Wednesday, August 4, 2010

And the Band Played On…

In the last post, I talked about the future of the housing market. Today I want to look at the banking industry. To date the Federal Deposit Insurance Corporation (FDIC) has closed more than 100 banks. When the FDIC closes a bank, it finds another bank in strong(er) financial condition to take over the assets and liabilities. Since the closed bank was undercapitalized, usually the FDIC guarantees any losses over a certain threshold as part of the deal.

This process makes the entire banking system stronger and, in theory, should help promote future loans as more assets are available to strong(er) institutions.

Unfortunately, we’ve only seen the tip of the bank closing iceberg. The FDIC keeps an official list of distressed banks. Banks are included on the list based on a variety of characteristics including underperforming business loans, commercial mortgages and home mortgages. The official FDIC list of “problem” banks has increased from 416 in Q2 2009 to 775 in Q1 2010. (Note closed banks are removed from the list, so the number of banks in trouble has more than doubled when we consider the hundred plus already closed this year.)

There will be more. Banks must reflect the underwater nature of mortgages they hold; but if housing prices drop even a few percent more, it will drive an even larger percentage of mortgages under water. An estimated 14 million home mortgages are already underwater (roughly 30% of mortgages). Four million of those are underwater by over 50%. Surely these must either be restructured or foreclosed.

The total face value of all mortgages underwater exceeds $2 trillion. If the average of these mortgages is 25% underwater, that’s a half a trillion bucks. Every 1% decrease in prices leads to at least $20 billion of additional losses (and that doesn’t consider mortgages currently above water that will slip below the surface at various price declines).

In order for the economy to grow, we need investment. In order to have investment, banks must make loans. In order to make loans, banks must minimally feel a teeny bit confident in order to stop hoarding cash.

It’s clear to me this confidence is not going to come from looking at their mortgage portfolios.


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