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Key Difference Between Homeowners and the Banks Holding Multifamily Real Estate Assets

What is a key difference? Keep reading for the answer, but the photo to the left provides a hint…

This site has been a vocal proponent of a form of Marty Feldstein’s proposal for the U.S. government to refinance residential mortgages of defaulting homeowners.  Many detractors complained that this would give these underwater folks a free pass, while hard-working people get no benefit. An expansive program would moot those concerns.

I would propose refinancing all residential mortgages for owners that are primary residents — especially the folks whose mortgages are current. If trends continue, many of these borrowers will join the ranks of the unemployed and underemployed — about 1 in every 5 Americans. The government’s cost of funds is near zero (while banks lend out the money at between 5 and 6 percent). If Uncle Sam lends out this money at 2-3%, it yields a significant profit.  Such modifications would need to undergo a three- to six-month trial period to ensure that the borrower is a reliable credit risk. Moreover, the borrower would need to sign personally on the loan, and agree to be liable even when an eventual foreclosure fails to cover the loan amount. If apartment building owners are sentimental about their properties, and disinclined to sell, then homeowners will certainly be even more attached to their properties. They will fight even harder to hold on to their homes for the sake of their families, and be less inclined to throw their keys to the bank.

Furthermore, doing nothing would be the worst possible remedy for those homeowners who are current on their mortgage payments.

According to one study, every home foreclosure drives down neighboring home prices within 1/8 mile by 0.75%. Properties within zero to 300 feet on average experience a 1.3 percent decline in value, while properties within a 300-660 foot ring (660 feet = one eighth of a mile) have a 0.6 percent decline. It appears that the best way to protect solvent homeowners from the contagion of falling home prices is mass refinancing across the board. This would also give Uncle Sam a healthy profit as well.

The current government-backed loan modification program in place for homeowners is deeply flawed: The vast majority of modifications haven’t included writing down loan balances, which some analysts believe would facilitate more successful modifications. Furthermore, many of these modifications are temporary. By reducing the interest rate or extending the loan over a longer term, more borrowers might be able to make monthly payments.

Note well: Uncle Sam’s profit would be completely undercut if he continues with the home buyer $8,000 tax credit — if it is not coupled with a verifiable requirement that homebuyers put down 20% of the purchase price from their own funds. The Chinese residential real estate market is stabilizing in no small part because of this rule as well.

CRE loans, by contrast, are typically held on bank books at par, or face value, even when overwhelming evidence shows that the value is a fraction of the original loan amount.  Since mark to market accounting rules have been relaxed, banks have no obligation, let alone, inclination, to put the loans’ correct values on their books, and take the hit. Borrowers who have relationships with banks can, on a case-by-case basis, “extend and pretend,” or “delay and pray,” extending and/or modifying their loan terms. This growing phenomenon is no different from Feldstein’s proposal, just on a grander scope, without the arbitrariness.

Despite some cautious optimism from American Banker that banks are becoming more aggressive with CRE borrowers, all evidence from this side of the table points to the contrary. Until the FDIC uses its power to revoke charters to force banks to: (1) lend more money, and (2) mark toxic assets to market, the big banks appear to be playing a waiting game. Wait for the small banks to fail, and get taken over by the FDIC. The FDIC will mark these banks’ assets to market, the big banks will take over their good assets and depositary relationships, and the market will eventually come back.

And why shouldn’t the big banks be so optimistic?

1) The banks are making tens of billions of dollars in fees on mortgage loans that are backed by the government (read: we taxpayers). Three big banks, Wells Fargo, Bank of America, and Chase, earned $14 billion in the first half of the year, up more than threefold from $4.1 billion in the year-earlier period from these fees alone.

2) Big banks received TARP money which was supposed to go out their doors to borrowers to strengthen our economy. Instead, banks hoarded it like squirrels, protecting their Tier 1 Capital Ratios, and preparing for the winter of mark to market which never came. (To be adequately capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 4%, a combined Tier 1 and Tier 2 capital ratio of at least 8%, and a leverage ratio of at least 4%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. To be well-capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 6%, a combined Tier 1 and Tier 2 capital ratio of at least 10%, and a leverage ratio of at least 5%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels.)

How did the banks get their TARP money? Check out this chart which shows another ratio: the amount of campaign contributions relative to TARP money received (Hat Tip: Calculated Risk).

Ultimately, banks have great incentive not to mark their multifamily real estate assets to market. Their lobbying and personal relationships at the highest reaches of government will prevent the TBTF (Too Big To Fail) banks from going under. Unfortunately, these banks will understandably opt for self-preservation over our economic recovery.

We do not have to help them achieve that goal.

So, a key difference between homeowners and the banks holding the multifamily real estate assets?

The banks have a huge lobby.

(Hat tip to the first person who correctly guesses the location of this lobby.)