Business Explained by Stever

I just read an article in the May/June 2006 Harper’s, The New Road to Serfdom, an Illustrated Guide to the Coming Real Estate Collapse by Michael Hudson. In it, he steps through why the current real estate market has the potential to cause widespread economic ruin.

To summarize, banks are writing more and more mortgages on inflated house prices to people who don’t make enough to pay off the loans. People are paying interest-only loans or even partial-interest loans, so they are never building any equity. If prices level out or fall, those people are doomed. They can’t sell the house for enough to repay the loan. So they’re stuck. If interest rates go up, then they can’t make their monthly payments either, and their only recourse is bankruptcy. If this happens enough, the banks are screwed because they lose the money they loaned.

Then I read the story about Wells Fargo: First-quarter profit rose 9 percent, as growth in deposits and fewer loan losses offset weaker results from mortgage banking. It sounds great, since they just had a $2 billion quarter. But look closely!

Here are the facts:

• They wrote 40% more mortgages than last year—about $31 billion increase.
• New applications are holding steady.
• “Nonperforming assets” (that means loans that aren’t being paid) rose 31% to $1.85 billion.
• They also wrote off $433 of bad loans.
• They set aside $433 million for bad loans—down 26% from last year.

Here are my inferences:

If they wrote 40% more dollars of mortgages, either their existing customers are taking out mortgages at 40% higher values, or they’re getting new customers. If they’re writing bigger loans, those loans likely on inflated home values. If prices fall, owners will be locked in at best, and go bankrupt at worst. If those are all new customers, it’s hard to imagine they’re all middle-class, creditworthy people who just now have decided to buy. I suspect they’re taking people on shakier and shakier terms (e.g. interest-only loans, less money down, etc.) Ultimately, that endangers them for reasons above.

Since pending applications are steady, it’s hard to imagine where further growth will come from except by more aggressive marketing to lower quality groups or by offering more aggressive/riskier terms (e.g. less down, etc.) to existing borrowers.

Yet they are doing this 40% run-up in writing mortages even as they experience a 31% increase in loans not being repaid. So that implies more and more loans in the future won’t be repaid.

So logic would suggest they hold back more and more money to cover the potential damages of future loan defaults. But they didn’t do that.

They wrote off $433 million of bad loans, and set their reserve to the same amount, probably setting the bad loan cushion on immediate writeoffs, not on projected loan defaults going forward.

So why would they do that? Well, my guess is that executive compensation is based on current profits, not future health of the company. And by lowering their reserve by 26%, they managed to push quarterly profits up over $2Bn for the first time, which sounds great in the press.

So here we have a bank making more loans, with a steadily increasing pool of bad loans, and shrinking reserves to cover the difference. And remember how leveraged banks are–a single $100,000 loan defaulted requires $2MM worth of new loans being successfully paid to recoup the lost money. If hundreds of millions default, it quickly becomes very hard for the bank to dig its way out of the hole.

But for now, things look great. Happy banking!

(Please note that I’m going solely off my understanding of the Harpers article and the Boston Globe article. If there’s something I don’t understand about this situation, please leave me a comment and I’m happy to publish corrections!)