The End of the Credit Crisis

The End of the Credit Crisis
by: Alex Trias
February 27, 2009

Now sit around in a circle, kiddies, and let me tell you the story of the credit crisis. It goes like this.


Homeowner owns a $400,000 home secured by a $500,000 mortgage. Homeowner is very concerned that the value of the home could drop to $300,000 in the next few years, which is when he plans to sell the home, and he does not have the $200,000 in cash to make up the balance and pay off the full mortgage. Currently, Homeowner is thinking foreclosure is the best and only option to avoid going into further debt.


Bank has a worse problem, because Bank has a $500,000 mortgage on its balance sheet but no investor is willing to buy it for more than $100,000. The reason why is because investors know that the security on this loan is worth $400,000 and that it will probably continue to deteriorate in value. More importantly, the investors know that Homeowner has a strong incentive to let this thing go to foreclosure soon, at a time when the underlying property is rapidly losing value. Finally, investors see the value of other mortgages falling rapidly, and don’t want to catch a falling knife.


Now we’re getting to crux of Bank’s biggest problem, which is that under some clever accounting rules, Bank needs to mark this mortgage to market. Bank knows that the mortgage is not worth $500,000, but right now if they went to foreclosure, Bank would get $400,000 because that is what the collateral would sell for. However, under the mark to market rules, the value of this mortgage is not $400,000 – it’s $100,000 because that is what an investor would pay for it.


You see where this is going. Under banking regulations, Bank needs $1 in the vault for every $10 that Bank lends out. If Bank’s $500,000 mortgage is worth $100,000, that translates to $4,000,000 that Bank can no longer lend out. Bank must curtail its lending dramatically, which means less profits for Bank, and less liquidity in the system. No good. And even worse, Bank just reported a $400,000 write-down to its overjoyed shareholders, and hedge funds are now taking Bank’s market capitalization down by 90%. The public watches the 90% decline in the price of Bank stock, and forms a view that the banking system may be failing. Hedge funds act on this fear by short selling Bank stock with verve and confident greed, sending the share price down further still, and reinforcing a sense of panic among the public. Other investors are jumping on the bandwagon, too, and short interest on Bank’s stock is now close to 50%! (Pssst – remember that short interest thing for later, okay?).


Bank management has an idea. They believe that foreclosure is the best solution to this problem because by forcing Homeowner into foreclosure, the mark to market accounting rules permit Bank to report that $500,000 mortgage not as an asset worth $100,000, but rather, as $400,000 in cash. Moreover, Bank is concerned that if the secondary market for mortgages deteriorates, further write downs will become necessary, feeding the downward spiral in its share price and profitability.


This story plays out across the economy, and results in foreclosure rates that surpass those during the Great Depression, and the sharpest and worst decline in bank capital in history. The world, it feels, may be ending.


Time to short Citibank (C)? Bank of America (BAC)? What about JP Morgan (JPM)? Well hold on, kiddies, let me finish the story.


Some clever folks who work for President Obama have an idea. They say, let’s order the banks to renegotiate all those underwater mortgages! It’ll look like we’re punishing Bank, and helping the little guy. But what we’re really doing is solving the credit crisis, and tossing Bank a nice juicy bone in the process.


See, right now, Bank has a $500,000 mortgage that is about 50% likely to go into default, and nobody will buy that mortgage because it’s got lousy creditworthiness. Bank doesn’t want to mess with renegotiating any mortgages in a bankruptcy court, so Bank goes straight to Homeowner and says “Homeowner, now you only owe us $300,000, which you can afford to pay us back.” Homeowner is delighted, and now has no incentive to go into default. This fact is not lost on investors who like to buy mortgages that are a good credit risk. Anything will beat those Treasuries that only pay 2.5% a year.


Suddenly, this $300,000 mortgage is a very good credit risk, and investors are far more willing to buy it – in fact, investors will pay a whole lot more for a high quality $300,000 mortgage than a very low quality $500,000 mortgage. In fact, investors are ready to pay $300,000 for that high quality $300,000 mortgage. So what does Bank get to do?


You guessed it. Bank takes a WRITE UP. For tax purposes, Bank claims a tax deduction for the $200,000 it just wrote off the mortgage (which boosts up Bank’s balance sheet right on the spot), but for accounting purposes, Bank writes the mortgage up from $100,000 to $300,000. Bank announces these write ups as a surprise profit next quarter, completely stunning the stock market in the process – most investors had just assumed Bank was going to fail or be nationalized. But nobody expected WRITE UPS!


And this adjustment to Bank’s balance sheet frees up ten times as much capital that Bank can now lend out. The news of increased lending is equally surprising, and the stock market greets the news with enthusiasm. Yes, the clever people in President Obama’s administration are starting to look rather clever indeed.


Hey, turning to reality for a minute, do you want to know what? Some bank executives this author talks to actually GET IT, see? This is really the plan.


But back to my story. Remember what happened with Volkswagon stock last year?


The U.S. Treasury has been purchasing Bank’s common equity. There just aren’t that many shares of Bank stock available to buy. Turning back to reality for a moment here, anyone notice what Treasury said about buying Citigroup stock? WONDER WHAT THAT’S ABOUT, KIDDIES? Let me finish the story and you soon will.


When Bank reports that surprise write up of the mortgage on its balance sheet, some short sellers decide to cover. Quickly. The problem the short sellers have is, they are all trying to cover their short positions all at once! And the even bigger problem is that because Treasury has been buying up Bank stock quietly, THERE IS NOT ENOUGH BANK STOCK ON THE MARKET TO COVER THE SHORT INTEREST. This is a case where demand for Bank stock is larger than the supply, and the higher the price of Bank stock goes, the higher the demand for the stock goes. Only Treasury won’t sell Bank stock. And momentum traders have just figured out what’s going on and have decided to ride this trend to the moon. Short sellers, one by one, go bankrupt.


And then the big bad wolf eats them.


The end.


Disclosure: Author owns shares of BAC and JPM.

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