified version is that certain bundles of mortgages started showing very poor results.  This was a natural result of going out too far on the limb with increasingly unqualified borrowers – it is exhilarating to go farther and farther out until the limb finally breaks, which is exactly what happened in mid-2007.

 

Certain MBOs, even ones that were strongly rated by rating agencies began producing losses much higher than projected (i.e. far more individuals than expected stopped paying their mortgages) leading to huge losses for the institutional buyers who then called for a time-out and stopped their funding of the MBO market.

 

Continued in Part II………………..