Rule Scrapped: Banks to Value Assets Using Mark-to-Market

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If at first you don’t succeed at cleaning up your toxic asset problem, just change the rules. That seems to be the lesson from last week’s action on the market. The Dow capped its best four-week performance since 1933. And the ASX/200 is up a nifty eighteen percent in the last three weeks alone.

What changed last week? Nothing really, except the rules. The Financial Accounting Standards Board (FASB) in the U.S. suspended its rule number 157-e. That rule had required that banks value their assets using a mark-to-market method. In other words, banks had to revise the value of their their balance sheet assets based on the current market price for assets.

Banks and others have complained that this rule distorts the price of assets for which there is currently no market, or which the banks intend to hold to maturity (meaning the current price is largely irrelevant). It’s a clever argument.

Behind it is the assumption that if the market were normal, the price of the assets would be higher. Therefore, because the market is not normal, the pricing information is incorrect. But maybe the market isn’t spewing out bogus price information after all. Maybe the price of the assets is what it is because they are what they are: deeply distressed and careening toward a larger write-down.

Either way, we’ve entered the age of Dr. Phil valuations. It’s not about what the assets are actually worth. It’s about your own feelings.

“How do you feel about your balance sheet?”

“You know I feel pretty good.”

“What is that? Have the default rates on your Alt-A loans gone down? Are fewer people behind on their mortgage payments than last week?”

“C’mon man. You’re bringing me down. You know it’s not like that. I was just starting to get better…”

“I’m sorry. Please continue. Just forget about reality for a moment. Examine your feelings. What do they tell you? Or what would you like them to tell you?”

“Well, today I feel like I’m going to get ninety seven cents on the dollar back on my sub-prime CDOs. Don’t ask me why. It’s just this feeling I got eating breakfast. Yesterday, I didn’t feel so flash. It felt like maybe the assets were only worth thirty cents on the dollar. But yeah…today is great. I feel great. The assets feel great too. Everything is great.”

Everything is not so great, mind you. Unemployment in the States has hit a 25-year high. The rate is now 8.5% with nearly 663,000 Americans losing their job in March. That will lead to higher default and foreclosure rates for those already facing falling home prices.

This is not just a problem in America. It’s a problem here and now in Australia. “Given the poor growth outlook for Australia’s two largest trading partners – Japan and China – Australia should be preparing contingency plans for unemployment to peak at 10 per cent,” writes Kenneth Davidson in today’s Age.

Hang on. Won’t rising unemployment imperil the Australian property market? It’s possible. More on that in a moment.

Meanwhile, are there signs of life in the resource market? A new report from the Royal Bank of Canada Capital Markets (RBCM) says to watch uranium and fertliser stocks. That is just what we did late last year in Diggers and Drillers when we added an Aussie-listed uranium producer that’s now up around 50% from our entry price.

With regards to uranium the report concludes, “After record spot prices in 2007 and a subsequent hard correction, RBC Capital Markets believes the uranium spot price will rebound in H2/09. Significant production cuts were announced in late 2008 and RBC Capital Markets believes the supply side of the equation remains at risk, while demand appears to remain in line with expectations.”

On fertilizer stocks, the bank concludes that, “potash prices continue to remain firm and agricultural fundamentals support a rebound in fertilizer demand through 2009. A continued rally in fertilizer stocks is dependent on overall crop prices, which should remain supportive for fall fertilizer demand in 2009.”

The outlook continues to be dismal for base metals and bulk commodities (mostly because of the lower expectations for global growth for the next two years.) You should keep your eye out for deeply-discounted assets. But all the resource share price gains this year should come from agriculture, energy, and precious metals.

Now, about the property market. There is a new claim that rising unemployment is a big threat not just to home owners, but also renters. “If unemployment rises to nine per cent next year, as many economists predict, the number of tenants facing eviction rises to 216,000 nationally,” reports the Sunday Telegraph, citing a report by Fujitsu Consulting.

We have no idea who these guys at Fujitsu are. But they are definitely flying their housing crash/rental crisis flag on a regular basis. In this case, the logic of the argument seems sound. Rental vacancies are low. Landlords have to pay mortgages on properties and know there are plenty of other tenants around. The squeeze begins.

Over the weekend, the Federal government stepped in to try and relieve the squeeze, but only for mortgage owners. It amounts to the construction of a mortgage prison for the unemployed, if you ask us. And it’s not exactly new. The Prime Minister has taken credit for a move announced by Commonwealth Bank chief Ralph Norris three weeks earlier. That move allows mortgage holders who’ve lost their job to defer payments on the mortgage for up to twelve months.

So what’s the story? Well, the short story is that his move keeps Australian house prices high and more Australians in mortgage debt for longer.

Don’t get us wrong. What the bank and its customers choose to agree to is between them. That’s the spirit of capitalism! Voluntary exchange, enforceable contract, no compulsion or coercion. You signs your mortgage and you pays your money. But have you ever known a bank to do something out of the kindness of its heart?

Banks don’t want to foreclose on a homeowner. It’s expensive. And the bank doesn’t want to own the home outright anyway. That’s complicated. It has to then carry it on the balance sheet and value it while it tries to resell it.

The bank would rather keep you in the home, where you think you own it. And most importantly it wants to keep you paying on the mortgage. The longer you’re in debt, slaving away at the mortgage, the more regular bank earnings will be (which isn’t so bad if you’re a shareholder collecting dividends.)

In its current form, the various banks’ plans allow mortgage owners to either capitalise interest or choose an interest-only option. Capitalising the interest means the value of the monthly interest payment is added to the principal. The loan grows larger over time. This threatens to put the mortgage owner in negative equity.

The interest only option is more likely. Hmm. Interest-only mortgages. Sound familiar? The mortgage owner doesn’t pay down the principal at all for up to twelve months. Blah blah blah. We could go on with the details. But you see the basic problem.

This is a move designed to keep people in their homes because it “feels” bad when people lose their homes. We’re certainly not making light of it. It does feel bad. And once you get beyond how you feel about it, it IS bad. But policy made to make people feel better doesn’t do anyone a real financial favour.

The problem is that there are already too many people in Australia who shouldn’t, financially speaking, have mortgages at all. They have not prepared for rising interest rates or the possibility of a job loss, both of which can throw the worst-laid housing plans into complete disarray. Rates may be cut tomorrow by the RBA. But joblessness is definitely on the rise.

This is also the banks trying to prop up property prices to support their own loan books. By keeping marginal buyers in their homes during a recession, it prevents a flood of new inventory which might depress prices (especially since demand for housing finance should be expected to fall in a recession, although we’ll know more about this later in the week when the numbers from the ABS come out).

The bottom line is that any effort by the bank or the government to keep the marginal buyer in a house he can’t afford just keeps housing more expensive for everyone else. Property prices are already too high. Keeping people in homes with huge mortgages just keeps them in debt for longer.

What Australia needs is a good property price correction to correct the inflationary excess of the credit boom that pumped up prices so much in the first place. The two-decade credit boom and investment in residential property hasn’t made the country wealthier if it’s put hundreds of thousands of people into debt they can’t repay. It’s made the country poorer.

And don’t forget the unintended consequences. So far, the mortgage moratorium applies only to the Big Four and their customers. Smaller banks, building societies, and credit unions aren’t part of the plan yet. Will this cause an exodus of borrowers from these smaller firms? Will they refinance with the Big Four in order to have access to the leniency terms?

Who knows? But it certainly can’t hurt business for the Big Four. They manage to grow their loan book at the expense of smaller non-traditional firms. This might not work out exactly the way they plan, though.

Many of these smaller firms are the ones extending credit to marginal first home buyers. So perhaps the banks will end up bringing on to their balance sheet the single riskiest mortgage assets in the Aussie market. Keep the subprime plague at bay from the front door, and open up the back door for a house warming party. Good plan!

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. “Rental vacancies are low. Landlords have to pay mortgages on properties and know there are plenty of other tenants around. The squeeze begins.”

    Is that right Dan. And who will be paying these higher rents?

    If the unemployed cannot afford rents…demand for these places will drop. By how much is another question. But as the recession/depression starts to bite, people will become more thrifty and less willing to pay stupidly high rents. I believe the shoe of power will go from the left foot of the landlords, to the right foot of the renters.

    Besides, under higher interest rates and mortgage stress, who can least afford to have their place with zero tenants? Landlords.
    Which landlords can survive by demanding higher rents and having zero tenants, when competing with other landlords who will settle for less so long as they have at least some income from a tenant.

    And then…you have the foreclosures. Someone has to buy the place. If it is an investor then you have more rental supply on the market. More supply = more price competition = lower rental prices.

    And don’t forget the ‘flippers’. The “i’ll buy a place, renovate it and sell it for more due to capital appreciation” fools. It might have worked in the past, but just watch them sell sell sell when the market drops. They can take capital depreciation less than anyone around. And again, a buyer might be an investor. Even if it is a poor FHB, that is one less renter.

    Besides that big rant of mine, I agree with the rest of what you had to say.

    Reply
  2. Pete – you are correct.

    Here in the UK, the falls in property values have resulted in a lot of people (who would have sold their properties) putting them on the rental market instead, in the mistaken belief that prices will rise in 6/12 months time.

    As a result we have a glut of rented accomodation available at ever reduced rental rates. Some estate agents are now offering “First Month Rental Free” and “Free Gym Membership” as enticements to let.

    Australia be wary..

    Reply
  3. Thanks Moray, that is helpful to know :)

    I just try to explain what I think is logical, but it helps to hear it first hand from somewhere else that is experiencing it.

    Also I have seen a graph (wow really Pete?) that shows rent prices stayed flat in all our Australian state capital cities in the 80/90’s when interest rates went through the roof.

    I say it again and again – rents correlate with wages. You can’t raise rents beyond a certain level unless wages go up. Rents can fluctuate between high and low ranges based on supply/demand, but they are range-bound based on wage levels.

    Reply
  4. I found that mythical graph I was talking about.

    Unfortunately the DR filter doesn’t like me pasting it much, so you’ll have to be creative to see it:

    img91 . imageshack . us / img91 / 4893 / realrentsvsrealinterestax1 . png

    (Take out the spaces)

    Reply
  5. We’ll probably get a bunch of news about the RBA’s cut tomorrow.

    Here’s an interesting piece of information for those of you who think the RBA controls the rates that banks lend at.

    They don’t.

    RBA cut the ‘short-term’ rates. Has not a whole lot to do with mortgages, especially if that money was borrowed from overseas by your friendly bank.

    In the UK their RBA equivalent (BoE) cut rates to 0.5%.

    Wouldn’t a 0.5% mortgage be sweet!?

    The actual mortgage rates are over 4%. That is still lower than ours right, and seems like a good deal?

    (Well, yes and no. Wait until their printing presses run hot, they’ll go up)

    Typical loans in the UK require an LTV of 75%. (LTV = loan to valuation…how much deposit you will need).

    Okay, so an LTV of 75% on a 300k house is…75k. Know any FHB’s with 75k to deposit? Even with the maximum FHOG of 21K, thats another 54K to make up from real savings.

    Will our banks start being cautious about LTV’s? Well, they already are starting, with most requiring a minimum 90% LTV.

    Watch that space.

    Reply
  6. Hopefully my above comment will pass ‘moderation’.

    Oh, re: RBA. Check this out:

    Banks may not pass on Reserve Bank rate cuts
    “Westpac on Monday warned it may not be able to pass on a rate cut in full to borrowers because of the high cost of money from overseas.”
    http://www.news.com.au/heraldsun/story/0,21985,25300524-662,00.html

    Reply
  7. Darn, not enough doom’n’gloom here. Let’s _import_ more! ;)

    Biker Pete
    April 7, 2009
    Reply
  8. Thanks for the accounting standards reportage Dan!

    Reply
  9. One person lost their job and move back to their dad’s garage (with wife and two kids) so to rent the house out to pay off loan and feel safer until gets new job (house adds to rent supply) it will pan out in a year the stats will really show up.
    How can wagers go up if profits are not increasing? If profits go down would wagers go down also?

    Reply
  10. Rick: Wages will come down certainly…high unemployment means more supply of employees, which means more competition for full-time jobs, which means that employers can choose skilled employees who will take less pay.

    It is a bad situation where wages are likely to stagnate or fall and inflation is likely to increase :(

    Reply
  11. The p1ssweak rate cut of .25% cements the RBA’s position of “we won’t have any effect, let’s just do some token gesture” in my mind.

    Reply
  12. Pete some of your posts are pure uninformed speculation.
    One in particular is plainly wrong.

    Typical loans in the UK require an LTV of 75%. (LTV = loan to valuation…how much deposit you will need).

    Being British I know for a fact that the standard deposit required was 5% and in more recent decades none was more than acceptable. More than a few lenders were offering > 100% mortgages over the last decade.

    The principles of mortgage indemnity permitted some reassurance to the banks. Hence when the crash came the insurance industry started worrying and making losses on their indemnity claims.

    Reply
  13. Joe, you said:
    “Being British I know for a fact that the standard deposit required was 5%”

    Joe, I am not talking about what WAS the case. I am talking about what is CURRENTLY the case. I am not suggesting that LTV’s were always 25% in Britain…they wouldn’t have half their problems if they were!

    FYI I got my information from http://www.mortgages.co.uk/
    The site compares mortgages from the different lenders. I looked at the big banks.

    So you say that I ‘speculate’, which is actually true. I speculate based on what I perceive to be LOGICAL. You can refute and dispute the logic, I am open to that. However I am not open to being told that I am wrong ‘just because’. That is real estate spruiker talk.

    If you disagree with me, give me some relevant points so that you may convince me otherwise.

    Reply
  14. Moneyextra.com check out mortgages, 180K mortgage on a 200K house (90% LTV) provides 2 pages of comparison results with a fixed rate at anywhere between 4.2% and 5.7% depending on provider.
    Signigicantly more than 75% LTV.

    Reply
  15. Hmmm … So house prices may go down in a recession – And if house prices were in a big bubble before the recession hit and if it is a particularly nasty recession in which lots of people lose their jobs, then the house price drops may be pretty big. But given that politicians don’t like to see house prices drop much at all even, they’ll do whatever they can to keep house prices higher than the basics might warrent. (I think that sort of sums it up?)
    As to whether Australia in particular has a housing shortage … Certainly not in absolute terms from what I can see. Although there are a whole bunch of cultural expectation factors and existing legislation and housing industry lobbying influences and both government and RBA jawboning, working hand in hand to try and ensure that Australians feel that they do have a housing shortage.
    But the politicians aren’t at all convinced the housing shortage argument is really going to win the day or they wouldn’t be cutting back on work visas for overseas people with building trade skills to migrate to Australia would they?

    Reply
  16. Joe:
    I had a look at Moneyextra but it looks like I need to sign-up to use it.

    Using your same criteria (180K mg for 200K home, 90% LTV) I looked at the site:
    http://www.moneysupermarket.com/mortgages/mortgagesstep1.asp

    From it I got the following results, which ‘may’ indicate trends in UK lending practices: (note 200K mg)
    ======================
    0 results for 10K deposit (95% LTV)
    23 results for 20K deposit (90% LTV)
    134 results for 30K deposit (85% LTV)
    199 results for 40K deposit (80% LTV)
    562 results for 50K deposit (75% LTV)
    608 results for 60K deposit (70% LTV)
    ======================

    From those numbers I not only notice that there are no 95% LTV mortgages, but that whilst there are some 90% LTV mortgages available, the majority of all mortgages offered expect 75% LTV. Make of those numbers what you will.

    However Northern Rock appears to be doing 90% LTV’s again, after being nationalised. Whether this is a good idea or not (considering they are using taxpayer money) is another matter.
    (http://www.financemarkets.co.uk/2009/02/23/northern-rock-returns-to-new-lending-at-90-ltv/)

    And this from an article does not bode well for high LTV’s:
    ==================================
    In a survey of 2,000 Brits, Fairinvestment.co.uk found that although the average mortgage LTV borrowed by homeowners is 64 per cent, three per cent of mortgage holders had borrowed 125 per cent LTV, five per cent had borrowed between 101 and 125 per cent, and 13 per cent had borrowed 91 to 100 per cent of the property’s value.

    This means that 21 per cent of mortgage holders borrowed more than 90 per cent of their property’s value, which could give them an increased risk of negative equity – particularly if house prices continue to fall.

    The Financial Services Authority has predicted that if house prices fall by 30 per cent from the level they were at the end of 2007, more than two million British homeowners will be in negative equity – this is more of a risk for those who borrowed 90 per cent of the property’s value or more, as according to some market analysts, house prices have already fallen by more than 15 per cent in the last 12 months alone

    http://www.ccrmagazine.com/index.php?option=com_content&task=view&id=712&Itemid=37
    ==================================

    Note that in my previous post I did say “typical” LTV’s were 75% in the UK now (not all of them of course).

    My overall point is that Australia is only BEGINNING to tighten its stance on LTV’s, yet we can take a look at the UK and notice that LTV’s have already tightened. From that we can draw an inference that Australia will tighten its LTV’s for new mortgages if the market starts to fall.

    This means that FHB’s will be UNABLE to purchase a new place unless they have a sizeable deposit, unless the Gov. upgrades the FHOG to something silly like 50K (hey anything is possible right?).

    I am speculating here. But I think what I have said is reasonable.

    Reply
  17. Joe I have a comment for you but it is ‘awaiting moderation’

    Reply
  18. Ned S: I pretty much agree with everything you said. Good point about the immigration thing. I guess we have some opposing forces at play here (Australian jobs vs Housing?). Still, very hard to tell what the Gov. will do, or even CAN do.

    I think a FHOG of 50K is possible, but would make the Gov. seem extremely foolish to most.

    Reply
  19. My wife and I absolutely agree with Morray and Pete about rents going down and collapsing fast.

    If weekly median salary is $950, no one can expect tenants to pay anymore than that.

    If a wife’s salary is $0 because she’s just lost her job, she can’t be expected to pay ‘usual’ rent, unless it is a much reduced rent.

    As reported over the weekend (and as we hear from friends and many others), rents are already decreasing in Sydney Inner City, North Shore and Eastern Suburbs, whether anyone likes it or not.

    Dean

    Reply

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