$25 Billion Settlement with Big Banks May Actually Benefit Them
Yes you are reading the headline correct. The $25 Billion settlement that 49 attorney generals negotiated with the large five banks, which is being described as a punishment, may actually benefit the banks.
WARNING: This article will contain more details than my average post, but just stick with it. I recommend reading the entire article but if you are familiar with the details of how loans were originated and ownership structure, skip down to Part 2.
Part 1: Brief History
Let me first start off by providing a very brief explanation on how many of the bad loans from 2002-2007 were created. We are all familiar with the 100% Loan in which a home buyer could purchase a home with no money down. Some loans even went as high as 110%. These were very different than the conventional loans that required a 20% down payment. After the bank originates a loan, they package the loan into portfolios and sell them to investors, but the bank normally retains the Mortgage Servicing Rights (MSR). What is MSR? The bank collects the monthly payment from the borrower and then pays the investor, but charges the investor a fee to service the loan.
But the banks had a problem. They had trouble selling 100% loans to investors. Investors wanted some skin in the game from the borrower but with the booming housing market, a huge government push to increase homeownership and insurance companies such as AIG willing to insurance everything, the big banks came up with the “perfect” loan. It was the 80/20 loan. To the borrower, it was still 100% financing but to the finance world it was a loan made up of two loans. The 80% 1st loan was originated by the banks and sold to investors like normal, but the 20% 2nd loan was in many cases the actual banks money.
Main thing to remember at this point: The 1st loan is made up of investor money (not the big bank’s money) and the 2nd loan is made up of big bank money. It is also important to note that 60-70% of all 2nd loans are owned by the big banks.
Now comes the housing crash. The economy took a turn for the worst and the housing bubble popped and we saw prices plummet. In the Bay Area of Northern California where the majority of my business is, prices were greatly inflated and dropped 80-90% in some areas! So what happens to the loans on a distressed property? Well, the 1st loan has top priority over the 2nd loan meaning in the case of a Short Sale the 2nd loan gets paid a few thousand dollars and the 1st loan gets the majority of the proceeds. SIDE NOTE: A Short Sale is when a home owner sells the property for LESS than what is owed in loans. Now what happens if there is a foreclosure? Then the 2nd loan gets wiped out completely meaning they get $0 and the 1st loan takes back the property. In a case of a loan modification, the 2nd loan has to write down losses first before the 1st takes losses.
So in short, with the housing crash and massive foreclosures, banks were recording massive loses because the foreclosures were wiping out their assets on 2nd loans. The banks did not own the 1st loans, they only serviced them on behalf of investors but the banks actually owned the 2nd loans. Keep this in mind, at one point JPMorgan Chase’s stock was worth $198 Billion yet they owned a little more than $200 Billion in 2nd loans. This was also a conflict of interest in my opinion when a bank like Chase serviced the 1st loan and also owned the 2nd loan. How can they truly service the 1st loan on behalf of investors when they knew they would wipe out their own money in case of foreclosure?
I truly believe that all the foreclosure delays created in the past several years on a national scale by our government have been ways to keep the big banks alive. If the foreclosures continued at the rate they were happening, many more banks would have been wiped out and the credit market could have been much worse. This would have then made our economic recession into a sure depression. So this is one of the reasons why foreclosures have been delayed and there is a huge backlog, also a reason why Short Sales take so long to be approved, IF they even get approved, and a reason why many attempted loan modifications fail.
Second thing to remember at this point: With distressed properties, the 1st loan would get back about 25-50 cents on the dollar of their original investment, sometimes more. But the 2nd loan would get back 1-10 cents on the dollar, if they were lucky enough. Obviously a big difference but the 1st loan has top priority over the 2nd according to principles of contract and property law.
Part 2: Back to the $25 Billion settlement.
A part of the settlement changes how liens are prioritized by making the 1st and 2nd loans share losses equally. In simple terms, if the property value is half of what the original loan amounts total then both the 1st and 2nd loans take a 50% loss. This basically means the 1st loan (owned by investors) gets less and the 2nd loan (owned by banks) make more. According to CoreLogic, 11.1 Million borrowers are underwater and 4.4 Million have both a 1st and 2nd loan… that’s a HUGE pay raise for owners of the 2nd loans.
So in your opinion is this “punishment” really a punishment? The big banks will essentially be credited for the $25 Billion payout by making more money on the 2nd loans. Also remember that the $25 Billion payout is split among the top five big banks. JPMorgan Chase made $18.9 Billion Net Income in 2011 so this payout for them, and the other banks, are basically 1 or 2 month’s worth of profits. Rumors right now are that investors that own 1st loans are planning a lawsuit to battle the settlement.
The potentially good news? With the 2nd loans now making more money on distressed properties there may be a lot more motivation to foreclose, approve short sales and approve loan modifications. Or maybe foreclose and turn properties into rentals, making the bank even more money…