Avoid Banks Stocks

Credit risk always seems to come out of nowhere. But usually it comes out of somewhere…like the dirty, little recesses of a bank’s balance sheet – the places where bankers hide all their unrecognized losses.

Ever since the suspension of rigorous mark-to-market accounting rules one year ago, banks have gained the ability to “time” their credit losses. This development does not feel like progress. Banks now possess the ability to defer embedded credit losses for a very long time, in the hopes that a “typical” postwar rebound in house prices and employment comes to fruition. But that’s not happening. In fact, housing and employment conditions are worsening. As a result, the US banking sector has been piling up an enormous stash of unrecognized credit losses.

Banks may be able to play their games of “make-believe” for a while longer, but they cannot get away with completely ignoring their losses, especially when the evidence is overwhelming that these losses are real and irreversible.

Going forward, increased foreclosure activity and mortgage losses will become a growing problem for bank stocks. We could soon see a reacceleration of credit provisioning in the banking sector, which might weigh heavily on bank stocks.

Mark Hanson of M. Hanson Advisors does great work on the details behind the headline foreclosure and housing price statistics – the kind of granular research that’s scarce on Wall Street. Hanson estimates, using data from the Mortgage Bankers Association, that there are 8 million mortgage loans in the “distressed” category, with and estimated 6.4 million headed for liquidation (foreclosure, short sale, or deed-in-lieu). April saw a record 92,500 foreclosures. At that pace, it would take the market over 8 years to work through the estimated foreclosure backlog.

This is much too long if the US housing market is going to return to anything resembling a free market over the next decade. So instead of a continuation of slow foreclosure processing, Hanson believes foreclosure activity will accelerate.

In a recent missive, Hanson writes:

When factoring in April’s 92.5k record Foreclosures (not including short sales), the distressed pool shrank by only 63.1k units… At this pace, it will take 101 months to clear the pool of 6.4 million loans headed for liquidation. At a pace of 180k Foreclosures per month, twice April’s record high, it will take 42 months to clear the existing distressed inventory.

On the bright side, based upon the default and Foreclosure pipe action, which I track in real-time daily in aggregate and on an originator and servicer-specific basis, it seems that over the past few months the banks have regained a mind of their own. Unlike action I tracked as early as January 10 when all the big servicer’s [notice of default] through foreclosure charts looked the same, most have diverged.

In fact, two of the nation’s top four servicers…have opened the flood gates beginning in March. And the GSEs, who led the Foreclosure charge higher beginning in Feb, are in property liquidation mode, which could force all the big GSE servicers to quickly follow suit on their own portfolios – none expected the GSEs to blink first and do not want to get left in the liquidation dust.

Perhaps this is the first sign in almost two years of an efficient default and Foreclosure process poking its head out. Time will tell.

I’ve read Hanson’s updates for years. You won’t find a more thorough, independent (conflict-free) analysis of the foreclosure statistics.

It’s fairly obvious that the backlog of foreclosures has built up like water behind a dam. The feds are trying to control the amount of water flowing through the dam. But it remains to be seen if they can keep controlling it to the degree that they have.

Once the dam gives way, the market may be shocked at how quickly the headline foreclosure numbers accelerate. A saying you often hear in the banking business is: “the first loss is the best loss.” (The same saying will eventually apply when banks as a group rush resolve their zombie commercial real estate mortgages).

Hanson highlights that Fannie Mae and Freddie Mac have recently accelerated their foreclosure activity. So the big banks, which service most of the GSE mortgages, can’t be far behind. If banks become convinced that housing prices will take another dip, they’ll look to liquidate their housing inventory ASAP.

The likelihood of this development argues for continuation of the “deflation,” or risk-averse, trade – basically, short stocks, long Treasuries.

Dan Amoss
for The Daily Reckoning

The Daily Reckoning