2009 February 03 Tuesday
Banks Overvalue Mortgage Securities

Banks are overstating the value of their mortgage bonds.

The wild variations on the value of many bad bank assets can be seen by looking at one mortgage-backed bond recently analyzed by a division of Standard & Poor’s, the credit rating agency.

The financial institution that owns the bond calculates the value at 97 cents on the dollar, or a mere 3 percent loss. But S.& P. estimates it is worth 87 cents, based on the current loan-default rate, and could be worth 53 cents under a bleaker situation that contemplates a doubling of defaults. But even that might be optimistic, because the bond traded recently for just 38 cents on the dollar, reflecting the even gloomier outlook of investors.

With unemployment rising the loan-default rate will probably rise too. This particular bond isn't even on the principle mortgages. It is on secondary mortgages and the decline of home values makes the sale of many foreclosed houses worth less than their primary mortgages, let alone their secondaries.

The Standard & Poor’s group, Market, Credit and Risk Strategies, which operates independently from the company’s credit ratings business, has been studying troubled securities for investors and banks. The bond that is trading at 38 cents provides a vivid illustration of the dilemma in valuing these assets.

The bond is backed by 9,000 second mortgages used by borrowers who put down little or no money to buy homes. Nearly a quarter of the loans are delinquent, and losses on defaulted mortgages are averaging 40 percent. The security once had a top rating, triple-A.

It amazes me that credit ratings agencies ever triple-A rated secondary mortgages, let alone doing this at the top of a housing bubble when housing price-to-rent and price-to-income ratios were so far out of whack from historical averages. Spain, Ireland, Canada, and Britain were even more out of whack. These sorts of charts ought to be used when rating securities. Do S&P, Fitch, and Moody's use these sorts of ratios when calculating bond ratings?

S&P is making it harder for the banks to continue to carry mortgage-backed securities (MBS) on their books at unrealistic valuations. But closing the barn door after the horses have fled doesn't help as much as doing it before they gallop away.

There’s a saying about death by a thousand paper cuts, and that’s clearly been taking place for most of the private mortgage-backed securities market over the course of the past twelve months. On Monday, Standard & Poor’s Ratings Services lowered the boom — again — on thousands of Alt-A and subprime RMBS, moving them all to a ‘D’ rating, as well as cutting hundreds of formerly AAA-rated securities multiple notches from their previous perch atop the ratings heap. The agency also began cutting ratings on prime deals, as well.

This cuts the incentive of banks to hold onto these MBSs as the prices implied by their ratings are now closer to their market prices.

Which ratings agency has moved most quickly to get realistic about the ratings of MBSs? Is one of the ratings agencies less bad?

Update: The US homeownership rate has declined back down to the year 2000 level. The Rove-Bush plan for increased minority housing ownership has totally failed. In its wake lower income minorities are burdened with housing costs they can't afford.

The AP's analysis reveals the enormous scope of the U.S. housing market bust and how unevenly the burdens are spread, both geographically and demographically. And the situation is worsening — a record 10 percent of U.S. homeowners with a mortgage are at least one payment behind or were in foreclosure as of last fall, compared with 7.5 percent a year earlier and just under 6 percent in 2006.

The burden is clearly more arduous among minority households, the AP analysis found. Just under a third of Hispanic homeowners spend at least 38 percent of their income on housing expenses, compared with about a quarter of Asian and black households and nearly 16 percent of white households.

Do-gooders too often do bad.

Update II: The US housing market has lost $6.1 trillion of value since its peak and more than half of that loss, $3.3 trillion, came in 2008.

About $6.1 trillion of value has been lost since the housing market peaked in the second quarter of 2006 and last year’s decline was almost triple the $1.3 trillion lost in 2007, Zillow said.

How many trillions more to the bottom? How many more banks fail along the way? How many will we bail out via the money we pay in taxes? We can't tell because as Mish Shedlock points out banks are hiding lots of assets off-balance sheet.

Share |      By Randall Parker at 2009 February 03 09:24 PM  Economics Housing

Anonymous said at February 5, 2009 10:39 AM:

I agree with your conclusions, but the problem is that the ethical belief system that
caused the sub-prime crisis is still in place. This is liberalism, to wit:

1. Only whites can be bad.
2. People of color are always hurting and need help.
3. Whites must help them.
4. Everybody is equal and if they aren't, gov't must intervene to make them equal.
5. Nothing else really matters except doing good -- even if it takes out the whole
economy and the country.

You'll notice that 911 didn't change the ethical system of the elites.
The sub-prime crisis won't either. What would ? Nuking ?
I think, maybe not even then.

Luke Lea said at February 5, 2009 11:25 AM:

When you consider how many mortgages are underwater, the home ownership rate is even lower, significantly so I suspect.

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