This blog is written weekly by Dock David Treece, a registered investment advisor with Treece Investment Advisory Corp. It is meant to share insight of investment professionals, including Dock David and his father, Dock, and brother, Ben, with the public at large. The hope is that the knowledge shared will help individuals to better navigate the investment world.

Wednesday, October 20, 2010

Mortgage Makers’ Billion-dollar Boo-Boo

It’s seems the time may have finally come to say goodbye to a lot of the big banks, among the Bank of America and Wells Fargo.

A recent Bloomberg article revealed that bond giant Pimco, money manager BlackRock, as well as the New York Fed, are all attempting to force Bank of America to repurchase mortgages that have gone bad. The real problem is the numbers. These bad mortgages were among others that were packaged into roughly $47 billion worth of bonds by Countrywide Financial (owned by BoA) and sold to Pimco, BlackRock and other investors as mortgage-backed bonds.

One Wall Street Journal Article claims that roughly 40% of Bank of America’s mortgages sold have been paid off. That still leaves $450 billion in outstanding loans, hardly covered by the loan repurchase reserves held by the four largest US banks which totaled $8 billion at the end of June.

Wells Fargo, in which Warren Buffett’s Berkshire Hathaway is a large investor, is in nearly the same boat. As the institution begins to brace itself for large loan repurchase requests, it does so with very little in reserves. According to a recent report from Wells, the company has just $1.3 billion of reserves to support approximately $144 billion in loans it sold to the public.

In short, banks simply don’t have the reserves to pay for the likely wave of loan repurchase requests about to come in. Looking at the degree to which these institutions have leveraged their reserves, it seems we may be watching the unfolding of the next Long-Term Capital Management.

At its peak, LTCM was leveraged about 100:1. Thanks to the housing market bulging with excess leading up to 2006, many big banks have leveraged their repurchase reserves beyond that insane ratio.

Long Time Coming

For years many of the big banks reaped windfall profits by taking advantage of their clients every way they could. Their offenses included:

• Making predatory loans, knowing that many borrowers couldn’t possibly down their debt.

• Bundling bad mortgages together, slicing and dicing them into tranches, and sold them as “safe” debt. They used the capital they received from the sale of this debt to finance further lending.

• Cooperating with the formation and pervasion of derivatives markets, which helped supply additional income by helping investors to use exotic new “securities” to “hedge” their bets on mortgage-backed securities against default. Banks did this while purposefully downplaying counterparty risk faced by investors in this unregulated market.

• Now many banks have been fraudulently foreclosing on homes, because the housing market grew so quickly that many didn’t take the time to properly execute and store necessary legal documents.

Now it appears the bill has finally come due. Big banks, particularly big mortgage houses and lending units are going to hurt in a big way, as are their employees and their shareholders.

Many will point to the government intervention as a possible means of staving off crisis. However, given current political pressure on Washington as election season approaches, trust in a potential bailout seems misplaced, particularly given the illegality of many actions taken by these institutions.

A quick note of clarification: Depositors in these institutions need not be alarmed, as bank deposits are still insured by the government through FDIC. Investors holding positions in these banks, however, may want to rethink the outlook for their holdings.


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