It’s going to be a big day for mortgage news today, so we thought we’d touch on a bit of background on the foreclosure issue. And shed some light on how foreclosures can lead to banks holding even more “toxic assets.”
People tend to speak in shorthand when talking about foreclosures—saying, for instance, that homeowners “hand the keys over to the bank.” But that’s not really what happens. And once you understand why that isn’t what happens, you can begin to understand how foreclosures can help banks cover up losses.
Foreclosure Is An Auction. When a borrower defaults on his home loan, a bank can force him to sell it at auction. The auctions are typically open to all comers. In theory, the auction process would establish a market price for a home that would allow banks to know exactly the recovery value on the loan. If an outside party bought the house from the auction, the bank would receive the proceeds and could write down any losses—the difference between the full value of the mortgage and the price paid at the auction.
How Banks Use Foreclosures To Put A Floor On Losses. Typically a bank will put in a bid on a foreclosed property in order to limit the losses on the loans. In a market where housing prices are going up or are expected to go up soon, this move makes sense. It allows banks to avoid a big loss on a temporary housing downturn. But if you are in an environment when house prices are in free fall with no bottom ahead, this winds up creating an artificially high price—and therefore conceals the actual losses a bank may suffer from the mortgage default.
Marking to Model, Still. But it’s far worse than banks just potentially overpaying for foreclosed homes. They may not only be overpaying. They may then be booking them at inflated prices.
Let’s take an example. Suppose a bank forecloses on a home purchased for $250,000 with a $200,000 mortgage outstanding. At auction, let’s say other bidders offer just $125,000 for the house and the bank buys the house for $175,000, taking a loss of $25,000 or 12.5%. Keep in mind that no money really changes hands. Basically, the bank buys the house and immediately pays itself back with the proceeds from the sale.
The bank has an asset—the house–that it now needs to price. It needs to decide if the house is worth $250,000, $200,000, $175,000 or $125,000. Which value does the bank get to use?
Since the asset was purchased in a distressed sale, the bank can use its financial models to figure out the worth of the house. These models are supposed to reflect outside markets but, as we’ve all learned, banks are very hesitant to truly book assets at market levels. One thing is almost certain, the bank won’t book it below the price they paid. In fact, it’s likely they will account for some additional recover—to say, $190,000—reducing their loss to just 5 per cent. On the books, the loan has a recovery value of 95 per cent.
Dropping Prices Mean Hidden Losses Mount. The bank’s purchase of the house may have put a floor on the immediate losses from the mortgage default but it doesn’t stop housing prices from dropping. If the housing market continues to deteriorate, the house now owned by the bank could be worth even less. The bank bought the house for $175K and booked it at $190K. But the market value of the house could be far less. If the value of the house drops to $150K, the bank is sitting on unrealized losses of 25% but has only booked a 5% loss.
How To Invent A Toxic Asset. Let’s conclude with the idea that this is exactly how a toxic asset is created. A bank buys something and books it at a value that winds up being far higher than the market value. It can’t sell the asset without realising horrific losses. Investors and creditors of the bank know that it is holding these things at far above their real value, however, and discount the credit worthiness and profitability of the bank accordingly.
Dislocation Ideology. All of this is made possible by one thing: an ideological conviction that the national housing slump should have been impossible and therefore that housing prices are sure to recover shortly. That’s what we call the “Dislocation Ideology”–the idea that housing markets are temporarily dislocated and will soon find themselves back on the old path onward and upward.
If a long term downturn were acknowledged, a conservative bank would avoid buying foreclosed houses and prefer to take the losses up-front, letting the outside buyers pick up the home and the downside risk of further price slides. But banks are still long housing, so they keep buying houses and booking them at inflated values.
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