Everyone has heard of the massive write-downs taken by major investment and commercial banks and lenders in the wake of the sub-prime mortgage problems and the declining real estate market. But what do these really mean and what is the likely long-term effect of these write-downs?
To understand, one first needs to understand how these companies hold these mortgage portfolios and how they are required to account for them on their balance sheets. The mortgage portfolios are held as assets, investments that the company has made – in this case by purchasing pools of mortgages packaged and sold by other banks, lenders and mortgage brokerages. These mortgages are collateralized against real estate, and the mortgage can’t really have a value that is any greater than the real estate against which it is secured since it is that real estate that can be captured and sold if the borrower defaults on the mortgage. Companies are required to represent the value of these types of assets on their balance sheets based on what they are really worth.
This process is sometimes referred to as ‘marking to the market’. In the case of these loans, they can be worth no more than the amount owed by the borrowers, but can be worth as little as the value of the collateral, adjusted for the potential expense the lender might incur if the loan defaults and the property is foreclosed on and is then sold.
When the value of real estate that collateralizes these loans decreases below the remaining principle owed on the mortgage, then the mortgage, as an investment, is worth less. Companies are required to reflect this reduction in value of these investments as ‘write downs’, or a non-recurring expense to the income statement, thus decreasing the company’s profitability, impacting shareholder equity, and usually decreasing the value of their stock. In this case, these decreases have been exaggerated by terms like ‘crisis’ and ‘meltdown’, and coupled with the real economic effect of a slower housing market, slower economic growth, and tightening credit standards has brought lower stock values and increased volatility in the investment markets.
There is another side to this that is almost totally ignored to this point and that isn’t allowed (by federal securities and accounting regulations) to be considered when looking at the income statement and balance sheet of a publicly held company. Two important points: 1) in real estate, what goes down will likely come back up in a reasonable period of time; 2) a minute portion of these mortgages will actually be foreclosed on and result in the sale of the underlying real estate at an amount that is less than the mortgage balance, and many of those borrowers that ‘walk away’ are still liable for the unpaid balance to the lender. When the housing market begins to improve, as the economy begins to see improved growth and as many of these sub-prime loans are refinanced the investment value of these mortgage portfolios will increase and much of what had been ‘written down’ will begin to ‘written up’ – increasing the apparent profitability of the companies that hold the portfolios and thereby increasing their stock value.
Today’s concerns over investment values may well be replaced by excitement over increasing returns and corporate profit as these portfolios are ‘marked to the market’ on the upside. Retirement account values will increase and the roller coaster we’ve been on these past months will fade into the distance. Some, however, those that over reacted to the economy and market’s weakness, may very well suffer the lasting effects, judgments made and opportunities missed.
Steve Forbes, in a recent issue of Forbes Magazine, writes about the effect that would be had on the stock markets if the SEC, Comptroller of The Currency, United States Treasury Department and Federal Reserve suspend the requirement to ‘mark to the market’ these mortgage backed portfolios for a period of twelve months in an attempt to allow stability to return to this important part of the investment markets. Forbes argues that most of these portfolios reflect ‘crisis’ values rather than real values, and that this not only weakens the U.S. stock market, but also holds down the value of the U.S. dollar. Forbes makes an excellent point and his idea deserves attention and consideration, but it would take courageous leadership with great political clout to make such changes, even though short term in nature. Federal Reserve chairman Bernanke and Treasury Secretary Paulson have recently evidenced some of the fortitude to support these changes, but by the time the legislative bodies act, the ‘crisis’ will likely be behind us and the damage, both short and long term, will have already been done – has already been done.
So, what does this mean to you? Over the long term, not much. In the short term, concerns over investment values, your future, the stability of your job, and your ability to take care of your family – only a few of those things that keep some of us awake at night. Remember that in investments, just as in real estate, what goes down almost certainly will come back up and history would suggest that the upward trend will lead to higher heights than we’ve ever seen before.
Rick Haskell – Signature Wealth Management
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