Freezing the US foreclosure wave
Last Friday’s (October 2010) news that Bank of America was freezing the foreclosure process in 23 states (thus joining JPMorgan Chase and Ally Financial Inc) came as welcome news to a few who predicted that this would help the “housing recovery”.
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Really? It may temporarily help the occupants who might otherwise be out on the street, but it severely hurts the municipalities where these foreclosures would have taken place, as well as the risk management practices and capital adequacy levels of the institutions that are holding these mortgages.
This freeze should come as bad news to regulators at the FDIC and FRS who have spent a lot of time over the last 2 years trying to clean up the stress testing and economic capital levels of the nation’s largest banks. To improve the banks’ balance sheets and the long-term housing recovery, these defaulted mortgages should be going into foreclosure immediately.
Expected loss calculation
At the heart of banks’ recent credit crisis was their inability to paint a realistic picture of the Expected Loss (EL) within their mortgage portfolios and the asset-backed securities on their balance sheets.
The expected loss is calculated as:
EL = EAD x PD x LGD
- EAD = Exposure at Default
- PD = Probability of Default
- LGD = Loss Given Default
Currently, nothing can be done with the first variable, the Exposure at Default. Unless the loan is in a modification program, the banks are stuck with the exposure. The same is true with the Probability of Default to some extent, given that it is already on the bank’s balance sheet.
If it is not on the balance sheet, better credit quality checks prior to mortgage approvals would have reduced the level of default.
It is possible that the obligor on the loan may have a better financial condition (better paying job, fewer credit card liabilities etc) but, for the purposes of planning, you really need to assume that the probability of default is as poor today as when the loan was originated – reiterating the point that more thorough and stringent tests were required prior to approval.
The bottom line is that all the poor decisions that banks made between 2003 - 2006 with regards to exposures, probability of default and securitizations are variables that are going to remain on their balance sheets for a long time to come. However, the last variable in the Expected Loss calculation, the Loss Given Default (LGD) is where the banks still exercise a large amount of control, and this is where the foreclosures come into play.
In the case of mortgage foreclosures, the Loss Given Default is determined by how much the bank can recoup from a property after the foreclosure proceedings.
If the loan balance is $400,000, the proceeds from the foreclosed proprty are $300,000, and the bank’s foreclosure costs are $100,000, then the Loss Given Default would be 50%. If a bank is able to get 75%, that would be cause for celebration and a bottle of Dom Perignon.
Quite often, though, the LGD can fluctuate given the balance between the size of the recovery and the time that it takes to make a full or partial recovery, as well as the prevailing conditions of the housing market. This is where a freeze on foreclosures completely ruins any accuracy in forecasting the Expected Loss. The risk management teams of all the banks that have freezed foreclosures have spent a lot of time forecasting the amount of the loan they can recoup given a default. They have also analyzed the amount of time it has taken in the past to recoup the collateral. Freezing the foreclosure process throws all of that out the door.
Example:
If the recovery process for a loan defaulting in January 2010 was initally estimated at 10 months, the current freeze could double that. Given that the occupants rarely maintain the property (some even partially destroy the property to express their anger at being served a foreclosure notice), the amount that the bank can recover usually begins to shrink with each passing day. Therefore, the initial estimates on the recovery and time within the LGD are almost worthless.
To be fair, the banks got themsleves into this mess in the first place. Little or no oversight of the underwriting process with regards to Probability of Default and Exposure at Default problems, has led to a massive wave of defaults that have been well documented. The wave of foreclosures has led to similar problems: the bank employees responsible for reviewing foreclosure documents were so overwhelmed, they just began “rubber-stamping” them with little insight into specific issues.
If the banks and regulators are serious about maintaining rigorous risk management practices, they need to continue the foreclosure proceess with due diligence. Freezing the process will do little to help the municipalities, banks and even the homeowners in the long run.
Reference
FDIC: The Federal Deposit Insurance Corporation is a United States government corporation created by the Glass-Steagall Act of 1933.
FRS: The Federal Reserve System (also known as the Federal Reserve, and informally as the Fed) is the central banking system of the United States.
EAD Exposure at Default
PD Probability of Default
LGD Loss Given Default
EL Expected Loss
FRSGlobal solution to this problem
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