THE MARKETS ARE FROZEN

The credit markets are frozen. The Real Estate values are in free fall. The banks will not lend. Loan officers are trying to explain to borrowers why they qualified before, but not anymore and there’s been a financial crisis. 

How did we get here and what does it mean? There’s no shortage of misinformation out there and certainly a lot of confusion. It’s been said right now that if you’re not confused, well then you’re not thinking clearly. Many clients have asked me to offer my opinion on how we got here and why … so here it is:

My experience originating loans since 1980 and through the S & L crisis has allowed me to observe and compare the thoughts of others with my own observations, and offer some explanations, opinions, and predictions. 

Let me first say that while “Wall Street” is the easy and popular target these days, I hesitate to be so fast to blame a street. It is true that during the S & L crisis, the loans were at least easy to find before the days of mortgage backed securities, derivatives and the like.

IT WAS AN ACCOUNTING PROBLEM

But let's take a few minutes and unpack this. Let's understand what has happened and why, because many people think it was a real estate problem, a mortgage problem, but the truth of it is … it was an accounting problem. 

How did this all occur? The situation with the mortgage market was a catalyst, which then helped real estate prices come down. When that happened, the underlying problem was exposed. The real problem (my opinion) was the accounting problem. Now, when did this all start? 

Interestingly enough it started when stock prices declined precipitously during the crash between 2000 and 2002. When that happened, when peoples’ retirement accounts were wiped out, when people saw their life savings gone, they were angry. When the Enron’s of the world and the Arthur Andersons were found to have done some things that weren’t necessarily the right thing to do, people got real angry. 

You see, many companies were not required to have full disclosure. There wasn’t a lot of transparency. Some of the share accounts may not have really given the full picture on the assets and the value that those companies had, so when they evaporated into thin air, and along with it their stock price, once again people got hurt. 

So, a few congressmen got together. Two of them in particular, Sarbanes and Oxley, proposed a bill, which passed, called the Sarbanes-Oxley Act. This new federal law required more transparency, more disclosure and created some stiff penalties that had never been seen before. A CEO could go to jail. A CFO could go to jail. People who were involved with taking care of the books could go to jail; not just for knowingly doing something wrong but also for things they “should have known”. Even if you didn’t know it…. you should have known. (Pretty serious stuff)

When something like that happens, it certainly grabs your attention. As this was proposed to congress, who in the world wasn’t going to vote for something like this? Who would not want more transparency? Who would vote against everything that was going on there and say, “No, I’m not going to vote against things that created, or I’m going to vote against something that created Enron or all these other issues that created the stock market and dot com bubble”. 

Nobody wanted to do that and they rushed to pass the Sarbanes-Oxley Act. The Act had good intentions but, like many problems, if it’s broken, you don’t just fix it you over-fix it. Unfortunately, this got over-fixed and when it got over-fixed, the transparency became just a little bit too much. (Obtrusive)

Just like when the tide is in, it doesn’t expose too much … but when the tide is out, you see the real underlying problems. The tide going out … that was the real estate market. 

You see, the real estate market had made up for a lot of mistakes, mistakes that were created by a lot of over-aggressive mortgage products, 580 FICOs, no income, hundred LTV loans, etc. The results of those obviously were not going to be very good in the long run. But with the hot real estate market, people simply sold their homes and it kept up this façade … you know the musical chairs kept going but once the music stops, once real estate prices started to slow down, all these problems became exposed. Foreclosures went up, real estate values started coming down, and here’s where we get into the issue!

SARBANES-OXLEY FASB 157 (MARK-TO-MARKET) 

Here’s where we get into the problem. You see, part of Sarbanes-Oxley is accounting rule (FASB accounting rule) 157, which is something that you may have heard called mark-to-market. 

What does mark-to-market mean? This means that you have to take your assets and even if you don’t sell them, you have to value them according to what the current prices of the market are. Of course, you want to take the conservative approach because you don’t want to go to jail. 

Let’s just pick some numbers here … let’s just say you lived in a home worth $600,000 and that your neighborhood was all homes worth $600,000. Suddenly, heaven forbid, your neighbor had to sell their home within 30 days because they had to raise cash, they were desperate, maybe a terminal illness in the family. Something wrong but they had to do this, so they were forced to sell and they had to sell (obviously a fire sale) under distress for $500,000. Does that mean that your home is now worth $500,000? Of course not. Maybe your home drops a little in price but if you don’t have to sell your home in 30 days, buyers aren’t going to come in and smell that fear. You can take your time and get a reasonable price for your home. However, if you were subject to FASB 157, mark-to-market, you’d have to say that your home is now worth $500,000 and therein lays the problem because this is how our banking system works. Let me address that. 

OPEN A BANK AS AN EXAMPLE

Let's say you and I decide to open a bank. We are able to raise 2 million dollars. That’s our capital. We have capital of 2 million dollars. So what does a bank do? Well we all know what banks do. They take in deposits (other people’s money) and then they take those deposits and lend them back out. They pay interest at a lower rate, they loan it out at a higher rate and they make the spread. That’s how banks profit. It’s not a very complicated formula. We all know how this works. Banks don’t lend their own money, they take depositors’ money and lend that same money back out. Pay a low rate of interest. Gain a high rate of interest. And if we did that, we could say, “Hey deposit money with us we’ll give you a toaster whenever we take in 30 million dollars”. We then loan that money back out. We make loans with it. Our ratio of loans to capital is 30 million dollars in loans to 2 million dollars in capital. (30 to 2 or 15 to 1). Now 15 to 1 is fine, that’s acceptable. Fifteen or 16 to 1 is where most banks are if they’re healthy. And you and I … we’re pleased about this. 

We’re making money on the spread. We decide to make our loans very cautiously.

We make a minimum of a 30% down payment or 70% loan to value, we decide we want all our borrowers to verify their income and we keep their ratios very low. In other words, no more than 10% of their income goes towards their mortgage payment, which is very conservative. Typically you can qualify with 28 or 30% or maybe even a little higher, but we limit it to 10% of your income to be really safe. And, we want everybody with the very highest credit rating. Let's say at 780 where 850 is the maximum credit rating, we want a 790 minimum credit score. And we do very well with this. Our borrowers pay us early; they send us holiday greeting cards. They’re terrific and we are very pleased with the way things are going. Our board meetings are a breeze. We look at our profits: there are no losses, no bad loans. Everything looks great. And if we’re a publicly traded company… well then our stock prices are going up, up, up and everybody’s happy. 

It’s wonderful. UNTIL... we have to, according to FASB 157, mark our assets to market. As real estate values start to decline, the loans in our portfolio, although they’re performing beautifully, now have to be reassessed. Why? Because our loans are a 70% loan to value, which is a 30% down payment from the borrower. However, if home prices decline, maybe they, because of a lower home price, are now a 90% loan to value. Well what’s more desirous … 70% or 90% loan to value if you’re the lender? It’s safer to have a 70%. Therefore, if that’s changed to a 90%, we’ve lost some value. 

And again, just to pick some numbers here, let’s say maybe that means that our portfolio, which is 30 million dollars worth of loans, if we were to sell it we could sell it for 29 million. So we’ve lost some money. How do we account for that? We haven’t sold the loans, so we didn’t physically take the loss. We aren’t suffering from payments not being made, so what happens here? We have a paper loss of a million dollars that we are now required to take because of mark-to-market accounting. 

Where would we take that million-dollar loss? We’d take it against our capital. So we had 2 million dollars worth of capital and then we’ve got a 1 million dollar paper loss. That means our capital is now 1 million dollars. We still have 30 million dollars in loans outstanding, on a million dollar’s worth of capital. What’s our ratio now? It’s 30 to 1. Wow! Alarms start going off. There’s huge concern. The FDIC is at our door. We’ve got big problems. We’re now on the FDIC watch list because we’ve got a 30 to 1 ratio and our stock price starts to get hit. We can’t borrow money anymore. Our depositors don’t want to put their money with us and they don’t trust us anymore. We see our stock going down, down, down and then activity from opportunistic shorters in the market come in and drive our stock price even further. We’re in trouble!!!

WE ARE OVER-LEVERAGED

Our problem is, and you may have heard this term, there’s too much leverage. We are over-leveraged. A million dollar capital with 30 million dollars worth of loans is a 30 to 1 ratio. 

Now you and I, we’ve had a great bank all along. We haven’t made a bad loan, we’ve been very, very careful; we’ve been very profitable. And still, none of our loans are late, none of our loans are in foreclosure, all of our loans are performing beautifully. But because of this mark-to-market accounting, our world has dramatically changed. 

And this is what many institutions have gone through. Fundamentally and financially sound institutions, because of a simple accounting rule, now find themselves in a lot of stress and forced to de-lever. That’s the only way out of this. How do we de-lever? There are only 2 things you can do: 

1) Increase capital

or 

2) Sell off loans, reduce the exposure. 

If we try to increase capital, who the heck is going to lend us money? Who’s going to invest with us? We’re in trouble; we’re on the FDIC watch list and our stock is getting killed. We’re no longer a very desirable target to invest money with. So we can't do that. 

What’s our only other alternative? Our other alternative is to sell off loans. And as we start to do that, we take greater and greater losses. Why? Because there’s not a good market for it right now and we are under duress so we’re selling very cheaply. When we do that, we now have to take more losses, which reduces capital further and compounds the problem even more. Like a toilet bowl flushing, our bank is circling the drain… going down the tubes. This is what we’ve seen happen to many institutions and it happens so quickly. 

Now think about this; put your thinking cap on for a minute … as we sell some of these loans and attempt to de-lever at fire sale prices, essentially what we’re doing is we’re hurting other institutions because as we sell at fire sale prices, those other institutions, because of mark-to-market accounting, have to reduce their assets accordingly or go to jail. 

That now compounds their problem, because they have to take that hit against capital and they have to de-lever. You know if I came to you in a board meeting and said, ‘Hey I’ve got a great deal for us. I really think this is super; think about this … we have an opportunity to purchase a million dollars worth of loans for $600,000. Now how about the quality of these? They’ve never been late, they’re all 790 fico scores, they’ve all got a maximum ratio of 10% of the income handling the monthly payment, the percent of loan to value is 50% (in other words you’ve got 50% equity in the home), again, never been late with a payment. These are crème de la crème loans. These are the most desirable loans out there and we can get a basket of a million dollars worth of these for $600,000. Now if you think about it, how long does a mortgage loan last? Well even if it’s a 30-year loan, people do refinance, in fact I am working on many of your refinances now! People do move.

On average it will probably pay off within 7 years. So 7 years from now we’ll get our money back but we don’t just get our money back we get a million dollars back on a $600,000 investment. That’s a 67% rate of return over 7 years. Not so bad. But wait a minute. We get interest on this don’t we? Let's just say these loans were paying 6%. Well that 6% was on a million dollars. On our investment of $600,000, that’s 10%. So we get cream of the crop loans at a 10% rate of interest and a 67% kicker at the back end. 

This deal’s too good to be true. We have to do it, right?’ Now what if we did do that transaction, but then, because of mark-to-market accounting, we were forced to sell assets. The assets that you’re forced to sell are the good ones, not the bad ones, because they’re the ones with value. You see the problem with banks is that they can't get from point A to point B. This scenario is exactly what happened to Merrill Lynch, Lehman, Wachovia, and WAMU, and why they pretty much all went under. 

Some were thrown a lifeline at the last minute (in the case of Merrill by Bank of America), but these proud institutions had no choice. They made a purchase, billions of dollars worth of loans worth 60 cents on the dollar in a similar scenario, great quality loans.

FORCED TO SELL GOOD ASSETS 

The problem was that they couldn’t get from point A to point B and they were forced to sell these good assets. But they had to sell these assets in a market where there are no buyers, so they had to sell them, not at the 60 cents on the dollar that they bought them, but 22 cents on the dollar for these great assets. But here’s the real kicker. You knew that they had to hold paper on 75% of it. In other words they only got 5 and 1/2 cents on the dollar and held 16 and 1/2 cents on a great asset. 

Times are tough out there. And this is why Merrill Lynch had its difficulties and why there is no longer a Merrill Lynch, why there’s no longer Lehman Brothers, why AIG had to get bought out, why Indie Mac Bank was seized, and the list goes on and on and on. 

The sad prediction that I have to report is that we are not done yet! The banks like Bank of America who purchased Merrill now have to digest the purchase. Going forward, they are going to feel a little like me after a big Sunday night dinner looking for the Tums!

THERE WILL BE MORE CASUALTIES

There will probably be more casualties there. 

So, in steps the Feds with a multi billion dollar rescue package. There is no shortage of misinformation here too because the media got it wrong. A lot of people who don’t understand say, “Oh it’s a rescue plan, it’s a bail out”. My opinion is that this is a very smart thing for the Feds to do. 

They had to do this to try and help unfreeze the credit markets. Let's think about what’s gone on here. The Feds step in and say ‘we’re going to give you 700 billion dollars to try and solve this problem, to try and de-lever’. They are not just going to take assets at top dollar. They want to create a marketplace. Maybe (hopefully) the Feds step in and buy assets at 60 cents on the dollar to help people sell off those into a market where there are some buyers. That helps financial institutions de-lever without having to go for broke and sell them at 22 cents on the dollar. Now, with the Feds buying them at 60 cents on the dollar, they can get from point A to point B. And, the Feds will make money on this deal. 

GOOD BANK BAD BANK

I saw this work during the S & L crisis when the Resolution Trust Corporation was established to purchase and hold assets so the banks could clear the balance sheets. They are now calling it in the media, "Good Bank, Bad Bank"

The Feds don’t have to mark-to-market and they have all the cash they can print. They’ll wind up buying at 60 cents on the dollar and redeeming just about all of it and gaining the interest in between. This is a smart move for the Feds; the Feds (you and me as taxpayers) can actually make money on this deal. But by the same token, they help create a marketplace. And think about it, when they create a marketplace, what happens is that the private sector comes back in and says, “Hey, maybe I’ll nibble on some mortgage assets as well”. 

They may consider this because … if I have to unload them, if I’m forced to sell them, I can sell them to the Feds because they’re a buyer at a reasonable price. So maybe I lose a little money but I don’t lose everything. Now the Feds also said they’ll take 9 lending institutions. What they’ll do is they’ll invest in some non-voting shares to help them raise capital.

Again, de-levering. Raise capital or you sell loans; the Feds help by doing both. This is a very smart thing for the Feds to do because it unfreezes the credit markets. It will take a little time for this to occur, but what the Feds are doing is absolutely brilliant. And we will see improvement; it just takes a little bit of time. 

Now let me talk about the 700 billion dollars because I’ve heard a lot of people say in the media, again no shortage of misinformation certainly there, “700 billion dollars isn’t enough because there’s a trillion dollars worth of sub-prime loans.” Well give these people a calculator because, there’s a trillion dollars worth of loans…. but are all of them going to be worthless? Do we think that everyone is going belly up? Well, even if every single sub-prime loan went into a foreclosure, what about the underlying value of real estate? 

If you wanted to really get ridiculous, let’s say every house was burned to the ground and there were no homes left. You’d still have the land value, and that’s worth 20-25%. So it’s silly to think trillions of dollars of sub-prime loans would be worthless. Let’s just say 15%, 20% went into foreclosure, (a very high number), and let’s say that the underlying assets dropped by 20%. You’ve still got an issue there, certainly, but maybe it’s 40 billion dollars or at worst, 50 billion dollars. Get crazy. The Feds say: we’re putting up 700 billion dollars, that’s more than enough to solve the problem. Yet people love to hype the headlines and don’t take the time to figure this out. Here’s my opportunity to set the record straight and explain (in my opinion) what is really is going on. 

KEEP OUR EYE ON THE BALL

My recently passed on father, James T. Learakos, told me in 2006 as I was preparing to take my wife and kids to Greece for a vacation, "Son, this party will end in another depression if we don't keep our eye on the ball". I told him he was crazy … things could not look better! Maybe a very small recession … but no way a depression!

His response was, "OK BOY". 

When I was kid, he would debate me. As an adult he would just say, “OK BOY” when he knew I was wrong.

Well my hope is still that he was wrong, but my fear is that he may be right if we don't get our facts straight and "keep our eye on the ball".