A Massive Overhang Fades Away

 | Feb 18, 2014 | 5:00 PM EST
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I've written multiple columns on the status of non-performing loans in the U.S. banking sector over the past few years, and most of those pieces have focused on first trust residential mortgages. That's because a home tends to be the largest consumption item that people possess -- so if folks can't pay for it, any secular resurgence in private-sector economic activity will be impossible without monetary and fiscal stimulus.

When Lehman Brothers failed in 2008, 5% of mortgages carried by U.S. banks were non-performing -- that is, unpaid for 90 days and no longer accruing interest. This represented a marked increase from the roughly 1% norm that existed before the subprime crisis, which had begun about two years earlier. Even after U.S. equity markets began to rise again in early 2009, the number and value of mortgage defaults continued to climb, and the non-performing ratio peaked at about 11% in early 2010.

From that point through 2012, that ratio stayed stubbornly high, in the 10% range. These mortgages encompassed most of the "shadow inventory" of homes: houses that are not currently for sale, but which will inevitably need to come to the market at some point in the near future.

Again, a mortgage becomes "non-performing" once it has gone unpaid for 90 days. At that point, there is almost zero statistical probability that a mortgagor will bring it current, so it becomes pointless for the bank to continue carrying the mortgage as an accruing asset. The loan is prepared for the recovery process, and the bank continues carrying the loan as "non-performing" until that process is completed.

This normally means foreclosure, though since the start of the subprime crisis banks have also engaged in short sales -- i.e., selling the home for less than what is owed by the mortgagor -- and loan modifications. If the bank employs one of the first two options, it removes the loan from the non-performing category. It reports both the charge-off amount and, later, the recovery amount, with the net loss being absorbed by loan-loss reserves.

Modifying a loan also removes it from the non-performing category. However, a very high percentage of these will default again, at which point the loan would once again become non-performing and the recovery process would restart. As a result of this, modified loans are categorized as "troubled debt restructurings" (TDR), separate from the other performing loans.

For most of the post-Lehman-failure environment, we saw no decline in the number of non-performing loans, nor in re-defaults from modified loans. That's even despite falling home values and mortgage rates, and despite the government's successful introduction of 12 loan-modification programs. This lack of improvement constituted the principal reason that the Federal Reserve implemented successive rounds of quantitative easing.

But the trend finally began to break positively last year. Among all of the roughly 6,500 banks in the U.S., the percentage of non-performing mortgages fell from about 9.5% to 7.5% during 2013, and recovery rates on those loans increased from about 8% to 38%.

JPMorgan Chase (JPM) and Bank of America (BAC) each saw particularly large reductions in non-performing loans, as well as sharply rising rates of recovery. When 2013 began, 20% of JPMorgan-held residential mortgages were in default -- the same ratio the bank had maintained seen since the Lehman crisis. By the end of the year, that percentage had dropped to 13%, and it is still in decline. Recovery rates, meanwhile, started out 2013 at about 5% and ended at about 100%. Similarly, BofA's defaulted mortgages dropped from about 19% at the start of last year to 13% at year-end, and the recovery rate moved from about 4% to 50%.

The situations at Citigroup (C) and Wells Fargo (WFC) are not as promising. While Citi's non-performing mortgages have declined from some 9.25% to 8.5% in the past year, that ratio is still pretty close to what it's been for the past three years. More troubling for Citi is that it is still reporting a recovery rate of only about 1.25%.

But the bigger trouble spot is Wells Fargo. Granted, the bank's loan-recovery rate has increased from about 9.5% to 35%, close to consistent with JPMorgan and BofA. However, its non-performing loans have held close to constant for the past three years, both in dollar figures and in the percentage terms -- about $33 billion and 13.5%, respectively. As I've stated before, I simply can't explain this.

The bottom line, though, is that the massive overhang of non-performing mortgages has diminished substantially in the past 12 months. These loans had represented a shadow inventory of properties, serving as a collective drag on the housing sector, bank profits and economic activity as they spurred the need for QE. Now, those concerns are fading into the background.

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