THE MARKETS

So 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. 

Now how did we get there, 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 of 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 1st 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 where at least easy to find before the days of mortgage backed securities, derivatives and the like.

Now that the Obama administration has spoken with the largest “Bank Tax” ever levied against a segment of the market. It is clear that the large banks who took tarp funds will now be at competitive disadvantage moving forward.

Now more than ever, it is important for the borrowers to engage the services of a mortgage professional who can shop price. The feds have in effect “taken over” lending standards….so loan approval or decline will no longer vary from lender to lender. The Feds now own Fannie Mae and Freddie Mac and the control the insurance that allows FHA loans to be approved.

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… is it was an accounting problem. 

That’s interesting…. so how did this all occur? Well, the situation with the mortgage market was a catalyst, which then helped real estate prices come down and when that happened; that exposed the underlying problem, 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. And when that happened, when peoples’ retirement accounts were wiped out, when people saw their life savings gone, they were angry. And when the Enron’s of the world and the Arthur Andersons were found to have done some things necessarily that weren’t 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 share accounts may not have really given the full picture on the assets and the value that those companies had and when they evaporated into thin air, 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, they proposed a bill that which passed Sarbanes Oxley, which required more transparency, more disclosure and there was some stiff penalties there too; crazy penalties that had never been seen before. A CEO could go to jail, CFO could go to jail. People that were involved with taking care of the books could go to jail, pierce the corporate veil here not just for knowingly doing something wrong but how bout this, for “you should’ve known”. Even if you didn’t know it…. you should’ve known. Well, then you are going to potentially go to jail. (pretty serious stuff). 

Now 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 .com bubble”. Well no body wanted to do that and they rushed to pass the Sarbanes- Oxley bill, which had good intentions but unfortunately just like many problems, if its broken you don’t just fix it you over fix it. And this got over fixed and when it got over fixed, the transparency became just a little bit too much. (Obtrusive)

Just like when the tides in it doesn’t expose too much….but when the tides out, you see the real underlying problems. The tide coming 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 a lot by over-aggressive mortgage products, 580 ficos , no income, hundred LTV loans, oh what a big surprise that was a tough loan.

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!

Here’s were 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. So what is mark to market mean? This means that you have to take your assets and even if you don’t sell them, you have to take them and value them according to what the current prices of the market are and of course you want to take the conservative approach because you don’t want to go to jail. Now lets just pick some numbers here, lets just say if you lived in a home worth $600,000 and that was your neighborhood, your neighborhood was all homes worth $600,000 and 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. Well does that mean that your homes 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; you can 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 there in lies the problem because this is how our banking system works. Let me address that. 

Let's say you and I decide to open a bank. Now we are able to raise 2 million dollars. That’s our capital. We have capital of 2 million dollars. So what’s a bank do? Well we all know what banks do. They take in deposits, that’s other peoples 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 and 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 said hey deposit money with us well give you a toaster whatever we take in 30 million dollars. We 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. 15, 16 to 1 that’s 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 were 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 up up and everybody’s happy. It’s wonderful. UNTIL……. we have to, according to FASB 157, mark our assets to market and because real estate values start to decline. The loans in our portfolio, although they’re performing beautifully, we now have to reassess them. Why? Well because if our loans are a 70% loan to value, which is a 30% down payment from the borrower, but 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? Its safer to have a 70% so therefore, if that’s changed to a 90%, we’ve lost some value. And again just to pick some numbers here, lets say that 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 loss some money. Now how do we count for that? Now we haven’t sold the loans, 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 required to take now because of mark to market accounting. Where’d 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. Well we still have 30 million dollars in loans outstanding don’t we, 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, were 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 down and then activity from opportunistic shorters in the market comes in and drives our stock price even further. We’re in trouble!!!

Well, what’s the problem here? Our problem is, and you may have heard this term, there’s too much leverage. We are over leveraged. 

A million dollar capital (30 million dollars worth of loans); that’s 30 to 1. 

Now you and I, we’ve had a great bank all along here. 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. Well how do we de-lever? 

Only 2 things you can do. 

1. you can increase capital,

or 

2. sell off loans, reduce the exposure. 

Well 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, our stocks getting killed. We’re not 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 were under duress so were selling very cheaply. And when we do that, we now have to take more losses, which reduces capital further and compounds the problem even more. And like a toilet bowl flushing, our banks circling the drain….going down the tubes. And 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 and 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, now 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, because 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?” Well 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 is 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 a lifeline at the last minute by (In the case of Merrill…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. The problem was that they couldn’t get from point A to point B and they were forced to sell these good assets. But you go to sell these assets in a market where there are no buyers and they have 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. 

Tough times 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 Indy Mac Bank was sized, 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 and Countrywide now have to digest the purchase. They are (going forward) going to feel a little like me after A big Sunday Night dinner looking for the Tums! 

Pile on the new Bank tax and it is a recipe for higher rates and fees to the next borrower.

There probably will be some more casualties there. 

So, in steps the Feds with a multi billion dollar rescue package. Hey and there is no shortage of misinformation here too because the media got it wrong. And 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 Fed's to do. 

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

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. The Feds don’t have to mark to market and they have the cash they can print.

They’ll wind up buying it 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 d 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 doing both. This is a very smart thing for the Feds to do because it unfreezes the credit markets. It takes 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? Now heck if you wanted to really get ridiculous and lets say every house was burnt to the ground or acid was poured onto it and there were no homes left, you’d still have the land value wouldn’t you and that’s worth something 20-25%. So silly to think and all trillions of dollars of sub-prime loans would be worthless. Lets just say 15%, 20% went into for closure, a very high number, and lets say that the underlying assets dropped by 20%. Well you’ve still got an issue there certainly but maybe its 40 billion dollars, at worst, 50 billion dollars. Get crazy. The Feds say: we’re putting up 700 billion dollars is more than enough to solve the problem. Yet people love to hype the headlines and don’t take the time, necessarily to figure this out. Here’s my opportunity to set the record straight and explain what really is going on in my opinion.

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 a severe recession or even another depression if we don't keep our eye on the ball" I told him he was crazy…things could not look better! (2006) maybe a very small recession…but no way depression!

….his response was "OK BOY" 

“OK BOY” was his response 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".