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Back to the loan level for a second. I'll walk through a hypothetical about what
happens on a lenders balance sheet when a loan goes delinquent.
And, I'll use a $200,000 loan, goes delinquent. Goes 45 days delinquent,
and the FDIC comes up, lest say it's Bank of America, and knocks on their door and
says, hey Bank of America, I see you have this loan that's 45 days delinquent.
I need you to set aside some of your equity capital in case you suffer a loss on
this loan. So the FDIC might tell them, set aside $2,000 of your equity capital.
So that equity capital that the bank uses to make loans is all of a sudden tied up
in the loss reserve account. They can put in the loss reserve account,
they set it aside, bank you can't touch it. Well, that $2000.00
in equity capital represents maybe $30,000 in the bank's lending power.
Because, for each dollar that the bank loans out, it only puts in about two and a
half cents, three cents of its equity capital. The rest of the money is borrowed
from your checking, your savings, selling CDs, borrowed from the Fed.
So, that's painful for the bank because they're loosing the opportunity to make a
$30,000 loan to someone and collect that interest. So, that's the first step,
that 45 day delinquency. So, let's say that same loan goes 90 days delinquent.
In this market the lenders aren't even putting people into foreclosure,
often six months or a year. But, lets say 90 days delinquent.
Under historical standards the lender would file a foreclosure suit.
They file that foreclosure suite and all of a sudden it shows up on a different list
to the FDIC. The FDIC comes knocking, and this is, this is just to give you the
structure of how it works. It's not actually how it works. The FDIC can't look on a
loan by loan, but the loans will show up in theory on a list.
So the FDIC says, gee lender do you have an appraisal or a BPO more recent than a
year on this loan? So they go out and get one. And, if they're lucky,
it comes back at $150,000. So, all of a sudden, the lender is owed $200,000,
the property is only worth $150,000. The FDIC tells the lender,
gee, you have to take $25,000 of your equity capital, half of that amount that
you're upside down, take it off your balance sheet, put it in the loss reserve
account in case you suffer a loss. That $25,000 of lender equity capital takes away
their ability to make an $800,000 loan or a million dollar loan.
So that is painful. And that is basically the whole main driver,
or one of the main drivers, behind the $800 billion dollar bail out is simply
because all of the banks', or a large portion of the banks',
equity capital was pushed to these loss reserve accounts. And,
so the banks didn't really have the equity capital to continue to make loans.
So, with the bail out money, it put money back onto the banks' balance sheets so
they could continue to function. Also, in addition to the lenders relaxing the
standards as far as mark-to-market, the lenders also tweaked how much money-- Sorry,
the government tweaked how much money the lenders had to set aside in these loss
reserve accounts. So they took a number of actions to help prop up banks in general,
but once and, just back to my hypothetical, once that situation exists,
all of this money, lets say $25,000 of the bank's money, is sitting in this loss
reserve account.
The bank's main goal is, well gee I have a $200,000 loan that's preventing me from
making a million dollar loan. How to I get that $25,000 and put it back on my
balance sheet? In theory, the way they do it is they resolve the loan in some form
or fashion. One way that the lenders probably aren't too happy with,
and I'll show you specifically later, is through the loan modification.
If the lender modifies an upside down loan, they maybe able to recover $15,000,
maybe $20,000, of that loss reserve because they can put a performing loan back on
their books. But still, they're sitting with $5,000 or $10,000
that's off in the loss reserve account that they can't use. Over time,
that is a huge waste of the lender's money. That's one of the main reasons why the
lenders are some what unhappy or displease to modify loans. The government says,
well we bailed you out here's your $800 billion so you guys,
quid pro quo, modify some of these loans and, you know, its just an act to try to
please the people instead of, really good for the bank in the short term.