San Diego Housing Market News and Analysis

Dave: Doesn't this, in essence, also take care of the Mark-To-Market/Mark-To-Model balance sheet valuation problem as well, in that it ignores that aspect (underlying valuations) of the problem?

I realize that P&I is a cash flow/Income Statement/Statement of Cash Flows issue, but this appears, to me at least, to also throw a veil over the underlying asset valuation problems, which would undoubtedly be a huge counterpart to the whole CRE portfolio.

We are going down the path of Japan, China, Argentina, and the South-East Asian nations whom we, the World Bank, and the IMF criticized for having lax standards.

During their financial crisis we said that they should strengthen financial rules.

What is the point of having good accounting standards (arguably the best in the world) when we backslide at the first opportunity?

That would be like telling students that B grades will now be given A grades. The grades are good, but the performance sucks.

While we are it, we should relax building codes and zoning standards so we can develop real estate for cheaper.

Kind of, yes. Basically, what it does is it says, "Hey, you've got this CRE loan that's paying as agreed. There's no issue with meeting the obligations of the note. BUT, the LTV is higher than we'd like. We (the FDIC) would like to see it at 80%. Instead it's at 90%-110% (depending on its vintage and other factors). And we know that the owner probably doesn't have a dime of cash to put into the thing. So, instead of re-classifying this loan as a TDR when it matures and you (the bank) re-book (or extend) it at a high LTV, we're going to let you keep it on the books as a performing asset." So, in essence, all of these TDRs-in-waiting just got a bump in value - for the bank's balance sheet purposes - of 20% or so from where they would have been re-marked as a TDR.

Now, is this bad? Yes and no. The bad part is that, in theory at least, it encourages more speculation. But the offset here is that the speculators are basically dead. Most folks are now in survival mode. So, I don't think there's a great deal of moral hazard in this approach. In addition, it's not like the banks are saying, "Hooray, more money to lend!" On the contrary, they're saying, "Shit, just dodged another bullet. Gotta get tough on these borrowers."

This is just another "forebearance-like" maneuver by the FDIC. And recall, this ONLY appears to apply to properties that can meet their debt obligations. If you can't meet your obligations AND you're underwater from an LTV perspective, you're fucked. As you should be.

As a taxpayer, this makes sense. I'd prefer that these "borderline" loans work themselves out over time, rather than re-classify them, put more banks at risk of failure, with a bigger burden on the FDIC Insurance Fund, etc.

Dave: I don't know if you've seen or read Andrew Sorkin's new book, "Too Big To Fail", but its an interesting read (a BIG, interesting read at 600+ pgs).

I bring it up because, as the book makes clear, the various programs intended to stave off financial disaster were, for the most part, seat-of-the-pants endeavors by the various government agencies and players.

I think what we're seeing now is the Great Unwinding and the attempt, by these same agencies and players, to ensure as much of a soft landing as possible, whether its in CRE, RE or banking and finance.

I know there are many out there that advocate the "fuck 'em, let 'em fail" approach, but I don't. Yes, it probably is the healthiest thing over the long haul, but the fact is that the short- to mid-term destruction would be nearly catastrophic.

Should the FDIC simply pull the pin on all non-performing assets? I don't think its wise and I agree that the moral hazard aspect is outweighed by the concomitant implosion of hundreds, if not thousands, of lending institutions. That's why I favored Bernanke's approach, even while agreeing with him when he said he "held his nose" during the AIG bailout.

Of course, I might be completely wrong, but I get the sense that the approach up to this point, wrong-headed as it might have been, sure seems better than the alternative.

The FDIC is basically grouping problem banks into three categories:
(1) Too big to fail (the 20 largest)
(2) Screwed up, but should be o.k. if we just give them a little forebearance and breathing room
(3) Too fucked up to save

The real trick is between groups (2) and (3) because a number of banks could go either way. The FDIC announcement in this thread basically pushes some banks that would have been in group (3) back into group (2).

The FDIC are behind the curve but they're not complete idiots. The know that a lot of banks must fail (and they're going to fail). But they also know that a number of banks can be saved if some tweaks are made in the regs.

So, to get to your question, I think the FDIC is basically going through the various asset classes and deciding what's beyond saving (e.g., most defaulted construction and development loans) and what can be saved (e.g., cash-flowing CRE). It's applying the same analysis to individual institutions. It ain't pretty and it ain't perfect, but it's a fairly pragmatic way of handling a bad situation.

I think what's coming down the pike for the Too Big To Fail Banks is MUCH higher capital requirements. But that's not going to happen immediately. That will get sprung on these companies after they're in better shape.

Dave,

Interesting read from the Economist on US bank failures and the import of same.

http://www.economist.com/businessfinance...

This irritates me. While it makes sense to keep some 'performing' loans from being written down, it ignores the second largest underwriting parameter - LTV.

I relate it to the stated-income loans of the residential boom. "Don't worry about the borrower's cash flow ability, the home will be worth more and the Bank will be fine!" Only this time it's "don't worry about our collateral position, the cash flow is fine!"

I think the Banks need to face reality about what their loan portfolios are truly made of (both from a cash flow and collateral coverage POV) and reserve accordingly.

Just my 2c...

Evol: While I don't disagree philosophically, the problem is what happens in reality. I think if you force "reality", you will crater hundreds of marginal banks and lending institutions.

Is it shitty? Yeah, it is. But the facts are that there are many of these marginal banks and institutions on the bubble and it makes more sense to help them through this than to force failure.

I agree, Allan. In my view, the time to be puritanical about this stuff was several years back. Now, the cat's out of the bag and we have to play the hand we've been dealt. (Let's see how many metaphors I can mix together in one paragraph.)

I think the rules should be somewhat flexible in times of duress (like now). (How flexible is debatable - obviously.) The time to rigidly enforce the rules so that this mess doesn't happen again (or for quite some time, at least) is in a few years after things have stabilized.

There should be balance. Again, many institutions should and will fail. And we need a WHOLE new set of rules, regs and capital requirements for the largest banks to neuter them, for all intents and purposes. But there's no reason to push an institution over the edge when the bank can repair itself with a few years' time. Recall that the "price" of that repair will be borne by its shareholders, not taxpayers.

There is no issue of pushing an institution over the edge. The institutions went over on their own initiative. The question is whether to try to pull them back.

The reason not to try to pull them back is to prevent incompetent bankers from continuing to be bankers. All the while the imprudent bankers were getting into trouble, they were making it harder for prudent bankers to gain business.

One effect of all this rescue activity is to make prudent and responsible people, who did not get into trouble, consider the option of being less prudent and responsible.

The purpose of the FDIC is to protect depositors, nobody else. The impairments should be recognized, and if that puts the institution in a state that calls for being taken over, that is what should happen.

If the FDIC is confident in the judgment that the loans with impaired loan-to-value ratios will be paid as agreed, the FDIC can just turn them over to the acquiring institution with an agreement that the FDIC will eat any losses if/when they occur. This will insure that volunteers to take over the failing institution can be found.

If the FDIC is not confident in the judgment that the loans will be paid as agreed, it is time to flush the incompetent bankers out of the industry.

I agree with both of your posts, analyst.

I agree that relaxing the rules, while distasteful, is appropriate in this financial crisis.

Here, we are advocating regulatory flexibility and pragmatism by allowing the changing of the rules in mid game. Not exactly righteous principles.

Alan & davelj are probably right with the 'greater good' theory. I'm in the banking business - I should be thankful for whatever bone they throw my way from a job stability standpoint.

However, if these new lax FDIC standards are implemented, banks should be required to disclose the aggregate LTV composition of their CRE portfolio for each property type. At least then investors and depositors can make a sound decision. My guess is SDNB had pretty high LTVs across the board compared to other banks.

Dave - do you really think effective legislation/regulations will be passed to prevent future problems? I've been shocked by what I've seen so far.

While I see alot of the wisdom of what Allen and Dave are saying, I think there are two problems that they are overlooking in their "play the hand we have" outlook.

1) Change only happens when we are stressed. It took the repeated depression like swings of 1900-1939 to get alot of the rules we have/had about banks. When things get better, we will have no inputus to go back. One or two of the weakest banks wont heal, and changing the rules will "come to early"; because it will forever be to early for them. Atleast until the height of the next bubble, when everything is perfectly awsome, and then it will be dracoionion measures that caused a recession (read bubble burst) that cause more 'hold my nose and do it' backpeddling on the rules.

2) Stable responsible banks exist. They are lead by old school guys who fought their boards/stockholders when they were 'only' making 8% returns and everyone else was 'earning' 15%. They knew 15% was a joke, and would blow up in their faces, and they were right. If the rules are changed and the responsible punished for being responsible, then next time everyone will go for 15% and will just cozy up to their local politican as insurance. So we get more corrupt politicans and more unstable banking. Just what we need.
We could avoid this, except for #1 above.

I would say that a reasonable idea would be to make the changes temporary, like, "for the next two years..." and then hold to the date. But we have tried that time and again, and as the date approaches, the lobbying intensifies, and we delay again, and we end up back at #1. Perpetual temporary changes are no different than just changing the rules.

The whole point of the FDIC is to eliminate the need for depositors to do such analysis. The FDIC is to do the analysis on a proper basis, and to flush out those not in conformance.

Do not underestimate the effect of bank stockholders forcing unsound behavior on their bank managers by comparing them to unsound bank managers making high returns by engaging in inappropriate banking behavior.

With respect to the FDIC, distinct from other entities, this is a black/white issue. The FDIC is failing to do its duty.

Where you and I part ways is that you apparently believe all bankers are either competent or incompetent. In my world, there are plenty of competent bankers, plenty of incompetent ones, and a HUGE number in the middle (that complicated gray area we hear so much about). My suggestion is to let those banks run by some of the less-than-middling-but-not-totally-incompetent managers survive, for the good of John Q. Public. It's only their shareholders that will suffer. But we can agree to disagree here.

I've been analyzing banks for almost 15 years. And I've rarely found much that's "black/white" in the world of finance - I see an awful lot of gray. You'll have to give me directions to the Fantasyland you live in - I'd love to visit sometime. But I agree that the FDIC has failed to do its job properly. Far from it. That, however, is a blinding glimpse of the obvious.

We are not discussing the "world of finance". We are discussing the FDIC as regulator of public depository banking.

There is no other category between competent and incompetent. The definition of incompetent is "not competent".

I have no doubt that there is a lot of gray to be seen. That is exactly what needs to go away. Anybody who is not fully competent should not be allowed to be the custodian of public depositors' money.

The facts are that commercial real estate was overbuilt in recent years, and sold/bought at bubble prices. If you are looking for Fantasyland, commercial real estate loans made during recent years is where you will find it.

It is not true that only their stockholders will suffer. The general economy suffers when bankers place (and leave) public depositors' money with speculators (bubble borrowers against commercial real estate) rather than with the productive economy.

The way to avoid saying in the future that the FDIC failed to do its duty is to insist that it do its duty today.