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The Sneaky Game Banking Giants Are Playing to Suck More Money From the Foreclosure Crisis

Banks are outbidding private equity Funds at foreclosures, believing they can beat them at the pump-and-dump game.
 
 
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It’s conventional to deem local journalism to be dead, but Josh Salman at the Sarasota Herald-Tribune has written well-researched investigative story on bank bidding at foreclosures in his neck of the woods, Big lenders bidding to keep homes, that has national implications.

Here’s the overview:

Banking giants from Wells Fargo to Fannie Mae are routinely paying top dollar on the auction steps to hold onto their own distressed properties, outbidding cash offers and paying well above assessed value, according to a review of thousands of Southwest Florida auction purchases.

They are speculating that the properties will appreciate even more in the next couple of years.

The article does not indicate whether the “banking giants” like Wells Fargo are only bidding on properties where the bank owns the loan or serviced loan for private label (non-Fannie and Freddie investors). We’ll assume only the former.

The degree of outbidding is not modest, at least in Southwest Florida (emphasis ours):

In some cases, lenders this year have bid up to 600 percent more than a property’s worth to retain foreclosures — one of the primary reasons the acquisition costs for competing real estate investors also has spiked in recent months.

In the 12 months ending June 1, 4,865 foreclosures were auctioned in Sarasota and Manatee counties. Lenders outbid third-parties to keep 3,754, or 77 percent.

Banks paid $259.2 million for the properties, an increase of 34 percent from the amount they spent in the same 12-month period a year ago…

“The banks seem to be offering more than they usually would — going for market value and above,” said Shannon Moore, broker and owner of Green Lion Realty in North Port. “I don’t quite understand the logic. It’s a vast shift from the last few years when would take any reasonable amount just to get rid of them.”

Now it’s worth keeping in mind that in the good old fashioned days, when homeowners had equity in the home at the time of purchase and prevailing home prices went down only at most on a regional basis, and then usually not too much, the bank would put in a bid for the home at the courthouse for the value of the mortgage so it would take it into “real estate owned” inventory and dispose of it later if no one was willing to snap it up on the courthouse steps for a high enough price. But analysts would probe banks about their REO inventories, particularly in a weak economy.

But the “paid” is a misnomer unless the bank bid above the mortgage balance to win at the auction, which the article says doesn’t happen that often. So from an accounting standpoint if the mortgage was $160,000 and the highest third party bid was $90,000, the bank could take the offer at $90,000 and recognize a loss of $70,000 plus foreclosure costs. Or it can bid $110,000 and move the property into REO. If I read the OCC guidance correctly, the bank has to value the REO at the lower of the “recorded investment in the loan satisfied” which I assume is the mortgage balance PLUS the foreclosure costs OR fair market value as determined by an appraiser. Gee, we know how independent those appraisers are!

And with appraisers relying on recent sales for valuations….you can see the logic of the bank overbidding on such a grand scale. They can bid up to the mortgage balance and not increase their loss exposure. Overbidding systematically increases the comparable sale prices appraisers will look at to prepare their valuations. And with the banks accounting for 77% of purchases out of foreclosure sales (and foreclosure sales representing 20% to 30% of all sales in these counties), the bank activity can influence appraisals, particularly since one might expect foreclosure sales to be concentrated in certain neighborhoods. And it’s even great enough at 15% to 23% of all sales to move overall price averages and trends.

It’s also important to not to dismiss this as “oh, this is just two counties in Florida.” Large banks are not set up to have local offices operate with discretion and go load up on real estate because the manager thinks it is a hot time to buy. This is clearly a policy decision at work, and the policy decision appears to be to “outbid” the private equity giant Blackstone:

Most industry analysts attribute the change in direction to the so-called “Blackstone effect.”

The infusion of capital from the giant New York-based hedge fund and several others like it has boosted home values and tightened supply since Blackstone began buying single-family investment homes in Southwest Florida last fall.

Coupled with pent-up demand from baby boomers, and conditions that make it difficult for many boom-time purchasers to list a home for sale, banks can hold onto distressed houses with less long-term risk.

“Why sell for pennies on the dollar to Blackstone, when they can do it themselves now,” Adamaitis said. “Blackstone set the market, and now banks are taking advantage of the opportunity. They now have all of the top variables to control the market.”

The idea is that the banks would turn down bids at auction — presumably from a local flipper or investor — to instead list the property on public Realtor databases, where it can draw higher offers from owner-occupiers.

The lenders hope to mitigate their losses on their bad loan by cutting out the middleman and waiting for prices to increase.

So we can expect to see similar behavior (which amounts to holding inventory off the market through bidding it back in at the courthouse) in markets with high PE fund activity. Readers can hopefully add to this list, but aside from big chunks of Florida, it includes Las Vegas, Phoenix, and Atlanta.

Needless to say, there are a lot of risks to this strategy. The first is that even in the Sarasota-Manatee market, with supposedly tight inventories, banks are only getting hit and miss results with this “let’s beat the speculators at their game” idea. Trying to best PE funds (whose exit is not typically a sale to an end user, but a rental income stream and an IPO of the rental company) isn’t necessarily smart, particularly if you are using Blackstone as your benchmark. That fund is the “buy Microsoft” of the private equity world. They can get away with mediocre investment performance due to the strength of their brand name. In the last real estate cycle, they famously bid for Sam Zell’s Equity Office Trust in February 2007, which was seen at the time and proved to be a peak of market buy.

By contrast, savvy real estate operator and early rental market entrant Carrington said more than a month ago that they had stopped buying homes altogether because dumb money was ruining the market, as in overbidding. From Bloomberg:

“We just don’t see the returns there that are adequate to incentivize us to continue to invest,” Rose, 55, chief executive officer of Carrington Holding Co. LLC, said in an interview at his Aliso Viejo, California office. “There’s a lot of — bluntly — stupid money that jumped into the trade without any infrastructure, without any real capabilities and a kind of build-it-as-you-go mentality that we think is somewhat irresponsible.”

The second issue that is if the banks don’t find buyers for these speculative purchases fairly quickly, the homes often deteriorate. Even though the strategy (in many cases) is premised on holding the property for a year or two to catch a rising market, that assumes the banks do a decent job of securing and maintaining the properties. Their track record is that they often don’t. Conversely, unlike the banks, the PE funds don’t lease out the properties as is. They all expect to at least spruce them up a bit; some even hunt for ones that need particularly types of upgrades that they’ve set out to do in a standardized way (same toilets, vanities, etc; they’ll bid with their upgrade in mind, meaning if their typical bathroom rehab won’t work, they won’t make the offer).

Third is the look like the banks are about to have the Fed wreck their clever plan of unloading homes later to real economy buyers at a better price. Thanks to the not-so-bad job numbers last Friday leading Mr. Market to up his odds of the Fed tapering QE sooner rather than later, 30 year mortgage rates are now 4.64% for a 30 year fixed rate mortgage, up from 3.25-3.30% in early May. And realtors say the decrease in buying power is even greater, since the FHA was giving a two point lender credit to help pay for closing costs. One mortgage broker pegged the apples-to-apples rate rise at 1.75% before the additional ratchet up at the end of last week, which Mortgage News called Among The Worst Days in Mortgage Rate History. And even though rates are low by historical standards, don’t kid yourself as to what this rate rise will do to the nascent recovery. From Housing Wire last month:

Fannie Mae Chief Economist Doug Duncan said the concern should be less about what the rates have risen to and more about the speed at which they are rising.

Duncan noted that in 1994, for instance, rates rose 2% over a 12-month period, resulting in a huge impact on home prices, which fell significantly.

“If the rise happens rapidly, it tends to have an impact,” said Duncan, who added that once rates rise 100 basis points, home sales may begin to slow.

Oh, but not only are banks likely to find themselves to have been too clever by half, but as usual, their cute fixation on their own accounting and profit fantasies is yet again hurting borrowers and leading them to skirt commitments made during those “get out of liability almost free” exercises otherwise known as mortgage settlements. Again from Salman:

The national mortgage settlement also was aimed at encouraging more short sales, loan modifications or deeds-in-lieu of foreclosure — all less bruising methods of disposing of distressed properties. Those processes have a smaller impact on a borrower’s credit and are generally thought to be less hazardous for the overall economy….

With banks now aggressively pursuing home seizures on auction again, some worry it will ultimately limit the envisioned impact of the mortgage settlement, especially if lenders believe they can command more for a bank-owned listing in six months than they can for a short sale today.

This approach might not seem as wishful as it is if the banks didn’t have even more foreclosures in the pipeline, a total of 15,000 in Sarasota, Manatee, plus DeSoto counties. Contrast that with the 1,300 houses sold to third parties in Sarasota and Manatee counties in the past 12 months. And remember, on top of that, many of those third parties were flippers or rental investors, not traditional home-buyers.

But aside from the banks’ questionable motivation, we also have Fannie’s and Freddie’s pursuit of the same strategy. Perhaps they are taking (bad) guidance from their servicers. But this may also be a way to max out GSE assets within the conservatorship guidelines. Remember, the GSEs are required to shrink their balance sheets over time. But the flip side is executive pay is based on the size and complexity of the organization plus apparent performance and the GSEs continue to peg their compensation at private sector levels. So keeping Fannie and Freddie as big as allowable and where possible, dressing up its accounts is also the path of increasing the pay of its top brass.

The most disconcerting aspect of the article was the confidence of some observers in the banks’ ability to manipulate prices. Or maybe not. As Abigail Field said via e-mail, “There’s so much bid rigging among bankers that it would be weird if there wasn’t bid rigging.”

But how successful are you, really, if you have more than an order of magnitude more product in the pipeline than you unloaded to third parties last year, and many of those are speculators who are already starting to withdraw from the game? The last time banks were all over virtually all sides of the market was in CDOs, where they had less than third-party relationships with collateral managers who were major buyers (they funded them!) and wound up with tons of inventory, either because they had badly clogged distribution pipelines or because they gamed their banks’s risk and bonus systems by hedge AAA tranches and generate what turned out to be almost entirely fictive profits. And we know how that move ended. In general, the history of market corners is not a pretty one, and the banks’ and the GSE’s behavior in hot investor markets, if Sarasota and Manatee counties are any guide, looks like a close cousin.

Banks appear not to have heard the old Wall Street saying, “A position is a trade that didn’t work out.” I suspect they are going to be long their REO for a more protracted period than they anticipate. Stay tuned.

 

Yves Smith is the founder of Naked Capitalism and the author of "ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism."