“Extend & Pretend” Practices Attracting SEC Scrutiny

The SEC is investigating bank practices that seem to have been enacted with the blessing of the Fed and Treasury: Extend & Pretend.

Many of the bailouts, mortgage mods and behaviors we have today exist to serve a single purpose: To allow the banks to kick the can down the road as far as they possibly can when it comes top their dual portfolio of bad mortgages and bank owned Real Estate (REOs).

Consider how ironic this is: From the GSEs becoming a dumping ground for every crappy mortgage to the failed policy of HAMP/mortgage mods, to the arbitrage between the the Fed’s ZIRP policy and Treasury’s 10 year bonds, nearly every reaction to the financial crisis has been a willful, concerted effort to kick the can down the road.

Rather than go Swedish, and force a shorter painful pre-packaged bankruptcy process, we have opted to take the long slow route:

1) Banks are slowly rebuilding their capital by borrowing from one branch of government and lending to another. This is a slow process, but its less well unerstood (and hence more politically acceptable) than merely giving Banks capital outright.

2) FASB 157 allows banks to carry all of these structured products made of bad mortgages on their books indefinitely.

3) Banks are carrying lots of housing inventory waiting for a better residential market to emerge 5 or 10 years down the road.

Under normal circumstances, the bad mortgage process goes Delinquency (late payments) Default (90 days behind), Foreclosure (legal proceedings to enforce the note).

Once a home goes into foreclosure, the accounting changes: It is now a loss that must be written down immediately. That hits the banks capital levels. Consider what the next 3-5 million foreclosures will do to banks’s capital cushions.

Once a foreclosure occurs, not only does the capital write down take place, but the local property tax liability accrues to the bank; prior to foreclosure, the liability is to the nominal home owner and/or property. Once the bank takes possession, its on them.

Hence, you can see why “Extend & Pretend” is so attractive to the large institutions sitting on massive REO inventory, enormous bad loans and CDOs, and huge future local tax obligations.

I wonder: How many bad loans are on the books as either performing or in modification when they are nothing of the sort? What are Citi, Bank of America, Wells Fargo and even JPM carrying that are misrepresented on their balance sheets?

Lastly, consider this: If banks had to accurately report their balance sheets, if they were required to give a full and honest accounting,many of these institutions would be declared insolvent.

We are now in a race to see what will come first: The next regained health and stability of our incompetently run banking sector, or the next crisis.

Place your bets! The trifecta of bad loans, easy money, and lax regulations begins a new every decade!

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Previously:
Fair-Value Accounting & FASB 157 (September 30th, 2008)

Time to Get Swedish (January 23rd, 2009)

See also:
SEC Probe Examines Bank-Loan Practices (WSJ)

Officials Disagree on Penalties for Mortgage Mess (NYT)