Closer To Pittsburgh

I’m a regular reader and a fan of Barry Ritholtz, the principal author at The Big Picture.  I highly recommend making it a regular stop as it has incisive commentary of many financial topics (although the financial industry is not the exclusive genre) and Barry has no qualms about regularly upsetting the apple cart of conventional wisdom.  Moreover, it is one of the very, very few sites where I have found (most of the time) educated and responsible comments from other readers.

But I have to disagree with a post Barry had yesterday over a settlement between Bank of America and Freddie Mac.  The posts states:

Did Bank of America get a deal?  Probably, but not nearly the deal described of 1 cent on the dollar.  Why?

1.  Sure, a payment of $1.28 billion versus $127 billion in loans is right about 1% of the loan value.  But despite some considerable (and sometimes warranted) hysteria about the housing and rampant delinquencies and foreclosures, most of those loans are going to be repaid.  Based on the last delinquency report from the MBAA, the percentage of loans in some type of delinquency (ranging from full-blown foreclosure proceedings to being one month behind on payments) is a little under 14%.  It’s possible that Bank of America’s loans are running at a higher delinquency rate.  For the sake of this hypothetical, I’ll just concede that they are running a 50% higher delinquency rate.  That’s a 21% delinquency rate.  Again, although there is no reason to do so, let’s also assume that the value of the average delinquent loan is higher than the average loan in this pool in general.  Then we get a very unconservative estimate of potential losses of 25% or about $32 billion of bad loans.

2.  It should be noted that a delinquent loan can be a total loss, but rarely is.  In fact, with some delinquent loans, a lender can not only recover the full balance payable and costs incurred with collection, but a delinquency also permits late charges.  So in some cases, a delinquency is actually a windfall.  But let’s imagine a worst case where all $32 billion in delinquent loans goes to foreclosure and that the loans were permanently delinquent from the initial payment.  The loans are secured by collateral, namely the borrowers’ homes.  Ultimately, the lender will recover a healthy amount after taking title to the property and selling it to a new owner.  How much could they recover?  As of about a month ago, properties selling after a foreclosure were selling at a 32% discount to other properties.  But that percentage is a comparison to other sales prices, not to the amount of the loss on the loan.  So we can’t immediately determine that the recovery would be 68% of the loan amount.  Moreover, by the time the foreclosure is complete, the lender may also be on the hook for some property taxes, commission, court costs  along with other expenses.  It’s tough to get a good grip on how much would be available to offset that hypothetical $32 billion in losses.  To be seriously pessimistic, let’s figure that every loan exceeded the value of the property by 20% meaning we’ve got what would typically generate about $25 billion in property sales.  From that $25.6 billion, apply the 32% discount and we get $17.4 billion.  From there, with expenses of sale and foreclosure, there is going to be another healthy reduction.  How much is difficult to determine beyond the commission to real estate brokers (typically 6%), so let’s continue with the pessimism streak and quadruple the commission to account for those other expenses.  That leaves $13.2 billion to offset our $32 billion loss.

Let’s stop there even though there may be other methods for Freddie Mac to offset their losses (tax reductions, mortgage insurance claims and deficiency judgment actions for example).  We’ve now got a bit under $19 billion in losses.  Now we’re at a rate of 7 cents to the dollar which still seems terrible.  But we’re also talking about a far smaller total loss.  When we started, the hit to Freddie Mac and via Freddie Mac and the US Treasury to the taxpayer, was $132 billion.  Now the loss (with some worst case estimates to get to that point) is under $18 billion.

So really, out of that $132 billion, Freddie Mac is now almost certainly recovering at least $114 billion which is 86 cents on the dollar.

Is it unfair to flip it that way as it seems to delude the reader that the loss isn’t that serious?  Yes.  In a way that is equally unfair to the manner in which a reader is told that, as a taxpayer, they’re on the hook for 99% of Bank of America’s bad loans.

Now that we’ve walked through all this, let me go back to where I stated that I disagree and modify it a bit.  I do disagree with the comment about the 1 cent on the dollar settlement.  I don’t disagree about how the federal government conservatorship of Fannie Mae and Freddie Mac has been a way to bail out huge Wall Street financial institutions in a way that may not get as much public notice as TARP.  But that point was too easily lost with the one cent on the dollar discussion.  It’s certainly OK to be outraged, but if we’re going to be outraged, let’s precisely articulate the issues and not sensationalize things.  Even if my estimates are wildly overblown, even if Freddie Mac doesn’t come anywhere near the losses that I’ve come up with here, even if the taxpayers are on the hook for only a small percentage of the losses, we should still be horrified that taxpayer are being soaked, whether it’s for $18 billion or $18, while Wall Street executives are showered with bonuses and shareholders reap profits.  But if we throw out the 1 cent argument, upon close examination, we’re going to make those bank executives look smarter than us when they justifiably show it to be terribly misleading.