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.


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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.

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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.