{"id":408927,"date":"2010-03-09T14:22:35","date_gmt":"2010-03-09T19:22:35","guid":{"rendered":"tag:www.economist.com,21005272"},"modified":"2010-03-09T14:22:35","modified_gmt":"2010-03-09T19:22:35","slug":"stress-tests-underwater","status":"publish","type":"post","link":"https:\/\/mereja.media\/index\/408927","title":{"rendered":"Stress tests underwater"},"content":{"rendered":"

MIKE KONCZAL is a finance blogging machine, so I hesitate to disagree with him, but I think he may be off base in an argument he makes today<\/a>, declaring the government’s bank stress tests to be essentially bunk. He quotes from a letter from Congressman Barney Frank (emphasis Mr Konczal’s):<\/p>\n

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Many investors in first-lien mortgages have indicated that they are willing to accept the fact of significant losses on those investments in order to move on and use their money for other purposes, rather than having it locked in underwater mortgages with a high and growing likelihood of foreclosure. With the interests of homeowners and investors aligned in this way, it should follow that large numbers of principal-reduction modifications could be made relatively quickly. That is not happening. According to investors, Administration officials, and other experts I have consulted, holders of second-lien mortgages are now a principal obstacle to many modifications. The problem of second-lien mortgages standing in the way of successful principal reduction modifications has reached a critical stage and requires immediate attention from your institutions.<\/p>\n

Large numbers of these second liens have no real economic value \u2013 the first liens are well underwater, and the prospect for any real return on the seconds is negligible.<\/strong> Yet because accounting rules allow holders of these seconds to carry the loans at artificially high values, many refuse to acknowledge the losses and write down the loans, which would allow willing first lien holders to reduce principal and keep borrowers in their homes.<\/p>\n<\/blockquote>\n

Many borrowers purchased homes during the boom while putting almost no money down. But you can’t get a conventional and cheap loan for 100% of a property’s value, so those borrowers would typically take out one big mortgage covering about 80% of the purchase price and then a second mortgage covering 20%. Other homeowners purchased a home with one mortgage but subsequently took out a second, borrowing against their home equity. When the bubble popped, some homes lost 30% or 40% of their value (or more), which meant that even the first loan was underwater; sale of a home at market price wouldn’t cover either of the loans on the property.<\/p>\n

This becomes a huge problem when homeowners face difficulties making payments and seek a mortgage modification. Holders of second liens are able to veto many mortgage modification agreements, and they’re willing to do so given the significant loss they’re likely to take from a modification. As Mr Frank says, second loans on massively underwater homes are nearly worthless.<\/p>\n

Mr Konczal then goes through work he previously did closely examining bank stress tests and explains that the four largest American banks held about $477 billion in second lien mortages on their books, with an expected loss ratio of something like 13%. He writes:<\/p>\n

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So the original loss from second-liens, as reported by the stress tests, was $68.4 billion for the four largest banks. If you look at those numbers again, and assume a loss of 40% to 60%, numbers that are not absurd by any means, you suddenly are talking a loss of between $190 billion and $285 billion. Which means if the stress tests were done with terrible 2nd lien performance in mind, there would have been an extra $150 billion dollar hole in the balance sheet of the four largest banks. Major action would have been taken against the four largest banks if this was the case.<\/p>\n<\/blockquote>\n

And, he adds, this places the government in a bind. If it forces banks to write down worthless second mortgages to clear the way for new modifications, then the banks suddenly look shaky again. If it doesn’t, then lots of homeowners are stuck in loans they can’t modify and may not be able to afford.<\/p>\n

I think that he may be overstating the potential pain to banks, however. It is the case that troubled borrowers are very likely to have second liens. But is it the case that second liens are likely to belong to troubled borrowers?<\/p>\n

We see that the four big banks hold $477 billion in second lien mortgages. Losses on those mortgages attached to underwater properties with borrowers seeking modifications are likely to be very high\u2014significantly higher than 13%. But 75% of mortgage borrowers in America are not<\/em> underwater. We would expect second liens to be far less common among borrowers with positive equity, but because there are so many more borrowers with positive equity, it’s not at all clear that most second liens fall into the category Mr Frank describes. And of those homeowners who are underwater and have second liens, not all need a modification. And so I think it’s tricky to assume that losses on these loans are much higher than has been reported.<\/p>\n

It would be interesting to know what assumptions the government made about the distribution of second liens when conducting the stress tests. If they believed that most of these mortgages were on properties that were deep underwater, then certainly the loss ratios were understated. But I don’t think we can conclude that from the data we have in hand.<\/p>\n

The other thing to note is that home prices have performed<\/a> well above both the baseline and the adverse scenario in the stress tests, which suggests that some of the expected losses from first loans haven’t materialised, creating room on bank balance sheets to absorb greater than expected losses on second liens.<\/p>\n","protected":false},"excerpt":{"rendered":"

MIKE KONCZAL is a finance blogging machine, so I hesitate to disagree with him, but I think he may be off base in an argument he makes today, declaring the government’s bank stress tests to be essentially bunk. He quotes from a letter from Congressman Barney Frank (emphasis Mr Konczal’s): Many investors in first-lien mortgages […]<\/p>\n","protected":false},"author":4534,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[7],"tags":[],"class_list":["post-408927","post","type-post","status-publish","format-standard","hentry","category-news"],"_links":{"self":[{"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/posts\/408927","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/users\/4534"}],"replies":[{"embeddable":true,"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/comments?post=408927"}],"version-history":[{"count":0,"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/posts\/408927\/revisions"}],"wp:attachment":[{"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/media?parent=408927"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/categories?post=408927"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/tags?post=408927"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}