June 2011

"I expect a very orderly kind of cooling to the housing market over the next few months" … Alan Greenspan 19 May 2006

The financial world is inundated with statistics, but often it is real life stories that tell the truth better than the numbers on the page. The following two stories clearly explain why we at Talbot Financial are avoiding the financial sector….and, in particular, banking stocks.

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Story 1. Joe is a school teacher in a tough urban neighborhood. He works hard and knows he will likely never be rich. Joe bought a modest home in 2005 for $180,000. He took out a second mortgage for $80,000 in 2007. Since then, living expenses have been rising much faster than Joe’s income.

Adding to the pain, the housing crisis meant Joe was “upside down” on his house since his loan amount was higher than the value of his home---a lot higher.

And while Joe could (and was) still making his house payments, the financial strain was adversely affecting his state of mind and physical health.

Earlier this year, friends familiar with Joe’s situation suggested he go to the bank and either renegotiate terms or exercise a “strategic default”…meaning defaulting on purpose because it made economic and/or personal sense.

Joe first went to the bank holding the $80,000 2nd mortgage. He explained his situation and calmly threatened default. He couldn’t believe what he then heard. The bank offered to release Joe’s $80,000 commitment for $4000. Joe was thrilled.

Joe then went to the first bank holding the $180,000 note, and did the same. The bank told him to stay in the house, maintain it, and put it up for sale. They said they would take whatever Joe could sell it for as settlement for the loan.

So Joe sold the home…for $119,000.

Because Joe maintained the home in good order until the home sale closed, he received over $3000 from a Federal program designed to discourage people from trashing their homes before default. Joe was incredulous.

Thus, for under $1000, Joe got out from under a $260,000 debt burden. He now lives happily in a nice apartment and his monthly bill for shelter has dropped by over 60%. His stress level is down and he feels like he won the lottery.

Meanwhile, bank 2 took at $76,000 loss, and bank 1 took a $61,000 loss. Oh, and the American taxpayer took a $3000+ hit. Remember, this was not a delinquent loan, nor an owner without a job who couldn’t make his payment.

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Story 2: Brian lives in nice suburban neighborhood of upper middle class homes. The homes were built in 2003-2004. There was a waiting list and a “lottery system” for eager buyers when the subdivision first opened. Homes sold for $550-$600,000. The going interest rate on the mortgages then was 5.75%-6.25%

By 2010, many of the homes were valued at $300-$350,000. Some were empty. And while interest rates were now in the 4’s, the homeowners could not refinance because they had no equity in their homes.

Then the neighbors got an idea. Why not buy the similar house next door and then default on the home they occupied? Most were still employed and had good credit scores. So they did.

Neighbors got together and coordinated sales and defaults so each could stay in the neighborhood, but with much lower payments.

Granted, they all took hits to their credit ratings, but they considered the trade-off worth it…especially if they were going to stay in their home for the next 7-10 years.

Meanwhile, the banks took the losses without much of a fight.

Why?

Well, as is now common knowledge, many (but not all) banks were guilty of one or more of the following:

  1. Issuing loans to people who never should have been given a loan.
  2. Sloppy paperwork.
  3. Bundling and selling the loans as AAA when they were not of that quality.
  4. Attempting to foreclose without proper paperwork
  5. Using “robo-signed” and outright falsified paperwork to create a “clean” foreclosure file.

Banks were (and still aren’t) eager to have the sins of 4-8 years ago aired.

But there is more.

You see, homeowners have it wrong when they say, “I’ll just give back the keys to the house and walk away. The bank has the house now, so I’m off the hook.” Not exactly.

When buyers buy, they sign to pay the full amount of the loan, not what the house is worth. Thus, technically, they are on the hook for the purchase price, not the home’s value.

However, to recoup the difference between what is owned and for what a house sells requires judicial action. Banks are reluctant to go to court because:

  1. It’s expensive
  2. It could take a long time to resolve…meanwhile the house deteriorates.
  3. The banking “sins” listed above now see the light of day….loan by painful loan.
  4. Judges aren’t always sympathetic to big banks compared to financially strapped plumbers or teachers.

Beyond this, many States allow banks a non-judicial foreclosure avenue; and while the rules vary State to State, the procedure is designed to be much simpler and faster. In exchange, however, for this less arduous and expensive procedure the banks forfeit the right to pursue the borrower for the delta (difference) between the home’s prices and the loan amount.

All of this is bad for banks….and their stocks.

What investors should also know is that accounting methods allow banks to carry many of these loans on their books at full value...as if the housing crash never happened! So, it’s not hard to surmise that bank marked-to-market residential portfolios do not reflect reality.

Of course banks could account for reality and choose to “lance the wound” and write down these loans in one fell swoop. That “cure”, however, could also kill the patient. Thus, banks are choosing to drain the losses slowly while government regulators wink and nod as the banks proceed.

Meanwhile, they are trying to get healthy by taking cash from the Fed at 0%….courtesy of the US taxpayer. The situation is akin to getting a blood transfusion…while leeches are simultaneously clamped all over your body. (Sorry for the visual here!)

In our view, this sector should currently be avoided as it lends itself more toward speculation than investment. There will be a time when the bottom is reached in these portfolios and loan spreads create real profits…but we are not there yet.

In the meantime, there are too many other places to make money.

 

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