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.

Company

% of All Loans Managed by Bank

Second Lien Holdings

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

Bank of America

19.9%

$158.5 billion

13.5%
Wells Fargo

16.9%

$62.6 billion

19.5%
JPMorgan

12.6%

$144.6 billion

13.9%
Citigroup

6.3%

$111.4 billion

13.2%

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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