January 12, 2012
by First Financial Network, Inc.
Banks continued to analyze their balance sheets carefully in 2011, evaluating the delicate relationship between moving loans to the held-for-sale accounting category and its potential impact on their stock price. For the most part, analysts viewed these activities positively provided the institution had adequate capital. In 2011, compared to 2010, the additional capital and losses taken translated into more transactions.
But despite these positive actions to clean up non-performing commercial loans, there remains a staggering volume of non-performing residential loans on both the books of banks and GSEs Fannie Mae and Freddie Mac. According to a recent white paper from the Federal Reserve, currently, about 12 million homeowners are underwater on their mortgages—more than one out of five homes with a mortgage.
In states experiencing the largest overall house price declines—such as Nevada, Arizona and Florida—roughly half of all mortgage borrowers are underwater on their loans. Fannie Mae, Freddie Mac and the Federal Housing Administration together hold about half of the outstanding REO inventory. Atlanta has the largest number of REO assets for sale by these institutions, clocking in at 5,000 units, followed by Metropolitan Chicago; Detroit; Phoenix; Riverside, CA; and Los Angeles, each of which have between 2,000 and 3,000 units.
Of particular concern is that the number of properties currently in the foreclosure process is more than four times larger than the current number of properties in REO inventory. This has led the Federal Reserve to predict that “if recent trends continue, the share of REO inventory held by the GSEs and FHA should increase.”
Earlier in the year, a report issued from the Office of the Comptroller of the Currency, estimated that close to 6.7% of mortgages backed by Fannie and Freddie were non-performing. Although this figure was not as large as delinquent mortgages reported in banks’ portfolios (19.7%), the GSEs rate is problematic because Fannie and Freddie guarantee more than $5 trillion in mortgages, double the amount held by all of the nation’s banks and thrifts.
The GSEs admittedly had a number of other issues to work through this past year. In mid-December, the Securities and Exchange Commission formally charged former Freddie CEO Richard Syron and former Fannie CEO Daniel Mudd for their roles in the subprime mortgage scandal. While it is well known that Freddie started acquiring subprime loans to meet affordable housing goals at least as far back as 1997, the SEC complaint alleged that Freddie had a coding system to track “subprime,” “otherwise prime” and “subprime-like” loans in its loan guaranty portfolio, despite the fact that it denied having any significant subprime exposure. According to Robert Khuzami, director of the SEC’s Enforcement Division, both of the GSEs “misled the market about the amount of risk on the company’s books,” which is a particularly troubling comment given that the GSEs accounted for nearly half of all outstanding single-family first mortgages from 2001 onward.
As Fannie and Freddie work to find their footing and concentrate on resolving their non-performing residential loans, they would be wise to borrow a page from the Federal Deposit Insurance Corp., which has successfully employed loan sales as an effective resolution strategy for non-performing loans. The FDIC established its first formal loan sales program, the Asset Marketing Program, in 1984. The AMP was conducted by the FDIC staff through various locations throughout the country, and while initially focused on the marketing of performing loans, the program was later expanded to accommodate the sale of non-performing loans.
Up to that point, the FDIC had typically retained non-performing loans from a failed bank and attempted to work them out itself by assigning specific FDIC officers tasked with negotiating repayment, restructuring or settlement of the debt with individual borrowers. However, as the volume of non-performing loans increased, the FDIC needed additional disposition strategies and therefore began to market these loans as well. All loans were packaged for sale in pools based primarily on size, asset quality, asset type and geographic location, following which the FDIC assigned values based on projected cash flows and established minimum reserve prices for each package. Similarly, following its establishment in 1989, the Resolution Trust Corp. implemented a Bulk Sales Program to dispose of the assets of failed savings institutions, which adopted many of the characteristics of the AMP.
Today, the FDIC continues to sell pools of loans directly to investors and as well as through structured sale transactions, whereby it contributes a pool of performing and non-performing loans to a newly established limited liability company, retains a participation interest in the future cash flows and sells the entire membership interest in the LLC, which represents the remaining interest in the loan revenue stream, to a single investor. Thanks in large part to these current loan sales programs, we have seen a steady rise in the number of non-performing commercial loans that have been resolved over the past few years.
Clearly, the economy won’t recover until housing recovers. We believe that the resolution of non-performing residential mortgages must be addressed in 2012.