America’s Japanese banks

August 17, 2009

A banking system loaded down with hundreds of billions of dollars worth of unrecognized bad debt — Japan in the 1990s? No, it’s the United States today.

And where are American banks hiding their losses?  Among other places, in their loan portfolios.

problem-debt-areas1

(Click table to enlarge in new window)

Banks have  written down billions in toxic securities, but many toxic loans are still carried at close to full value.  According to data published by the Federal Reserve late last year, banks are carrying $3 trillion of residential real estate loans and $1.7 trillion of commercial real estate loans on their books for a total of $4.7 trillion.  Dan Alpert at Westwood Capital thinks as much as a fifth of that total could be uncollectable.

“We know lots of mortgage loans are underwater,” he says, describing the situation where the value of collateral has fallen below the principal balance of a loan.  “A majority of the loans banks are holding were originated at the height of the bubble, when securitization broke down.”

When securitization markets were fully functional, banks had been able to package and sell their loans to investors.  When those markets buckled, banks were forced to eat their own cooking — much of it rancid.

Banks argue that loans should not be marked down if they’re still “performing.”  As long as borrowers are meeting their contractual obligations, there’s no reason to take a writedown.  The problem is, this gives banks an excuse to extend, amend and pretend. They can make concessions on loan terms or delay foreclosure notices, if only to maintain the fiction that borrowers will make good.

With real estate prices likely to fall, and stay, 40 percent below the peak, borrowers have a big incentive to renege on their side of the bargain.  This is how we become Japan.  Emergency bailout facilities allow banks that otherwise would have failed under the weight of bad loans to hold those loans to maturity — pretending the bad ones will be paid off in full over time.

In reality, many loans will default and banks will bleed capital for years.   Take commercial real estate.  As the Congressional Oversight Panel has reported, few CRE loans that were originated at the peak will qualify for refinancing when they mature. Banks can pretend they will, carrying the loans at values far above what will ever be paid back.

FASB wants to bring some clarity to the issue.  A plan under discussion would force banks to record loans at fair value on their balance sheets.  But it’s not clear how much good that would do.

One problem is that it’s much more difficult to determine the fair value of a loan than it is the fair value of a security, where more liquid markets with more frequent price quotes make measurement relatively easier.  With loans, banks must rely on internal models.what-loans-are-worth

Banks are now required to report fair value estimates four times a year.  But the most recent data raises just as many questions as it answers.

(Click table to enlarge in new window)

For instance, what estimates are banks using in their models?   As Jonathan Weil of Bloomberg noted, Regions Financial carries its loans at 34 percent above fair value, Citigroup carries its loans at no premium.   This could mean Regions faces bigger losses down the road, or it could mean Citi’s fair-value calculation is too charitable.  More likely, it means both.

Determining fair value is largely subjective.  So FASB’s proposal, to make banks adjust their balance sheets accordingly, is imperfect.  It could have a positive impact if regulators use the new information to force banks to raise more capital, cushioning balance sheets from the future writedowns we know are lurking.

But will banks raise enough?  Probably not.  Alpert is highly skeptical that banks’ fair value estimates are accurate: “Given the decline in value of collateral backing these loans, it’s very likely banks are underestimating the severity of future losses.”

So what do we do?  We can start by eliminating government guarantees that allow banks to avoid dealing with the problem.  As things stand, the biggest banks have no incentive to write down loans because the Federal Reserve, Federal Deposit Insurance Corporation and Treasury Department have, in effect, promised them unlimited financing to hold loans to maturity.

As the Japanese can tell you, this is just a recipe for stagnation.  Thanks to a debt bubble that authorities refused to deal with decisively, that country is now entering its third consecutive lost decade.

27 comments

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Winkler is correct – this pervasive denial of loan value reality is troubling. However, it is easy to state value — just set the loan total against a current appraisal. If a mortgage loan is $200,000 and the property appraises at $125,000 then the loan has a high probability of failure, whether it is current today or not. The banks know this, and the government knows this, but neither wants to face reality after adding many billions to the national debt. Denial will not make the risk go away, it just hides the inevitable statistical probability of failure.

Posted by Stuck | Report as abusive

This is a great article. The real question is whether real estate will have a comeback in a time span that is shorter than the decades it took for Japan to recover. Considering they went down for about twenty years the argument would be that U.S. real estate markets will stay down for a similarly long period.I think we will see a comeback as population creates an ever-greater demand for buildings and homes and as our economy recovers and we see speculation moving higher again. The stock markets are still below their all-time highs but have staged a real comeback from the lows around 6,500. As stock markets tend to move ahead of the actual economy this would be a harbinger for better days to return. Too, we’ve seen real estate prices continue to rebound from their lows and as our economy rebounds this should continue.All of this suggests that if they can keep the loans on their books until a home goes into foreclosure or until a time when the prices rebound they will in fact be able to get the value. Also, with potential for a devalued dollar the price of a home could rise again in dollars that are less valuable but still the same in a pure numbers sense.Posted by John Gotts

[...] America’s Japanese banks (Rolfe Winkler) A banking system loaded down with hundreds of billions of dollars worth of [...]

$4.7 trillions toxic asset. It must be a joke. If it is true than we all have to jump in the Atlantic Ocean.

I’ve only worked for a lender once in my life. When I asked about the accounts that never seem to get paid, I was told that in practice they never wrote off bad loans but just restructured the loans on the books. It would be difficult for a third party to prove impairment of debt on an account-by-account level because outsiders do not have access to the information. The auditors certainly never go into that kind of detail.So if there is a $100,000 debt, I can modify the asset as a $110,000 debt – since I made an astonishing 10 percent return. Without receiving any payments, I can do the same thing for many years. The financial statements will look beautiful. Managers will get bonuses. People will marvel at our low default rates. Employees will come and go. Those who know anything will not hang around long enough to take responsibility or make a case against the company.I remember while working for a large consulting firm how shares in personal portfolios seemed to disappear after valuation runs. People were actually doing SQL entries manually by hand. It was chopped liver. Again nobody had to learn about the losses although I always asked if something was wrong with the processing environment. It’s always hush-hush, ignore the problem and then move on to the next job. I have no idea whether a company is actually worth what the financial statements say.

Posted by Don | Report as abusive

Should a bank appraise a portfolio of thousands of property loans daily? Quarterly? Annually? Only during a financial meltdown? Maybe just bribe the appraiser service to inflate the troubled property values (again)? The loan can only be worth what the contract says, or simply drop to zero on a default. Banks must either have higher cash reserves through this correction process, or fail.

Posted by Ben | Report as abusive

Mr. Gotts has made a very good point. Japan is a fading society whose aging and declining population will ensure a grim demographic fate. America, on the other hand, has steady immigration and growing families and all these people need a place to live. Real estate may be down for now, but it ain’t out, and future demand will straighten things out. JMHO= gotthardbahn =

Posted by gotthardbahn | Report as abusive

[...] America’s Japanese banks (Rolfe Winkler) A banking system loaded down with hundreds of billions of dollars worth of [...]

My career was that of a professional pilot, and as such success was measured in terms of real survival, based on real performance…if a situation developed where due to weather or other out of my control circumstances and I were to find myself three hours away from my destination, but only had two and half hours of fuel on board..well, that would be considered a problem…at that point the real question of being a professional and of being in charge comes into play…of course you can BS yourself and tell yourself that you can make it..things will change for the better…you can BS the passengers and tell them that everything is all right…but the facts are you are 3 hours out and you only have two and half hours of fuel..Weighting on what to do of course,is the fact that it is a major inconvenience for everyone involved to make an unscheduled stop, not to mention very expensive for the owner operators of the equipment…and becomes even more difficult when the weather guessers are telling you that there is a chance that things might get better in the next two and half hours…but airplanes are not bankers, investment bankers, stock brokers or financial mystics, airplanes work in a real way in a real world…so if you chose to BS yourself by believing the weather guessers as they lounge about in their big padded easy chairs next to the Coke machines, or get some feeling that you can make it, or whatever causes you to guess wrong and make that wrong decision, the euphemistic word that describes what happens in two hours and thirty one minutes, is called catastrophic…So maybe it is time for Obama, just like any airplane captain, to stand up and tell us what is really going on without Bsing us or himself anymore…if he really is the captain of the ship of state, if he is really running the show, then he needs more than anyone else to lay it out, to tell us his passengers what is going on and what to expect..and most importantly to make the right choices and decisions..if he does not because big bankers are feeding bad information, or he guesses wrong, the word is still going to be catastrophic…

Posted by R Eriksen | Report as abusive

How are home prices going to rise when people are getting pink slipped every day, forced time off, part time work and if they can find a job after being unemployed it’s at 10,20,30,40 % less then they were making before. I have friend in sales and he told me current housing inventories are enough for a 6 year supply with new ones coming on the market daily due to foreclosures, walk aways, etc. the bankers who set this whole mess up built it up side down, were as they say in really deep doo doo and for along time, not months years and maybe even a decade. The people responsible for the mess don’t want it cleaned up because if they did clean it up they would have to come clean with the real extent of the damage.

Posted by Greg | Report as abusive

Foreclosures are expected to rise thru 2011. CRE has around 2 trillion dollars of bad loans floating around out there. This market rally has nothing but hot air behind it. Every major bank is insolvent.. they have been since the big crash a year ago. They’re just using fraudulent accounting practices to hide it.. and the govt. has aided them in the fraud.Anyone that thinks this “recession” will end any time soon is drinking too much of the kool-aid. With millions more homes to go into foreclosure (alt-a, option arms etc), trillions in bad CRE debt that needs to be cleared, unemployment to continue rising (the U6 is nearly 17% right now .. but no one ever reports that)… anything they do to attempt to recover from this by printing more money will trigger another slow down just as a recovery starts.. otherwise they’ll have rampant inflation.Great article… more people need to put some pressure on the govt to force these institutions to put everything on their balance sheets at fair value!

Posted by Brian K | Report as abusive

OMG you forgot to add the other liabilities called OTC DERIVATIVES some $300 TRILLION UNFUNDED NOTHING TO BACK THEM, NO EXCHANGE TO TRADE THEM ON ,UNREGULATED SHADOW BANKING BY THE BIG 5. Did you also forget as they continue the bailout’s of too big to fail into the trillions the USD crumbles which creates a hyperinflationary event which is a distrust in the currency not a inflation push. Then the already destroyed helpless unemployed have even a bigger problem. INFLATION WITH POOR BUSINESS CONDITIONS.

Posted by Brian Scrocca | Report as abusive

It seems they Powers that Be cover each others backs rather than protecting We the People. In legal language folks, this is a criminal conspiracy but nothing will be done about it unless… ???

Posted by Captain Moroni | Report as abusive

“$4.7 trillions toxic assets”???No,”dude”,its-WAY-MORE-THAN-TH AT.

Posted by Tomsk | Report as abusive

If I owe #1,000 more than my car is worth, should the bank be forced to declare my loan as ready to default even though I still make all the payments? We will all continue to make our loan payments as best we can and we’ll still keep driving our cars and living in our houses. As long as we don’t have a problem with the payments, the bank doesn’t have a problem with the loan.

Posted by Tim Casey | Report as abusive

The commercial market is on the verge of collapse. This is going to break the slight pause on prices in the residential market and force the prices of properties to drop another 10-30%. Don’t drink the real estate agent cool-aid…hold off. Some people say…”you’re going to miss the $8K tax credit”… Would you rather loose $8K and buy the same house for $20-50K less or buy a house now and find out that your down payment got absorbed by the devaluation? I’ll take my chances and wait. The more I wait…the more down payment I save. I wish the gov’t would raise interest rates. I want to see those malibu loans get forclosed.

Posted by Mr. bk America | Report as abusive

[...] I think that this article from Reuters paints a very clear picture about the remaining problems concerning real-estate loans: [...]

Core problem for Japan has never been the state of it’s banking sector, but the state of it’s private sector which accrued too much debt during the boom years, and central bank which has limited itself on policy options.

Posted by E. Liori | Report as abusive

This is evidence of the way our country operates today. Irrational values and not realistic values of the cost of a home. Real estate was selling at a much higher price than it cost to build it, having greatly inflated pricing. The deregulation of banking was a major mistake, as they became much to big and did away with competition. The Federal Trade Commission would not have allowed this years ago, and our politicians were major players in this stupidity. Money influences what I do and don’t do, just as it does Senators and Represenatives. Our politicians are prostitutes, and until this stops, we will never be a great nation again.

Posted by Charles Quarles | Report as abusive

Please remember that “the Market” allocates investment to the most productive use at the most efficient means…. hail the Market.

Posted by Caveat Emptor | Report as abusive

Why would banks want to further dilute or make evident possible additional pressure on stock prices? To make evident the real truth of what is coming down the road could make stock prices crash to levels previously witnessed…Believe me Fat Cat Banking Executives do not want to take further pay cuts or regulatory oversight-Matthew Lexus former Fat Cat Banking Executive

Real estate in Japan still hasn’t recovered. Current real estate prices there have yet to surpass 1985 levels, let alone the levels reached in the early nineties before the bubble burst.If you look at real estate appreciation in this country in the 00′s, it is nearly unprecedented historically speaking. I would predict further decline in prices, to late 1990 levels before it is all over (at least a decade of marginal growth in real GDP). Usually economic growth drives real estate, not the other way around.

Posted by Joe Bonasses | Report as abusive

Derivative short selling plus Hidden Treuhand plus bank secrecy equals financial meltdown. Americans do not understand the role offshore tax havens play. As an expat living in banking secrecy paradise, I can tell you that the American problem cannot be fixed until you understand the impact of Hidden Treuhand in this crisis. A red thread runs through the problem that besets American fiscal health to European banking secrecy; think Senate investigation concerning the role of the Deutsche bank to whom bailout money was transferred to because of debt obligations, as Tim Geithner puts it, and the role of the UBS bank in hiding 52,000 American accounts with an estimated US$15 billion in bunkered assets.I predicted a raid on stockholder wealth would be possible using Hidden Treuhand and wrote about it in my book: Hidden Treuhand: How Corporations and Individuals Hide Assets and Money. The root of the problem is legal. On the American side, deregulation of derivatives, on the European side, factor in Hidden Treuhand (German law) and bank secrecy. Put them together and you have the perfect storm. Americans suffer from regional myopia. Stop talking about globalization and thinking so provincial!Google Hidden Treuhand and please take a look at what I am talking about. Corporations use subsidiaries embedded with hidden Treuhand to move money without transparency. I can prove it – Halliburton – I put their offshore corporate papers in my book.

Posted by Shelley Stark | Report as abusive

Great article! How does any upcoming action affect recent changes the FASB made to mark to market accounting? Once the FASB retracted a number of regulations on how banks were able to account for their assets, we began to see many banks begin to report quarterly profits. It all seems like smoke and mirrors to me…

“Determining fair value is largely subjective. …”The process of marking to market, while in a market panic, is worse than subjective. It’s subjective with a heavy twist of psychotic. The free market, even when not in a panic, can make horrendous errors in valuing assets. The faith that people place in mark to market is unfathomable.It would be nice if articles about the mark-to-market change actually explained what it did rather than what agenda-driven authors think it did.

Posted by JCH | Report as abusive

Good article on Hidden TreuhandThe Rich are just getting richer; it’s so obviousHiding there wealth in the best scams, which just keep getting bigger….Free market my ass: The oil companies, drug, banks & defense companies charge what they can get away with; buying government officials where necessary…These secret clubs and bank accounts are secret for one purpose; to make the rest of us modern day slaves…Its a big game they are playing, and with no winners eventually..What they fail to understand in their game is, money can’t buy happiness. The best things in life are free. Clean air and water (& plenty of it), a 6 minute cycle to work, relatively unpopulated outdoor living and temperate year round climate. A good quality of life wouldn’t you say. Thats good old NZ; but dont come all at once.While we are not making a fortune down here, money is only relative to the cost of living

Posted by Richard | Report as abusive

Thank you for the excellent article, but unfortunately it only hits one one aspect of bank weakness: real estate lending. I’m wondering (and not eagerly) what would happen to bank books if you added the following for analysis: personal credit, corporate lending, non-RMBS CDS, CDOs, etc., and leverage on all of the above!As ugly as your analysis makes the banks look, the picture is still much grimmer, notwithstanding the willingness of the USG (both admins.) to fork over trillions of dollars in taxpayer money to keep them running.

Posted by Lilguy | Report as abusive

[...] America’s Japanese banks – Rolfe Winkler [...]

Uncle Sam should force these insolvent zombies to post their losses so we can move on. To delay, after all the TARP, etc. is criminal. Book ‘em Danno!

Don’t worry. the US is monetizing the deficit. US banks are buying all the government debt issued at auctions, then passing it on to the fed, who prints the money for it.Slowly at first, then rapidly (more so as the $ falls substantially) inflation will come back, and house prices will rise above the value of loans, putting everyone back in positive equity on their homes.Older US citizens will lose a lot of investment money as its ruined by inflation, sending them back to work, and with a low dollar the US will once again be back in export surplus and the economt will correct.Inflation is the solution, relax!

Posted by Christian | Report as abusive

Christian,That would only happen if interest rates stayed the same, *then* you’d see housing prices reinflate. But with inflation comes higher interest rates, and higher interest rates mean lower prices because the interest makes the asset more expensive to afford.A 600,000 property at 5% is relatively the same as a 175,000 property at 23%. It’s what people can afford that drives housing.Interest going up will cause property values to collapse.

[...] Rolfe Winkler writes: Banks argue that loans should not be marked down if they’re still “performing.” As long as borrowers are meeting their contractual obligations, there’s no reason to take a writedown…This is how we become Japan. Emergency bailout facilities allow banks that otherwise would have failed under the weight of bad loans to hold those loans to maturity — pretending the bad ones will be paid off in full over time…. [...]

[...] minds are reading America’s Japanese banks also by Winkler. A banking system loaded down with hundreds of billions of dollars worth of [...]

[...] minds are reading America’s Japanese banks also by Winkler. A banking system loaded down with hundreds of billions of dollars worth of [...]

[...] minds are reading America’s Japanese banks also by Winkler. A banking system loaded down with hundreds of billions of dollars worth of [...]

[...] Figure 10 — Total real estate debt held in the United State from Rolfe Winkler’s America’s Japanese Banks. [...]

[...] bad debt hidden in loan portfolios.  Why aren’t we hearing about this from our President? Unrecognized bad debt link Business Week had a good article a few weeks back about banks continuing down the path of risky [...]