More BSE in the banking system: claiming income that wasn’t

BusinessWeek continues to be must-read stuff at the moment (even if its latest paper issue has been overtaken by events, such as Bear Sterns getting bought for less than its building is worth, while the paper version makes encouraging noises about how it could come back..).

The latest example of the Banking BSE is the way that some of the organisations that loaned money for Adjustable Rate Mortgages (ARMs) booked income – even after you’ve dealt with the way that they handed out money to people who didn’t have what you’d loosely call “enough income”.

BW has the dope:

During the housing heyday, banks aggressively sold risky adjustable-rate mortgages known as option ARMs. Under the terms of those loans, borrowers pay less than the total interest owed each month. Yet lenders report the full amount of interest as income by adding the shortfall to the borrower’s outstanding balance. In essence, banks are counting their chickens before they hatch.

Let’s just try that again. I lend you, say, £100,000 (which I’ve borrowed anyway from Some Big Financial Institution). It’s a 25-year loan whose rate will vary from, say, 3% to 8%. That’s going to bring in £5,000 over those 25 years – so, £125,000 over its life.

You book this as income. Great! You’ve made a profit of £25,000 and it’s only 11am! Lattes all round!

A month later, a payment comes due. You don’t pay. I add this to your capital owed. This actually could be counted as even more profit since this extra capital is all yours to keep; you’ve got an agreed payment schedule with the BigFinInst, and the extra money this person owes is good news – it’ll be extra for you to keep.

Another month goes by, and another and the person still doesn’t pay. Fantastic news! Your profits are going up all the time! Pity about the cash flow, but there’s always someone willing to lend you some more money – especially when you indicate to them that you’ve got a really profitable loan which is due to make more money than the normal loan from a BigFinInst. Hey, why not sell them a slice of the loan?

Got the idea? Back to BW:

Companies don’t disclose the full details on such loans. Countrywide Financial (CFC) earned at least $561.7 million on option ARMs in 2007. It was one of the few bright spots for the lender last year, which reported an overall loss of $704 million. WaMu recorded $1.42 billion from such loans during that period.

But those gains at Countrywide and WaMu may soon be wiped out by writedowns. Other types of subprime mortgages already have reset en masse to higher rates, triggering defaults and wreaking havoc on banks’ earnings. At Countrywide and WaMu, option ARMs are only now starting to reset.


The resulting situation could be ugly for them judging from the fate of early entrants into the option ARM game, including Downey Financial (DSL) , IndyMac (IMB) , and FirstFed Financial (FED). Frederick Cannon, a bank analyst with Keefe, Bruyette & Woods (KBW) estimates that a third of FirstFed’s Option ARMs now resetting will default this year while similar loans at IndyMac are going bad at a faster rate than other mortgages. Downey began to ease the terms for borrowers in option ARMs last summer. But the troubled debt at the lender jumped nonetheless from 1.53% of assets in June to 4.79% by yearend. IndyMac declined to comment. FirstFed and Downey did not return calls for comment.

If WaMu and Countrywide experience the same sort of problems, they will face significant writedowns and reverse years of gains. “The benefit of hindsight shows that income was clearly overstated,” says KBW’s Cannon. Says a WaMu spokesman: “It’s difficult to project delinquencies, but the credit profile of these loans would not have historically been defined as high-risk.” Countrywide said its financials conform to accounting standards.

Oh, sure, they conform – you’re allowed to book that “income” as money, even though none of it has come through the door yet.

The thing that is different about this finance problem from the shares bust of 2000-2001 is that that one was only that – shares. It was a stock bubble, purely. In this one, houses and finance are intertwined, and that’s far more toxic, because where in previous recessions you might be able to shelter in one or the other (except, of course, the Lawson-created housing bust of 1987/8/9 – which I took part in, dammit – followed by the global recession of 1990/1), this time it’s taking in both. And that’s really hard to work your way out of.

What’s also interesting is that the Americans’ strict religion about money is preventing them from acting in the most effective way – the one the Swedes took. (Yes, BusinessWeek again.)

When the bust hit, it hit hard. Gross domestic product fell 6% between 1990 and 1993, prompting a tide of bankruptcies that threatened to swamp the financial system. The central bank governor, Bengt Dennis, was dubbed “Dennis the Menace” after he briefly jacked up interest rates on loans to banks to 500% in an effort to halt speculation against the currency in 1992. “Everything was so black you almost didn’t dare open the paper,” recalls Lars H. Thunell, at the time the deputy chief of Nordbanken, Sweden’s No. 2 bank, and now CEO of the World Bank’s International Finance Corp. in Washington.

The government’s response: A $14billion restructuring fund and a takeover of Nordbanken, the hardest-hit player. The bank’s bad loans were sold off at a steep discount to a new government-backed company called Securum, which was headed by Thunell. At one point the operation owned 2,000 buildings, controlled industrial companies such as chemical giant Nobel Industries, and employed 30,000 people. “The Swedes were smart, they moved quickly, and they knew how to organize the rescue,” says John R. Macey, deputy dean of Yale Law School, who has written about the Swedish approach.


  1. It will be interesting to see the demographics of the groups affected by this slump. Like you, we were hit by Nigel Lawson’s mis-engineering of the housing market. It took us ten years to shake off the negative equity. I wonder whether our generation has been more cautious this time round, so that the pain will be felt by those older and younger. If that is the case, what will that mean for the wider economy. Will we be inclined to support some parts of commerce and industry, but not others?

  2. This is an extreme, grotesque tale of raw greed and deception. Thankfully Newton’s third law – every action has an equal and opposite reaction – manages to kick in every time and save us from completely destroying ourselves. Although the consequences we are facing now as a result of this debacle are bad, they are not as dire as they would be if these institutions were able to execute their dirty, reckless schemes to their full potential. Millions of poor families would be impoverished to the point of desperation and having to turn to the government for a lifeline which would probably not be there. As long as banks continue to operate under principles of blind greed and short-termism, history is destined to repeat itself. Too bad they couldn’t take more notice of the laws of physics.