I have wanted to write this column since early 2010, when I first noticed something seriously wrong with U.S. banks. But the so-called experts told me I was wrong, making me doubt my analysis.
It turns out that I was right, and today I want to review my thought process in hope that readers will find some useful lessons.
My main concern was that banks, to suit their needs, had changed the definition of a bad loan. Data from Inside Mortgage Finance shows that, before June 2007, banks never let more than 1 percent of loans go 90 days delinquent without a foreclosure. That figure shot up to 4.87 percent by the end of 2009--and, not surprisingly, foreclosures rose from under 1 percent to over 3 percent during that time.
If they had kept the same standards from before the crash, the foreclosure rate would have soared to somewhere around 8 or 9 percent. It would still be near that level today, and every bank would be out of business.
This might seem common knowledge, but apparently no one has thought through the implications of this information: The banks miscalculated the quality of their assets and marked them up rather than down.
How do we know this? Normally banks take losses after a certain period of delinquency because they know they won't get some or all of their money back. The only way to honestly avoid the loss is if they think there is greater probability of recovering their principal by waiting.
Of course, in late 2009, the opposite was true: Mortgages were rapidly losing value and collateral (home prices) was collapsing. So they used rosier assumptions about the value of their assets at exactly the same time that they should have been more pessimistic.
Another way to think about this is to take the case of a retailer with 1,000 unsold sweaters. Normally they'd be worth $50 each, but now they're out of season so should be marked down to $30.
Then suppose someone goes to the warehouse and finds that the sweaters are all ripped and damaged--like loans that are 60 days overdue. Common sense dictates that they're really worth even less, perhaps $5 or even nothing. The retailer nonetheless decides to carry them on the books at $40 each.
Doesn't make much sense, but that is analogous to what the banks did with their mortgages.
The dirty secret is that everyone knew this was happening. Regulators didn't want a "crisis" so they encouraged the practice. (Those same regulators then forced them to build excess capital specifically because they knew about the problem.) Executives and shareholders, happy to stay afloat, went along for the ride. Auditors did as they were told.
These are also the people who talked me out of doing the story early last year. Several well-known "experts" agreed that my data was correct but said it didn't matter. Given that I am a journalist first and foremost, I did not believe that I could proceed without a single source backing my thesis. But the recent chaos validates my underlying logic.
Unlike Microsoft or Apple, banks don't have vast stockpiles of cash. They're highly leveraged pools of loans that cannot endure significant losses without blowing up. Only a small error can sink a bank, and a giant miscalculation like the one I describe above is catastrophic.
That's why the banks have remained in a state of crisis ever since. And now they're getting sued by the federal government over fraudulent mortgages (the same loans whose values they've been overstating for the last 18 months).
The moral of the story is to think critically and trust your own brains more than any "expert."
(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of Sept. 7.)
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