Mortgage Meltdown

So Far Treasury Is Making Money On Investments In Banks

Beginning back in June, some of the larger banks began buying back the Treasury Department's preferred securities the Government purchased as part of the TARP Capital Purchase Program.  You remember TARP (Troubled Asset Relief Program), right?  It was passed as part of the Emergency Economic Stability Act (EESA) at the height of the credit crisis almost one year ago in the days following the collapse of Lehman Brothers, AIG and Bear Stearns.  There was no shortage of debate or controversy at the time either.  Many saw the $700 billion TARP program as a give-away to the Wall Street businesses that people thought got us into this mess.  Others saw it as vital to preventing another Great Depression, and worth risking the "moral hazard" dilemma.  Besides, those in support of the plan argued, if the banks survive, then the government might get paid back most of its $700 billion anyhow.

Although it may be too early to count TARP as a worthy gamble, it is interesting that, at least so far, the American Taxpayer has actually made money on the Government's investment in the nation's banks.  Every few days, the Treasury Department releases a completed transactions report (latest one available here), that shows where the TARP money has gone, as well as the money that has been paid back.  So far, 41 financial institutions have repaid the principal invested by the government.  However, most also bought back the warrants issued as part of the purchase of preferred stock by the government.  In doing so, the government has made about $2.89 billion on its investment, not including interest payments that were made during the time that the government was a preferred shareholder.  About $70.5 billion of the total $200 billion invested in financial institutions has been paid back, with Citigroup indicating yesterday that it might be prepared to raise sufficient capital to buy out $20 billion of Uncle Sam's $45 billion investment in that company as well (article here).  If the Treasury Department can make a similar return on investment on the remaining $130 billion investment in America's financial institutions, I think most taxpayers would be quite pleased indeed.  Somewhere, Hank Paulson is smiling.

Like Citi Before It, Bank Of America Gets Second Bailout

Late last week in a joint announcement by Treasury, Federal Reserve and the FDIC, it was revealed that Bank of America would receive another round of bailout money.  The structure of the new bailout is virtually identical to that received by Citigroup last November (my prior post on Citi is here).  $90 billion of the $191 billion spent in the Capital Purchase Program has been invested in these two banks.

Treasury will buy an additional $20 billion in preferred stock under the terms of the Capital Purchase Program on top of the $25 billion already invested in Bank of America.  Also, as with Citi, the Federal Reserve will enter a guarantee against losses of more than $10 billion on a $118 billion pool of asset backed securities held by Bank of America.  The term sheets are available here and here.

Like Citi, Bank of America was likely too big to fail, particularly after the government had already invested $25 billion.  Thus this new round of financing was provided under what has become known as the Targeted Investment Program, which to be eligible the Treasury must determine the institution "is sufficiently important to the nation’s financial and economic system that a loss of confidence in the firm’s financial position could potentially cause major disruptions to credit markets or payments and settlement systems, destabilize asset prices, significantly increase uncertainty, or lead to similar losses of confidence or financial market stability that could materially weaken overall economic performance."

Meanwhile, even with the trillions of dollars poured into the financial system, turmoil in the financial markets continues.  All financial stocks were pummelled yesterday after State Street announced bad financial results and disclosed a number of new risks and potential problems with its capital ratios.  Congress and the Obama administration are also considering establishing a federal "bad bank" that would do what TARP originally was supposed to do, take toxic assets off of bank balance sheets.  Some are estimating that the cost of this program could reach $2 to $3 trillion (or more) in additional federal government outlays (Forbes article, "A TARP In The Trillions?" here; Financial Times article here).

A Second Bailout For Citigroup

This morning the U.S. Treasury Department and Citigroup announced a new bailout for Citigroup, including a guarantee against losses on mortgage backed assets and an additional $20 billion equity investment by the government (on top of the $25 billion in preferred stock already purchased by the government).  Treasury's joint statement with the FDIC and the Federal Reserve is available here, and the Citi press release is available here.

The deal between the government and Citi involves a number of facets.  The first aspect is similar to the original purpose of the TARP program -- the government will guarantee "against the possibility of unusually large losses" (as characterized by the Treasury statement) on a $306 billion pool of mortgage backed assets (loan and securities) held by Citi.  The assets will remain on Citi's balance sheet, and Citi will retain any income streams from the assets.

The term sheet posted on Citi's website states that Citi will be responsible for the first $29 billion in losses (in addition to any existing reserves on Citi's balance sheet) on the portfolio on a pre-tax basis.  After that, losses will be allocated 90% to the government and 10% to Citi.  The first $5 billion in losses assumed by the government will come from TARP funds.  The second $10 billion comes from the FDIC funds.  Any additional losses will be borne by the Federal Reserve through a "non-recourse loan."  The government will provide the guarantee for 10 years for residential mortgage-backed assets and 5 years for commercial assets.

As a "fee" for the guarantee against losses on these assets, Citi will issue $7 billion in preferred stock to the government.  Citi will also issue warrants to purchase 254 million shares of common stock at a strike price of $10.61.  Citi also cannot issue dividends on common shares exceeding one cent for three years.

Another component of the deal is the Treasury's purchase of $20 billion in additional preferred stock, subject to the same terms and conditions of its original $25 billion as part of the Capital Purchase Program.  This $20 billion will come from TARP funds allocated pursuant to the EESA.

In an earlier post about the Capital Purchase Program (here), this blog noted that the government would have a natural inclination to provide further support to financial institutions in which it has already invested.  Whether this is a sign of that phenomenon remains to be seen.  In this instance, the reason for the additional support for Citi was likely because of the sheer size and importance of Citi in the financial markets.  Given how the Lehman bankruptcy froze the credit markets and ground financing to a halt, the government could not afford a further deterioration (of at least the perception -- Citi appears to have been well-capitalized at all times) of Citi's financial condition.

Banks Line Up For TARP Capital Purchase Program

So far about $160 billion of the $250 billion allocated to the TARP Capital Purchase Program has been committed by the Treasury Department to approximately 29 financial institutions.  The list below was published on Bloomberg's website (here)

FIRST ROUND
Citigroup           $25 billion
Wells Fargo         $25 billion
JPMorgan Chase      $25 billion
Bank of America     $15 billion
Merrill Lynch       $10 billion
Goldman Sachs       $10 billion
Morgan Stanley      $10 billion
Bank of New York    $3.0 billion
State Street        $2.0 billion
TOTAL               $125 billion

SECOND ROUND
PNC                 $7.7 billion
Capital One         $3.6 billion
SunTrust            $3.5 billion
Regions Financial   $3.5 billion
Fifth Third         $3.4 billion
BB&T                $3.1 billion
KeyCorp             $2.5 billion
Comerica            $2.25 billion
Northern Trust      $1.5 billion
Huntington          $1.4 billion
First Horizon       $866 million
City National       $395 million
Valley National     $330 million
Washington Federal  $230 million
UCBH Holdings       $298 million
First Niagara       $186 million
Old National        $150 million*
HF Financial        $25 million
Redding Bank        $17 million
Provident            --**
TOTAL               $35.18 billion


*Old National hasn't decided whether to participate.
**Provident didn't say how much it expects.

Could An Accounting Rule Be At The Center Of The Financial Crisis?

Oh, the trouble caused by fair value, or "mark-to-market" accounting.  First, it was at the center of the Enron accounting scandal (here), when that company used this accounting rule to manipulate its earnings on energy derivatives contracts (unrealized gains on these contracts constituted one-half of the company's profits in 2000).  Now it seems that mark-to-market accounting under FASB 157 may be a key contributor to the wave of bank failures and the current turmoil in the financial markets.

In the debate over the Emergency Economic Stabilization Act, some of the alternative proposals involved suspending the application of FASB 157 (FASB opposed the proposals, here).  Many believe that the fair value accounting, also known as "mark-to-market," required by FASB 157 for illiquid mortgage-backed assets has caused banks and other financial institutions to carry these assets on their balance sheets at far below their intrinsic value. This is one reason that supporters of the EESA believed that the government could actually make money by purchasing the distressed assets and re-selling them at a profit once the market improves.

Banks may have been writing down these assets too far because the fair value of the assets must be tied to the market value of the assets.  But because these days most mortgage-backed assets are being sold in distressed, forced sales at "fire sale" prices, the market may not reflect their true value.  Nonetheless, companies were applying FASB 157 to require these fire sale prices to largely establish the value of similar assets on their balance sheets.  The effect of FASB 157 was aptly described in an article on CNBC's website (here):

The rule is “well-intentioned,” says Joshua Ronan, professor of accounting at NYU’s Stern School of Business, but has created the market equivalent of a "negative feedback loop" or transactional gridlock.

“If the market is temporarily depressed for a number of reasons, then you are compelled to value these assets at what you can sell them for. But any number of these assets—CDOs—are very illiquid, thus trading is thin,” explains Ronan.“As a result, you have to resort to models, and in this environment people will be very cautious and mark them down."

Although there were some proposals to amend EESA to require the suspension FASB 157 for some period of time, ultimately the EESA only included a provision, Section 133 of the Act, that required the SEC and FASB to study the role of FASB 157 in the mortgage meltdown.  Under the terms of Section 133, the study will focus on the effects of FASB 157 on a financial institution's balance sheet; the impacts of such accounting on bank failures in 2008; the impact of such standards on the quality of financial information available to investors; the process used by the Financial Accounting Standards Board in developing accounting standards; the advisability and feasibility of modifications to such standards; and alternative accounting standards to those provided in FASB 157.  The entire text of the EESA is available here.  The SEC announced the initial steps for the study yesterday (here).

In the meantime, the SEC and FASB have provided additional guidance in the application of the mark-to-market rules in the current illiquid market for mortgage backed assets hoping to lessen the "negative feedback loop" and allow companies to reduce write-downs on assets where there has been a distressed sale of same or similar assets in the market.  The SEC tells companies that:

• Management's internal assumptions on the present value of future cash flows of an asset can be used to value an asset when market for the asset does not exist.
• "Broker quotes may be an input when measuring fair value, but are not necessarily determinative if an active market does not exist for the security."  Thus, when a bank goes to sell an asset and receives a low-ball bid from a broker, under this new guidance the bank does not have to mark-down the asset as a result of this lone bid.
• Companies can disregard forced-sale or distressed sales of similar assets in fair valuing mortgage backed assets: "The results of disorderly transactions are not determinative when measuring fair value. The concept of a fair value measurement assumes an orderly transaction between market participants. An orderly transaction is one that involves market participants that are willing to transact and allows for adequate exposure to the market. Distressed or forced liquidation sales are not orderly transactions, and thus the fact that a transaction is distressed or forced should be considered when weighing the available evidence. Determining whether a particular transaction is forced or disorderly requires judgment."
• Moreover, even orderly transactions in an "inactive market" do not automatically set the price of the same or similar assets. 

The Mortgage Bankers Association issued a press release applauding the new guidance from the SEC and FASB, particularly the endorsement of the use of discounted cash flow to fair value assets where there is no active market.  The press release states that “FAS 157 was never test driven in a market where the only transactions occurring are distressed sales. In such an environment, FAS 157 was only exacerbating the market illiquidity. This announcement should have an immediate impact allowing companies to reflect the true value of their mortgage assets and increasing capital and liquidity in today's stalled credit markets.”

Although it may take some time -- it certainly was not reflected in the stock market activity yesterday -- I think that the new guidance will have the effect envisioned by the MBA.  Unfortunately this action was not taken earlier.  I think the SEC's study conducted pursuant to EESA will find that the way companies were applying FASB 157 did play a significant role in our recent troubles.

Local Lenders Have Opportunity to Gain From the Subprime Mortgage Meltdown

There seems to be only bad news for the mortgage lending industry. Since 2006, more than 220 mortgage lenders have closed. Mortgage lending giants are reporting record losses and face lawsuits from investors and borrowers. With so many subprime lenders closing their doors and large lenders tightening their belts, who – other than plaintiffs' attorneys – has the best opportunity to gain here. The answer is close to home: community banks and local credit unions.

Throughout the 1990s and into the 2000s, many local savings banks and credit unions lost significant market share for home mortgages because they continued their traditional practice of balance sheet lending – e.g., think George Bailey's savings and loan from It's a Wonderful Life.

The downside of this practice is that it limited the local lenders' ability to compete with the new products and special rates being offered by subprime lenders (who always intended to sell off their loans to larger institutions and/or investors). The upside is that it also insulated many of these lenders from the financial difficulties created by the crash of the subprime markets. Although most feel the pain caused by the decline in housing prices, they are not plagued by the same rate of foreclosures, bankruptcies or lawsuits faced by lenders who offered subprime loans. Now, these banks have a unique opportunity to recapture market share lost during the subprime boom.

The question, of course, is whether community banks and credit unions are able to fill the vacuum left by the hundreds of lenders who have closed their doors and how they can safely do so without facing the same risk in a market that some believe will continue to decline. Some industry experts say that some increased market share is already taking place as more borrowers, wary of adjustable rates and subprime loan practices, are refinancing their adjustable rate loans and home buyers are also more likely to seek traditional loans from local and trusted sources. The rest will depend upon whether local savings bank move to take advantage of the opportunities left in the wake of the subprime meltdown. One certainty is that any lender seeking to fill the vacuum should proceed with caution in this ever-changing economic and legal environment.

Bear Stearns Collapses

Last summer, when two large hedge funds run by Bear Stearns that invested in mortgage backed securities collapsed, it touched off the initial meltdown in the credit markets and the subsequent wave of litigation, write-downs, and write-offs.

Now, in perhaps another ominous sign of things to come, Bear Stearns' financial condition deteriorated so severely that it became a "victim of an old-fashioned run on the bank." (Business Week Article, here) JP Morgan Chase Co. and the Federal government stepped in to avoid a bankruptcy at what was Wall Street's fifth largest investment bank. JP Morgan is acquiring Bear Stearns for $2 per share, basically less than liquidation value (Bear Stearns traded above $70 per share early last week and as high as $170 per share a year ago). The Federal Reserve engineered the transaction, and will fund up to $30 billion of Bear Stearns' less liquid assets.

Shareholders still have to approve the sale, and there may be additional litigation related to Bear Stearns collapse. It has already been named a defendant in securities class action lawsuits.

Bear Stearns, founded in 1923, survived the depression but could not weather the storm caused by its focus on underwriting and investments tied to mortgage backed securities.

"Project Lifeline" Update

More companies have signed on the "Project Lifeline," an agreement among mortgage industry players brokered by the Treasury Department, which is summarized in this blog on February 13 (here). As reported here, members of the Hope Now Alliance, which comprise of companies who service over 90% of subprime loans and 70% of all loans, have signed on to the deal.

It is questionable what effect Project Lifeline will have on reducing mortgage foreclosures. While it may give delinquent borrowers a breather, it does not appear that lenders and mortgage servicers are going to be reforming the terms of many subprime loans. In fact, a top Treasury Department official commented that proposals that "would retroactively change contracts on existing loans" could cause long-term harm to the housing finance system because it "would make it more difficult for future subprime borrowers to get into a house in the first place."

Meanwhile, foreclosures continue on an upward trend, with a report yesterday that January foreclosures increased 57% over 2007 and were up 8% from December 2008.

Fed to Give Market Greater Information

The Federal Reserve Board announced significant changes to its communications policy on the U.S. economy.  Fed Chairman, Ben Bernanke, indicates the Board will double the frequency of policymaker forecasts for economic growth, unemployment and inflation, and extend the forecast horizon to three years.  The new policy will give the public more information about the Fed's views on the economy, and this may be welcome as the U.S. continues to grapple with heightened economic uncertainty, the decline of the real estate market and tight credit.

Starting next week, the Fed will release projections for inflation-adjusted GDP growth, unemployment and inflation four times each year.  Previously, the Fed has released these projections semiannually, usually in February and July.  The new strategy, however, will not include numeric targets for the inflation rate, despite Mr. Bernanke's hope that it would.  The European Central Bank and the Bank of England provide numeric targets for inflation.

According to the Chairman, more information is likely to improve market performance:

. . . if practitioners in financial markets gain a better understanding of how policy is likely to respond to incoming information, asset prices and bond yields will tend to respond to economic data in ways that further the central bank's policy objectives.  For example, if market participants understand that arriving information about the economy increases the likelihood of certain policy actions, then market interest rates will tend to move in a way that reinforces the expected actions, effectively supporting the goals of the central bank.

The Chairman's speech in its entirety can be found here.

E-Trade Loses Half Its Value After Announcing More, As Yet Unquantified, Losses From Mortgage Backed Securities

E-Trade Financial Corp., an online securities broker that had diversified in to mortgage lending, lost over half of its market capitalization (approximately $2 billion) on Monday after it announced that it will incur greater losses on its holdings of mortgage backed securities and that the SEC had made an informal inquiry regarding its loan and securities holdings. This announcement, reported here and here, came only three weeks after E-Trade revised downward its year-end earnings forecasts in its third quarter earnings release due to losses recognized during the third quarter from loans and mortgage backed securities.

E-Trade withdrew that October 17 earnings guidance and told the market that it could not provide any new guidance due to the trouble valuing its asset-backed securities. The company stated: "Actual securities-related losses will depend on future market developments, including the potential for future downgrades by rating agencies, which are extremely difficult to predict. Accordingly, management believes it is no longer beneficial to provide earnings expectations for the remainder of the year."

E-Trade was already the subject of a purported securities fraud class action lawsuit (here) that was filed in the wake of the initial announcement in September that its 2007 year-end earnings would be negatively impacted by loan write-offs and securities write-downs.

Like other companies that hold asset-backed securities, E-Trade is struggling with how to account for the value of these securities in an environment where demand has dried up for the securities. As the market has dried up, the credit ratings have been reduced, leading to the write-downs -- E-Trade noted that $50 million of its asset-backed securities that initially had AAA (investment grade) ratings have been downgraded to junk status.