I have written many columns focusing on the overhang of nonperforming first trust residential mortgages concentrated in the four largest money centers during the post financial crisis years. My last column on the subject was published in February: A Massive Overhang Fades Away.
Even though the carried value of nonperforming residential mortgages in the money centers has declined by about 40% in the past five years, it is still extraordinarily large by historical measures. At the current rate of resolution, it will take another decade to be fully resolved.
One of the most interesting aspects of the current situation is that even though the residual losses that still must be taken by the money centers is massive, almost all of them have stopped setting aside loan-loss reserves to absorb them.
The recovery of losses from the sale of the underlying collateral has risen dramatically. This was one of the prime drivers for not setting aside loan-loss reserves to cover net losses incurred on the charge off of defaulted loans.
Revenue not set aside for loan loss reserves is counted as earned income and it is beneficial to stock holders. The problem, however, is that the money centers have now reduced their loss reserves to the extent that it appears they are now anticipating full recovery from losses by way of the sale of the collateral; the houses taken into the Other Real Estate Owned (OREO) as a result of foreclosure or deed-in-lieu-of transactions.
To put this in perspective, the residual carried value of nonperforming first trust residential mortgages at JPMorganChase (JPM), Wells Fargo (WFC), Bank of America (BAC), and Citigroup (C) in billions of dollars are, respectively, $15.50, $27, $23 and $6.
The loan-loss reserves set aside for each of these companies are, however, only a fraction of these amounts. Listed in the same order as above, they are, respectively, about $800 million, $250 million, $575 million and $900 million.
On average, the amount set aside for loan-loss provisions, as a percentage of earning assets, has declined roughly from about 1% to .1% in the past few years. That reduction goes straight to the bottom line and pushes up reported net earnings, which are then also available to be distributed as dividends.
The rationale for this adjustment is that losses recovered by way of the sale of the physical collateral has surged in the past few years. Recovery rates at JPMorgan, Wells Fargo and Bank of America have increased to about 100%, 85% and 44% respectively, from 6%-8% a few years ago. The money centers are all managing the allocation of revenue to loan-loss reserves on the assumption that the recovery rates of the past few years will remain over the next several.
The issue with that is that one of the reasons for the recovery rates increasing was the dearth of primarily single family dwellings available for resale which has largely been a consequence of the money centers not sending nonperforming loans through the recovery process. In other words, the value of residential properties in the US has been managed up by the banks.
The complicating factor is that this process has also resulted in an increase in demand for new homes and worked to the benefit of home builders. But that process has also resulted in potential demand for the existing properties being held off of the market by the banks to be siphoned away by the builders and the buyers of their properties.
The net effect is that the longer it takes the banks to resolve their nonperforming loans by way of sending the collateral through the recovery process the less likely it is that the recovery rates will remain at the elevated levels the banks have been able to engineer over the past few years. It's a kind of giant game of kicking the can down the road.
A bigger issue for investors right now, with respect to this issue, is that although federal regulators have refused to get involved, local jurisdictions are starting to. When a mortgagor defaults, the lender becomes responsible for maintaining local real estate taxes and home owner's association dues. If the lender doesn't maintain those taxes and fees, then the municipality or association can foreclose.
In some jurisdictions, the association may even extinguish the mortgage through this process without paying it off. There is a court case in Nevada concerning this issue now and it could become a catalyst for the money centers to resolve their nonperforming loans much more quickly -- and take the necessary losses to do so.
