Portland Mortgage Broker

This is going to be one of my longest blog posts ever, but I think it’s critical that we understand what’s going on in our markets today so we can appropriately devise a long-term solution. We “solved” this problem once before in 2002, and made it only five years to the next bear market.

Following the collapses of Enron and Worldcomm earlier this century, the stock markets spent a period of about 27 months trying to figure out who they could still trust. There was much ambiguity, cries for increased regulation, and a protracted bear market where the NASDAQ gave up 70% of its value and the S&P shed 49%. Now think back over the last 12 months, and see if you can find any parallels.

I’m going to try my best to explain something the government did to stabilize our financial systems back then, because it’s somewhat of a complex issue that contributes enormously to the problems we’re facing today. What I’m talking about is rule 157 of the Sarbanes-Oxley act. Sarbanes-Oxley (SOX) was the government’s response to Worldcomm and Enron, to address the industry needs of accountability and transparency. I understand that most of us won’t ever need to know what SOX does (or doesn’t) do for us, but there is one component of it that bears a direct impact on the financial crisis we have today. It is this rule 157, or the mark-to-market rule.

Under mark-to-market accounting principles, publicly traded corporations are required to value their assets and holdings based on whatever price they might fetch on the open market at that given point in time. At first blush, this seems completely fair and it certainly solved the problem of inflated valuations showing up on corporate balance sheets. It also worked well during the five-year period following the market’s low on Oct. 9, 2002, throughout which time assets continued to appreciate wildly.

Here’s the problem we face when assets begin to depreciate. This is also why the most conservative banks in the world are in trouble today – even those who handled only great, “A paper” loans. As an asset (in this case, real estate) devalues, the risk of holding the mortgage securitized by that asset increases. To put this concept on paper in real terms, consider Joe Homebuyer who bought a $100,000 home with a $25,000 down payment through ABC Bank in San Bernardino, California. His loan-to-value ratio (LTV) is 75%, meaning he has 25% equity in his home. Historically, loans with an LTV of 75% have a certain ratio of default. We’ll call that 1%, meaning that over the next 5 years about 1% of these 75% LTV mortgages will default and be foreclosed upon. ABC has calculated this risk of default into the mortgage interest rate and/or fees charged to Joe, and sent him on his way. ABC then has two ways of dealing with this mortgage loan. They can hold it themselves for the expectation of future cash flows, or they can sell it to an investor for an immediately payable premium. For the sake of this explanation, we’ll assume that ABC holds the mortgage themselves but at the time the mortgage was written it could have been sold for $80,000.

Now let’s take a look at what happens two years down the road. Joe’s home has depreciated a total of 17%, and is now worth $83,000. He’s paid down $1,000 of the principal of his mortgage, and currently owes $74,000 to ABC. Instead of seeing his LTV gradually decrease though, it has actually INCREASED due to his declining property value. His LTV now stands at 89%. Today, a mortgage at 89% LTV might have a typical default ratio of 7% - much higher than the 1% assumption that Joe’s mortgage was originally underwritten at. Because of this, ABC’s mortgage note that was worth a $5,000 premium two years ago ($80,000) could now only be sold for $64,000 – a $10,000 discount from the outstanding balance.

This is where mark-to-market gets in the way. ABC has not realized a loss yet, because Joe is still making his payments and ABC has not needed to sell the loan. However, SOX requires ABC to value that mortgage note based on what similar mortgage notes are selling for today and immediately “write down” the difference using funds from their capital reserve account. It is the equivalent of buying a $20 stock, watching it fall to $15, and being required to pay back that $5 “loss” out of your savings account – even though you haven’t sold the stock yet.

Now let’s say that I, Greg Downey, am the founder and CEO of ABC Bank. I assembled 50 of my closest business associates and together we started the bank with $2 million in 2006. This is our capital. Over the following six months, we raised an additional $30 million in deposits. We pay 2% to our depositors for the use of their $30 million, and lend that same $30 million out to home owners throughout the United States at 6%. Now we have a loan-to-capital (LTC) ratio of 15:1 – we are lending at a pretty typical 15 times the amount of our capital reserve account.

Over the next couple of years though, the real estate market that securitizes our $30 million in loans starts to devalue as in the example of Joe Homebuyer. We have 1,000 of these mortgages that have lost $10,000 in street value, for an aggregate value of $1 million. Even though the loans are still performing well, we must “write down” that $1 million on our balance sheet by drawing from our capital reserve account. Suddenly, our LTC ratio doubles from a healthy 15:1 to 30:1. We’re placed on the FDIC watch list, all the ratings agencies immediately downgrade us, our stock plunges 40% in value as investors rush to the exits, the media starts talking about all of our “risky” mortgages, and depositors begin pulling their money out to take it to a “healthy” bank. ABC is forced to start selling some of its mortgage notes at fire-sale prices to try and bring its capital ratio back down, thereby realizing the losses we talked about earlier. This process continues until eventually ABC is forced into an FDIC takeover or a major investor such as the Federal Reserve or Warren Buffet throws more money our way.

This is why so many banks have been in the news lately. Now granted, some of these banks such as Washington Mutual and Countrywide did in fact specialize in subprime-type loans that the market had no business ever even seeing. However, this also explains why some great banks (Citigroup, Chase, SunTrust) are still being forced to “lose” billions of dollars in written-down assets and increase their risk from an investment perspective.

So what is the solution? I’ll write more on that later. I could have earned my doctorate with the length of this blog, and my fingers are getting tired from all the typing. Please check back next week for my answer to the dilemma, or better yet subscribe to my RSS feed so you make sure not to miss a single update. Comments, as always, are totally welcome. Do you agree with my analysis? Does it make sense to you?

Thanks, and have a great weekend! Please remember to give me a call if you’re ever in the need for a Portland Mortgage.