Thursday, February 19, 2009

Obama’s Accounting Gimmick to Protect Lenders

By Rolfe Winkler (Option ARMageddon):

If Bush’s strategy for dealing with the banking and housing crises was to bury his head in the sand, Obama’s strategy has been to bury his head even deeper. The housing crisis, like the banking crisis, isn’t going to be “solved” until asset prices are allowed to fall. The Bush administrations, in concert with the Fed, had a simple strategy: throw good money after bad in order to prop up asset prices, protecting failed homedebtors and bankers from absorbing their losses. Obama has simply doubled-down on the same strategies. Literally.

The key part of Obama’s housing plan announced yesterday is to subsidize mortgage payments, reducing effective interest costs in order to put a floor under asset prices so banks and homeowners don’t have to declare bankruptcy.

(Click chart to enlarge*)

Naturally banks love the Obama plan. By subsidizing monthly payments, and not forcing banks to write down principal by more than a token amount of $1000 per year for 5 years, the plan will keep homedebtors tethered to vastly overpriced mortgages. Who does this really benefit? Not the homedebtor, who has little chance of ever building equity in the home. He’s effectively paying over-priced rent to a bank. No, the banks are the real beneficiaries.

How does subsidizing mortgage payments prop up house prices? And how does this benefit banks? Well, if homedebtors who would otherwise walk away from an underwater property can be convinced to keep making their payments, then banks can continue to treat the mortgage as a “performing loan,” which means they don’t have to write it down. The bank’s capital doesn’t suffer and the bank survives. Sort of. Capital levels are far more depleted than the official balance sheet figures suggest, of course, so the bank is basically walking dead. Hence the term “zombie bank.”

Luckily, fair-value accounting gives the lie to such accounting shenanigans. Investors know many “performing” mortgages have a high probability of default. They have no interest in valuing these mortgages at the fictitious value banks would like to pretend they are worth, so buyer bids evaporate and the market stops functioning.

But even banks can’t keep up this fiction indefinitely. As time goes on, sellers will be forced to “hit the bid” that is actually available in the market. Also, as unemployment rises, many borrowers previously categorized as “performing” will default, forcing banks to write down the mortgage. In other words, the market will eventually win. Prices will fall and the banks will be put out of business.

Accounting gimmickry facilitated by Obama’s “foreclosure relief” plan will protect banks only temporarily. To survive the crisis, the banks need more. They need the government to blow a bubble to replace the one that’s bursting. In the short-run, TARP money and accounting gimmicks can keep them in business. In the long-run, they need the Fed to reinflate prices.

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*price/quantity figures in chart don’t reflect actual figures for the housing market…they are chosen from thin air to illustrate the price floor concept…

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