SEC Fears Banks Are Putting Lipstick on Piggish Loans

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Do you get suspicious when someone tries to hide something from you? What if it were a bank? According to the Securities and Exchange Commission, that just might be going on. As if it weren't bad enough that loan values on banks' books don't reflect market values, now the SEC suspects many regional and community banks are restructuring dicey loans to make them appear less troubled. In addition, a conflict of interest at big banks appears to be delaying mortgage modifications and foreclosures … which delays adjusting the books to reflect bad loans. 

Can you believe bankers would do such a thing? Yeah, me too.

Extend and pretend
The SEC is examining two practices that gussy up bad loans. One, "extend and pretend," gives borrowers more time to repay. Sometimes the loan gets repaid. In other cases, it kicks the can down the road … so the bank gets stiffed, but it doesn't have to 'fess up quite yet.

Once it's clear the loan won't be repaid, the bank is supposed to 'fess up and reflect the loss in its financials. Why would a bank agree to kick the can down the road instead? By extending and pretending, the bank pushes out the day of reckoning on its books -- and deceives investors and regulators.

Troubled debt restructurings
Another way to gussy up bad loans involves breaking them into pieces. Changing loan terms and breaking them up is permissible. But the SEC thinks banks may be breaking loans up so they can classify a piece as good. That reduces the amount the bank needs to reserve for bad loans and charge against earnings. As a result, both the balance sheet and profits wind up looking better.

Real estate … still
The SEC appears particularly concerned about commercial real estate loans. At the end of last year, 7.8% of banks' commercial real estate loans were delinquent. An estimated two-thirds of such loans maturing through 2015 are underwater, heightening the risk of strategic defaults.

By one estimate, rising losses on commercial real estate loans could cause hundreds of bank failures in coming years. At the current rate of bank insolvencies, that could cost the Federal Deposit Insurance Corporation $52 billion by 2014.

You say tomato, I say tomahto
Accounting isn't cut and dry. Declaring a loan good or bad is a judgment call. And that creates wiggle room and opportunities for abuse. 

Who's on second? The biggest banks.
There are reports of holders of second mortgages -- e.g., home equity loans and home equity lines of credit -- taking holders of first mortgages hostage. The holder of a first mortgage has first dibs on any money recovered from a borrower, while other lien holders must wait their turn. If the principal on a first mortgage is lowered, the holder of a second loan against the property typically gets completely stiffed (assuming they're not the same party).

But what if the bank managing the first mortgage also owns the second mortgage? The owner of the first mortgage may see writing down the amount due on a first loan as its best way to avoid a costly foreclosure. But a small modification of a first loan can entirely wipe out a second loan, requiring the managing bank to write off 100% of the value of its second loan.

That sure looks like a conflict of interest to me. Who owns these second mortgages? It just so happens that the biggest four banks -- Bank of America (NYSE: BAC  ) , Wells Fargo (NYSE: WFC  ) , JPMorgan Chase (NYSE: JPM  ) , and Citigroup (NYSE: C  ) -- own about half.


% of All Loans Managed by Bank

Second Lien Holdings

Bank's Original Stress Test Estimated Loss on its Second Lien Holdings

Bank of America


$158.5 billion


Wells Fargo


$62.6 billion




$144.6 billion




$111.4 billion


Sources: Rortybomb and Federal Reserve, as of stress tests.

What's more, JPMorgan Chase reported recently that 64% of borrowers who are 30 days to 59 days delinquent on a first mortgage serviced by the firm are current on their second.  That may not be logical from a personal financial planning perspective, but for a bank in that situation foreclosing on the first can reasonably be expected to force a write-off on the second. That situation could motivate big banks to extend and pretend instead of foreclose or modify first mortgages.

Foolish takeaway
In addition to the SEC's concerns about loan values on bank books, community and regional banks are well represented on the FDIC's lists of "problem" and failed banks. "Extend and pretend" and other accounting tricks may be inflating the book value of these banks, too. There's no specific evidence of problems at large regional banks US Bancorp, PNC Financial Services Group (NYSE: PNC  ) , and BB&T Corporation (NYSE: BBT  ) -- although Fifth Third Bancorp (NYSE: FITB  ) declined to tell The Wall Street Journal whether a subpoena it had been issued was related to the SEC's investigation. As things stand, no one really knows how extensive the accounting tricks in the opaque banking industry are right now.

And at the four big national banks, conflicts between first and second mortgage holdings may be delaying foreclosures and modifications -- and inflating book value.

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Fool contributor Cindy Johnson has been underweight financials since 2008, which has been a good move overall (albeit not lately). She does not own shares in any security in this story. No way.

The Fool owns shares of Bank of America, JPMorgan Chase, and Wells Fargo. Through a separate Rising Star portfolio, The Fool is also short Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (6) | Recommend This Article (8)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 03, 2011, at 4:04 PM, hogroamer wrote:

    I am SO sick of the bank bashing! They were in trouble because the government wanted everyone to have a home and easy money to pump up the economy. They followed instructions, got into trouble and were termed "greedy" by the public. Then the government wanted them to be responsible and then every one said they weren't lending - 10% unemployment and a weak economy, I wonder why?!!! The banks are holding back inventory in the housing market to avoid further contraction in housing prices and losses which, by the way, hold up real estate value so we all don't lose. They try to work with customers that are behind on payments, like Obama wants, and they are accused of reporting bad loans as good loans. The banks are trying to turn around a very large ship and that takes time and ingenuity. I don't work for a bank, nor do any family members but I still believe it's time to quit criticizing American business for trying to prevent panic and make money.

  • Report this Comment On May 03, 2011, at 4:25 PM, wasmick wrote:

    Relax, it's not like it's bashing from a real's the SEC! IT's like being called short by Tom Thumb; consider the source.

    By the way guys, Bernie Madoff just left with your wallet, keys, car and wife.....perhpas you might want to investigate?

    I didn't think so...........

  • Report this Comment On May 03, 2011, at 5:49 PM, Richard233 wrote:

    Wait a second, while the banks did indeed do SOME things because of congress, lots of the things they did most certainly were not.

    Remember, its not the bad loans in and of themselves that screwed things up, its all the leveraged exotic financial instruments and credit default swaps that did the trick since this multiplied the effects exponentially.

    Banks WERE guilty of greed and stupidity.

    They made loans that were designed to cause defaults down the road. Why? Simple, if the mortgage holder could not pay the bank seizes the house and sells it, adding on service fees for their trouble designed to extract whatever equity had grown from the "Ever rising" real estate prices.

    Part of the scam was based on the fact that Fannie and Freddie only required the loans be "good" for a certain amount of time, after that, any loses were not the lenders problem. Well guess what length the ARM mortgages ran the "introductory" rates for?

    Yep, just until after that time frame.

    I don't mind the concept of bailing out the banks to prevent insolvency, but at that point the shareholders and bondholders should have had nothing except whatever was left after covering the costs, perhaps after a "fee" was applied like the ones they had been

    profiting so richly from.

    Whoever designed the various liar loan policies and pushed the ARM's based on the concept of making money from fees after the house is foreclosed on should be in prison and whatever ill gotten gains taken away.

  • Report this Comment On May 03, 2011, at 7:58 PM, ronbeasley wrote:

    Misleading garbage.

  • Report this Comment On May 05, 2011, at 5:49 AM, omvco wrote:

    perhaps it is time to consider a more independent valuation process for bank securities portfolios, especially for complex, less liquid securities:

  • Report this Comment On May 07, 2011, at 8:20 PM, Computergeeksta wrote:

    It shouldn't come as a big surprise if banks or any public company are trying to inflate assets and hide losses. Well, by the time the SEC catches on to whats going on the crooks have already spent all their bonuses.

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