Banks, how do they work?
June 5, 2011 9:34 PM Subscribe
When a bank decides to foreclose instead of restructuring a mortgage, is this favorable or unfavorable to its balance sheet? So that I can learn more about this side of the banking business, are there any resources that go into detail in explaining the decision-making process of banks in this situation, especially in the context of the financial crisis?
As an active real estate person, I can tell you that right now banks are 'restructuring' very few of their non performing loans, and most of the bad debt is eventually becoming short sale or REOs. I have no idea what drives them, it seems that there's no rhyme or reason to their motivations. It really does not make sense, and they are so unorganized, lagging & delaying their decisions. Definitely not a profit motive. Between us we say that they got so much bailout money that they don't care. Or maybe the ones who hold the mortgages today, are not the ones who suffered the big hits. Maybe they bought them at a discount. Anyway, it's really fucked.
posted by growabrain at 12:28 AM on June 6, 2011
posted by growabrain at 12:28 AM on June 6, 2011
I think both are bad. I'm not a banker, but from what I've read, it's a choice between the lesser of two evils.
1. Foreclosure: fast, but risky. Generally foreclosure procedure can be completed within 3 months; but the risk is that the house won't sell; and in its vacant state, it will not generate any money, attract vagrants and vandals, and bring down the selling price of properties in the neighborhood. Before the advent of the sub-prime mortgage, the ex-owner pays for all of this risk by forfeiting his 20% down payment; and the bank selling for 20% less will generally can move the property quickly. Present crisis nullifies these assumptions. Today, even good borrowers walk away from their under-water property; leaving the bank with hard choices.
2. Restructure the loan: which is a milder form of default. The bank can avoid the whole costly and risky process of foreclosure and resale. However, this assumes two things: One, that the loss on writing down the loan is reasonable compare to number 1 (if it is going to lose as much as a foreclosure, then I think the bank would rather foreclose instead). Two, that the current borrower fits with the new loan. Let's face it, a borrower who ask for restructuring is almost a defaulter. Without the restructure, he/she would definitely default. So, from the bank point of view, this borrower no longer show good credit or capacity (or both), and writing a new loan to this person, in light of this new information, is certainly riskier than a straight-forward sale (with cash in hand). Of course, back in the day when there was local bankers and personal relationships, perhaps something can be work out; but today, banks are faceless and inter-changeable to customers and vice-versa, so from a strict business-sense, a REO sale would be preferable.
3. Not foreclose, nor restructure; wait and see. Both choices above result in immediate write-down to the bank, and with the current massive loss in real-estate, it will certainly bankrupt a lot more banks. Some 2000 banks already bit the dust (see FDIC) and countless other funds and financial firms. So, most banks and our government collectively choose to put our heads in the sands and crossing fingers for now, waiting for better time. This means the banks can pretend that all those non-performing loans are still viable, and they don't have to write down the loss; and the borrower can pretend to still have good credit even though they can't pay the mortgage. The government thus can delay bailing out yet more banks, and our pension funds and investors can pretend that one day, we will see all those saving invested in real-estate on Wall St will pay dividends. It's a collective waiting game for the ball to drop.
PS: the only restructure I've seen was voluntarily offered from the bank. A client I knew got a letter in the mail from their mortgagor, reducing their principle, without asking. They was incredulous, but it was real. Those who went to the bank asking for restructuring are less successful; some time get term concession (lower payment for longer period of time) instead of principle reduction.
posted by curiousZ at 12:45 AM on June 6, 2011 [2 favorites]
1. Foreclosure: fast, but risky. Generally foreclosure procedure can be completed within 3 months; but the risk is that the house won't sell; and in its vacant state, it will not generate any money, attract vagrants and vandals, and bring down the selling price of properties in the neighborhood. Before the advent of the sub-prime mortgage, the ex-owner pays for all of this risk by forfeiting his 20% down payment; and the bank selling for 20% less will generally can move the property quickly. Present crisis nullifies these assumptions. Today, even good borrowers walk away from their under-water property; leaving the bank with hard choices.
2. Restructure the loan: which is a milder form of default. The bank can avoid the whole costly and risky process of foreclosure and resale. However, this assumes two things: One, that the loss on writing down the loan is reasonable compare to number 1 (if it is going to lose as much as a foreclosure, then I think the bank would rather foreclose instead). Two, that the current borrower fits with the new loan. Let's face it, a borrower who ask for restructuring is almost a defaulter. Without the restructure, he/she would definitely default. So, from the bank point of view, this borrower no longer show good credit or capacity (or both), and writing a new loan to this person, in light of this new information, is certainly riskier than a straight-forward sale (with cash in hand). Of course, back in the day when there was local bankers and personal relationships, perhaps something can be work out; but today, banks are faceless and inter-changeable to customers and vice-versa, so from a strict business-sense, a REO sale would be preferable.
3. Not foreclose, nor restructure; wait and see. Both choices above result in immediate write-down to the bank, and with the current massive loss in real-estate, it will certainly bankrupt a lot more banks. Some 2000 banks already bit the dust (see FDIC) and countless other funds and financial firms. So, most banks and our government collectively choose to put our heads in the sands and crossing fingers for now, waiting for better time. This means the banks can pretend that all those non-performing loans are still viable, and they don't have to write down the loss; and the borrower can pretend to still have good credit even though they can't pay the mortgage. The government thus can delay bailing out yet more banks, and our pension funds and investors can pretend that one day, we will see all those saving invested in real-estate on Wall St will pay dividends. It's a collective waiting game for the ball to drop.
PS: the only restructure I've seen was voluntarily offered from the bank. A client I knew got a letter in the mail from their mortgagor, reducing their principle, without asking. They was incredulous, but it was real. Those who went to the bank asking for restructuring are less successful; some time get term concession (lower payment for longer period of time) instead of principle reduction.
posted by curiousZ at 12:45 AM on June 6, 2011 [2 favorites]
I'd like to add that, because of the way mortgages were setup during the run up of the housing market, restructuring is exceedingly difficult today because *no one* can authorize the loss. The underwater mortgage is not own by the bank; most likely, it is only its servicer. The real owners of that mortgage are millions of investors, some institutional, some small time, even foreigners. Each own a tiny slice of thousands of mortgages in complex and opaque financial constructs calls CDO. The CDO was setup with the assumption that there is no loss and with no clear provision as to who is authorized to make decision in case of loss. So, even if the bank want to help borrowers, it can't, because it is not legally authorized to renegotiate the mortgage. Some mortgage portfolio was returned from the investors back to the banks, and those it owns; but there are very few bank who still keep mortgage "in portfolio" anymore. Those that did was bought and destroyed long ago (2000-2005).
posted by curiousZ at 1:11 AM on June 6, 2011 [2 favorites]
posted by curiousZ at 1:11 AM on June 6, 2011 [2 favorites]
I'm not a banker either, nor an accountant, but FWIW I work for a financial regulator (though not one you are likely to have heard of). The answer may depend on what you mean by "favourable to its balance sheet". By definition a balance sheet is always in balance--do you mean "favourable to its asset position"?
My impression is that both foreclosure and restructuring are bad for the balance sheet (in the sense that either reduces the assets of the bank), since both of them reduce the value at which the mortgage can be carried on the balance sheet. The details will vary though. A mortgage that's in negative equity can still be carried on the balance sheet as an asset at full value if the borrower is still paying, or thought to be capable of paying. (Note that the value of the mortgage is not the principal mount--it's the net present value of the income stream represented by the payments, if I understand correctly.) A restructure (whether by extending the duration or reducing the principal) reduces that value. A foreclosure crystallises the loss as soon as the sale is complete and converts the value of the mortgage into the value of the cash received--which at present almost by definition will be less than the value of the unimpaired debt. This of course assumes that a restructure is even possible, as curiousZ points out.
Come to think of it, it also assumes that the mortgage is in fact still carried on the bank's balance sheet. If the mortgage has been securitised, it probably isn't. I'm still trying to get my head around this, but if the mortgage has been securitised, probably all there ever subsequently was on the balance sheet is the asset consisting of the cash received for the CDO. Which has of course long since been spent. There will be a liability in the form of the obligation to pay the CDO holders the income stream from mortgage repayments (I think this is how it works). If I'm right in this, as curiousZ points out, restructure is basically impossible and foreclosure gets a liability off the balance sheet, not an asset.
Is there an accountant in the house? I'm well aware that I've just set myself up to be shot down in flames.
posted by Logophiliac at 9:04 AM on June 6, 2011
My impression is that both foreclosure and restructuring are bad for the balance sheet (in the sense that either reduces the assets of the bank), since both of them reduce the value at which the mortgage can be carried on the balance sheet. The details will vary though. A mortgage that's in negative equity can still be carried on the balance sheet as an asset at full value if the borrower is still paying, or thought to be capable of paying. (Note that the value of the mortgage is not the principal mount--it's the net present value of the income stream represented by the payments, if I understand correctly.) A restructure (whether by extending the duration or reducing the principal) reduces that value. A foreclosure crystallises the loss as soon as the sale is complete and converts the value of the mortgage into the value of the cash received--which at present almost by definition will be less than the value of the unimpaired debt. This of course assumes that a restructure is even possible, as curiousZ points out.
Come to think of it, it also assumes that the mortgage is in fact still carried on the bank's balance sheet. If the mortgage has been securitised, it probably isn't. I'm still trying to get my head around this, but if the mortgage has been securitised, probably all there ever subsequently was on the balance sheet is the asset consisting of the cash received for the CDO. Which has of course long since been spent. There will be a liability in the form of the obligation to pay the CDO holders the income stream from mortgage repayments (I think this is how it works). If I'm right in this, as curiousZ points out, restructure is basically impossible and foreclosure gets a liability off the balance sheet, not an asset.
Is there an accountant in the house? I'm well aware that I've just set myself up to be shot down in flames.
posted by Logophiliac at 9:04 AM on June 6, 2011
(IANABanker, Accountant or home owner)
I'm tempted to say it's management willpower vs reality, that accepting modifications is giving up, cutting your losses, running, etc. Foreclosure and auction at least gives the hope that the principal will be recovered. I recall hearing on Planet Money or TAL that banks often have final approval of the auction sale and can and do punt if they don't like the results. There's also adverse selection and strategic defaults going on. There's also the depressing fact that people who restructure have a higher default rate, post modification.
But just as much, I figure the loan modification thing is done by computer algorithms that maybe two developers put together after talking to one manager's muddled ideas on how this should happen. Maybe there's still a manual step in the chain with a project meeting that takes places for one hour every Wednesday.
posted by pwnguin at 10:52 AM on June 6, 2011
I'm tempted to say it's management willpower vs reality, that accepting modifications is giving up, cutting your losses, running, etc. Foreclosure and auction at least gives the hope that the principal will be recovered. I recall hearing on Planet Money or TAL that banks often have final approval of the auction sale and can and do punt if they don't like the results. There's also adverse selection and strategic defaults going on. There's also the depressing fact that people who restructure have a higher default rate, post modification.
But just as much, I figure the loan modification thing is done by computer algorithms that maybe two developers put together after talking to one manager's muddled ideas on how this should happen. Maybe there's still a manual step in the chain with a project meeting that takes places for one hour every Wednesday.
posted by pwnguin at 10:52 AM on June 6, 2011
Planet Money, the NPR blog and Podcast and radio program has done a couple pieces on this issue. I believe the strongest incentive is for the bank to foreclose. You're likely to find a longer, more complete answer there
posted by Heart_on_Sleeve at 12:23 PM on June 6, 2011
posted by Heart_on_Sleeve at 12:23 PM on June 6, 2011
Here's one of many good posts on the blog Naked Capitalism that tackles these issues. Do some reading there and you'll begin to see how these complex systems function--I won't say "work," cause they're broken, badly. (I can only think about these issues in small doses, or I feel sick to my stomach. When you find yourself thinking "no, it can't possibly be that bad," you know you're beginning to understand it.)
posted by Corvid at 2:20 PM on June 6, 2011
posted by Corvid at 2:20 PM on June 6, 2011
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posted by XhaustedProphet at 9:43 PM on June 5, 2011