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September 04, 2007

Hit to the Head with a Two-by-Four
by Adrian Ash

"...The Fed wants mortgage lenders to ease their terms and delay foreclosures. Yet it's just capped new lending at six state-chartered banks, hoping to restore their 'financial soundness'..."

BUSY DOING NOTHING about asset-price bubbles until after they burst, the Federal Reserve has still been chiding no end of miscreant banks, foreign firms, lenders and brokerages about fraud and money-laundering since the Dot Com Bubble burst.

It just got busy scolding a number of state-chartered banks for poor lending standards and putting too much risk on their balance sheets, too.

Six of them, in fact, so far this year - and five of them since June alone.

All are members of the Federal Reserve System, and five of the Agreements are written "[to recognize a] common goal to restore and maintain the financial soundness" of the banks in question - North Valley, Mid America, Marco Community, Anadarko and now Premier.

Marshall Bankfirst, meantime, has agreed with its subsidiary - Bankfirst of Sioux Falls - to take specific steps "to address weaknesses in asset quality, credit administration, management, and risk management identified by the Federal Reserve Bank of Minneapolis."

Steps like what? Well, steps like not adding one red cent to Bankfirst's loan book without explicit permission from the Fed. Nor can it originate or underwrite any loan that will be sold or syndicated to a third-party. It must also detail, within 60 days of signing the Agreement on Aug. 8th, new "loan policies and procedures that shall, at a minimum, address, consider, and include underwriting standards that are appropriate for each type of loan product offered."

Sound kinda like banking basics to you? But hey, "it wasn't like we needed to be hit upside the head with a two-by-four," as Kim Culp, newly hired president of BankFirst, told a reporter from TwinCities.com. "Executives at the bank say they've been working with regulators to resolve the issues for several months," the news service explains, "and many of the changes requested in the order already have been made."

Funny how you'll find no mention of the Written Agreement on either Marshall or Bankfirst's website, however - nor how many of the changes demanded (not requested) by the Minneapolis Fed have already been made.

Premier Bank, the latest target of Fed tutting, also fails to mention its chairman's day out at the Kansas Fed on Aug. 23rd. Now, I've never been offered a loan by Premier Bank of Denver, Colorado. So I really can't say how strong - or lax - the bank's lending standards have been.

But evidently, judging by the "Written Agreement" that its chairman, Eric Wang, signed a fortnight ago, the team at Premier Bank couldn't tell you how strong their lending standards have been, either:

• Premier must not extend or renew any credit to people whose previous debts to the bank have either been written off as a loss or were identified as "substandard" by the Kansas Fed's investigation;
• It must "maintain, in accordance with generally accepted accounting principles (GAAP), an adequate valuation reserve for loan and lease losses";
• The bank has 10 days from Aug. 23rd to either write off or collect those loans that the Kansas Fed's investigation classified as a "loss";
• It was given 60 days to submit to the Kansas Fed "new underwriting standards that include, at a minimum, documented analysis of the borrower's repayment source, creditworthiness, cash flow, and debt service ability;"
• The bank must also give written reports to its board of directors showing the number - and value - of outstanding loans that are growing in size (negative amortization), loans for which it holds inadequate proof of ability to pay, and loans which can have payment deferred.

Put another way, Premier will now set aside money to cover bad debts, and it will actually get round to stating just how bad those bad debts have become. It's also going to tell the board of directors - those guys with legal responsibility for the bank's financial soundness - just what in the hell is going on. But if the board is in doubt, it can always read the local paper.

"As at Dec. 31 last, Premier Bank had nearly $8.7 million in what is called 'noncurrent loans and leases'," says David Milstead for the Rocky Mountain News, "representing 8.5% of the bank's assets. By comparison, all Colorado chartered-banks, including Premier, had about 0.5% of their assets nonperforming [on average] at year's end."

Yes, Premier then cut its non-performing loans to $5.3 million by the end of June 2007, "but the number still represented more than half of the bank's capital," Milstead reports. No wonder then that Premier has just agreed to end all new subprime lending, if by "subprime" we mean people who've failed to repay their debts in the past!

The bank will also ask prospective borrowers just how they hope to make their repayments in future - a critical question that seems to have gone missing from home-loan application forms both in the US and throughout the English-speaking world. Suddenly, however, those basic questions that lenders used to ask of potential borrowers are back.

Lenders accounting for one-in-eight British mortgages have now tightened their standards, according to Bloomberg, withdrawing credit and raising interest rates to subprime borrowers. "There are some [British] lenders who have pulled their current product range and not announced any new ones," says Ray Boulger, head of Charcol, the country's largest mortgage broker online.

"Others have put up rates until they get little or no business."

"The same person trying to get a mortgage will find the situation more difficult now than three months ago," says Fionnuala Earley at the Nationwide Building Society, the United Kingdom's fifth-biggest mortgage firm. "Some lenders will reassess how much they want to lend. You're not going to stretch yourself for volume in a market you think is a little risky."

Hence the "clear signs" Nationwide sees that the British housing market is finally slowing after trebling in the last decade and adding another 10% since mid-2006 alone. There's a big drop beneath current prices, in other words. The average UK home now costs £183,898...nearly $370,000.

In the United States, home prices might be falling faster - and starting from slightly less absurd heights - but the sorry faces at US mortgage brokers look just the same. Banks are "jacking up short-term rates to dissuade buyers from choosing riskier mortgages as defaults on subprime loans climb," reckons the Chicago Tribune. "The housing slump will worsen," the paper says, citing truly gloomy forecasts from J.P.Morgan, the Mortgage Bankers Association, and International Strategy & Investment in New York, "as banks restrict the availability of credit and falling real-estate prices prevent owners from tapping home equity for extra spending money."

No surprise then that, across the US as a whole, new mortgage applications fell by 4% in the week-ending Aug. 24th. The interest rate charged on one-year home loans leapt at the same time, up from 5.84% to 6.51% to record the biggest jump since the Mortgage Bankers Association began keeping records more than ten years ago.

How to unblock the plumbing that pipes money to would-be homebuyers? The world and his stockbroker now expect the Bernanke Fed to cut its key lending rate at the Sept. 18th meeting. Interest-rate futures put the chance of a 25-basis points cut at 100%. And just today (Sept. 4th) the Fed and the Treasury asked mortgage lenders who've parceled and sold outstanding home-loans as an investment product to other financial institutions to consider "loss mitigation strategies [including], for example, loan modifications, deferral of payments, or a reduction of principal."

Evidently, the Fed is worried - very worried. The looming wave of non-payment by subprime home-buyers as they face a sharp hike in their adjustable-rate mortgages now threatens a second wave of Bear Stearns-style losses and fire-sale liquidations. "The $197 billion of mortgage resets so far this year is less than we will see in two months [Feb. and March] of next year," as John Mauldin of Millennium Wave Advisors recently noted. "The first six months of next year will see more than the total for 2007, or $521 billion."

There's also the small issue of foreclosures and forced auctions accelerating the rate of deflation in home prices, too. And throwing young families out of their homes never plays well with the electorate, least of all when you're trying to assure everybody that the problem is "contained" and real-estate only ever goes up in the long run.

But for as long as the Fed and its agents continue to chastise state-chartered banks for their lax lending practices - and for as long as Written Agreements, if not cash penalties, prevent the most wayward lenders from lending anew - how can Dr.Bernanke ever hope to prop up the bottom of the US real estate ladder?

And what of the potential homebuyers themselves? "Just because you fly around sprinkling the ground with cash doesn't mean people are going to spend it," as Japanese parliament member Kouhei Ohtsuka, a former member of the Bank of Japan, said in mid-2003.

If Bernanke still thinks he can out-smart deflation in house prices, he might want to check his Japanese history once again.

Adrian Ash
BullionVault.com

Head of research at BullionVault.com, the fastest growing gold bullion service online, Adrian Ash is also City correspondent for The Daily Reckoning in London, and a regular contributor to MoneyWeek magazine.

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