Friday, August 26, 2011

Even More Explosive Incentives to Spur Principal Write-Downs of Underwater Home Mortgages

I think it would be helpful to first focus on just whose books all of these Mortgage Loans are on.

Most Loans are classified as Held-For-Investment, thus are recorded on the Balance Sheet at Amortized Cost, thus not at Fair Value.

A pretty high percentage of Mortgage Loans are on the books of 5 companies. At Dec 31, 2010, here are the Loans that were Held-For-Investment at these 5 companies.

……………………………...........(bils of $s)
Fannie Mae
…..Of Fannie Mae…………….......407
…..Of Consolidated Trusts…..2,577
…..Total Fannie Mae……….....2,984

Freddie Mac
…..By Consolidated Trusts…..1,646
…..Total Freddie Mac………....1,838

Banc of America……………........940

Wells Fargo…………………..........757

JPMorgan Chase……………........693

Total of these 5 Companies...7,212

Yeah, that’s $7.2 trillion of Loans Held-For-Investment, just on the books of these 5 companies. This is a really big deal, and a key part of the current US economic problem.

There are also Mortgage Loans classified as Available-For-Sale on the books of these 5 companies, which are recorded on the balance sheet at Fair Market Value. But the largest portions of Loans are classified as Loans Held-For-Investment, and are recorded at Amortized Cost.

How big of a problem is Amortized Cost vs. Fair Market Value for these Loans?

Well, if you can believe the company’s audited financial statements and footnotes, both Fannie Mae and Freddie Mac have the Total Fair Market Value of their Loans above their Total Amortized Cost…..and by not a small amount……Fannie Mae by $46 bil and Freddie Mac by $14 bil. That surprised me, and is good news.

On the other hand, two of the three huge commercial companies have their Total Fair Market Value of their Loans below their related Amortized Cost at Dec 31, 2010, as follows…..Bank of America $15 bil and Wells Fargo $11 bil…..that’s not good news. On the positive side, JPMorgan Chase’s Total Fair Market Value of their Loans are above their related Amortized Cost by $3 bil.

Here are the Allowance for Loan Losses as a percentage of Loan Balances at Dec 31, 2010:

Fannie Mae………...2.06%
Freddie Mac………..2.11%
Wells Fargo………...3.04%
Bank of America…..4.45%
JPMorgan Chase…..4.66%

Given the horrible US housing crisis, I was very surprised at how low these Bad Debt assessments are. I thought that they would be much higher. Frankly, I think these companies, and their external auditors, are optimistically dreaming, particularly the first four.

So to solve the US Housing crisis, the country must also deal with the Loans on the books of Fannie Mae and Freddie Mac.

Fannie Mae and Freddie Mac are in essence the US Government.

Thus, the US Government shouldn’t need to incentivize them to write down the principal balance of all their underwater mortgages.

Perhaps the best way to go here is for both Fannie Mae and Freddie Mac to sell to the US Government at Fair Market Value the portions of all mortgage loans that are more than say 90%, or probably even better, more than 80% of the FMV of the related Homes. That will let both Fannie Mae and Freddie Mac get rid of the clearly toxic portion of all of their Mortgage Loans.

The US Government writes down the principal balance on all of these mortgage loans it acquires to what it paid for them, or Fair Market Value. The home owner is elated, as will be the US housing market and also the US economy.

And Fannie Mae and Freddie Mac both also reduce, in some even-handed manner, the interest rate a bit on all of their remaining home mortgage loans, both the ones that were previously underwater, and also the ones that weren’t underwater.

Also, the US Government reduces the interest rate a bit on these now second mortgage loans it acquires, and the homeowner doesn’t have to make principal payments to the US Government for a period of time, until after the US economy and US unemployment have both gotten much better. And the term of this second mortgage is for 10 years, which matches the CBO scoring period.

The CBO scoring to the US Government should be substantially positive. And both Fannie Mae and Freddie Mac should need no more US Government capital infusions. And if this plan is both wisely designed and well implemented, both Fannie Mae and Freddie Mac should eventually get nice stock price appreciation, most of which will accrue to the benefit of the US Government.

Now back to the commercial financial institutions.

I earlier proposed very explosive tax incentives for these financial institutions to either write down their principal balances of underwater home mortgages or to sell to the US Government at Fair Market Value the portions of all mortgage loans that are more than say 90% of the Fair Market Value of the related homes.

The huge carrot here was explosive acceleration of Loan Loss Provision US federal income tax deductions in the year these underwater loans are either written down or sold.

But these large financial institutions have repeatedly shown that their patriotism to their company and to their own pocketbooks far exceeds their patriotism to the US.

Thus, I think it would be wise to add a stick to this carrot tax incentive approach.

I would also require all large financial institutions, which obstinately choose neither to write down their underwater first and second home mortgages, nor to sell them to the US Government, to get their Total Loan Loss federal income tax deduction for 2012 reduced by a reasonably large percentage of the total underwater amount of all their first and second home mortgage loans that are underwater.