BKUNA (see post below) isn’t the only bank with low quality earnings that rely on negative amortization. Remember: negative amortization is the amount of interest due on a mortgage that the borrower defers to future periods. Accounting rules allow banks to count these “deferred payments” as current income. But if borrowers default on their loans, if they never make payments in cash, then “income” previously recognized has to be reversed.
Say I’m carrying a balance on my credit card; I owe interest on that balance. If I’m not paying my bill on time–if I’m making the minimum payment each month, for instance–then I’m “deferring” interest payments to the future. Wouldn’t it seem foolish for the credit card company to treat my “deferred” payments as income today? Banks that sold option ARMs are doing exactly this: watching the unpaid balance on their mortgage loans rise while counting nonpayments as income today.
If home values are increasing and borrowers can refinance, then there’s little risk to the bank that the loan amount won’t be paid back. But home prices are now falling across the nation. And defaults are rising…….
Banks that relied heavily on option ARM mortgage originations (BankUnited, Downey Financial, Luminent Mortgage, Countrywide, even Washington Mutual) are all in serious trouble…..and their stock prices reflect this. Research firm CFRA was on top of this problem back in 2006. People who went short on their research did very well.
A great article from the WSJ on poor quality earnings at banks:
This Game Theory
Is Cautionary Tale
By HERB GREENBERG
December 8, 2007; Page B3
The reality of Generally Accepted Accounting Principles, or GAAP, is that they give companies just enough rope to hang themselves and their investors, if they so please. Much of GAAP is so subjective that you could drive side-by-side snow plows through the gray areas.
That is something to keep in mind if, with the latest wave of write-offs, you believe it is time to start bargain hunting among the most beaten down financial-services companies tied to the mortgage blowup. The time may very well be right, but a recent report by Gradient Analytics warns that financial-reporting practices of some of these companies yesterday and today could still come back to bite investors tomorrow.
Gradient, a Scottsdale, Ariz., research firm that caters to mutual funds and hedge funds, was early to spot accounting issues at Krispy Kreme Doughnuts, Biovail and Children’s Place Retail Stores, among others, and their stocks subsequently tumbled.
“I think for a number of years they played games,” Donn Vickrey, a former accounting professor who co-founded and is now editor-in-chief of Gradient says about the financial-services companies.
By “playing games” he means a tendency during the mortgage boom “to report numbers that were artificially high.” There were a variety of ways to do that, all of them completely legitimate and blessed by the gods of financial accounting rules — otherwise known as the Financial Accounting Standards Board.
One of the most-popular tactics was front-loading income and cash flows through what is known as “gain on sale” accounting, as loans were packaged and sold to other investors. The amount recognized largely reflected what the company expects to receive at some point in the future, based on predictions of such things as delinquencies, prepayments and interest rates. It is totally discretionary; the more conservative the predictions, the lower the gain.
Just as companies may have been reporting numbers that were too high, Mr. Vickrey believes some might now be reporting losses and charges that are artificially low, hoping they will somehow get bailed out before the situation worsens.
This is being done, he believes, by such things as deferring recognition of losses; transferring mortgages that are likely to default from one part of the balance sheet to another, where management has more discretion in determining the seriousness of the loss; somehow concealing “the aftereffects” of aggressive gain-on-sale accounting, and reliance on interest income from negatively amortized mortgages — those in which the amount owed rises if payments don’t cover all the interest due, which in this environment at best appears dicey.
Much of this, he says, involves meeting “the bare minimum letter of GAAP, but not adhering to the spirit of GAAP.”
Among the five biggest companies involved in mortgage securities, Gradient believes Washington Mutual and Countrywide Financial have been the most aggressive, with Washington Mutual edging out Countrywide as having “the most risk for a material misstatement.” Washington Mutual didn’t respond to requests for comment.
Countrywide said its accounting is appropriate and it has taken steps to reduce risk.
Gradient warns that Washington Mutual may not be properly valuing loans it is holding for investment purposes. As a result, reserves for future losses may be too low.
While the company boosted its loss provision in the third quarter, the Gradient report says “the increase appears to be too little too late as the allowance for loan losses has failed to keep pace with the increase in nonperforming loans.”
Meanwhile, in recent years, interest from negatively amortized mortgages leapt as a percentage of interest income to 7.2% for the first nine months of this year from 1.8% in the same period two years ago. Not only is that income unsustainable, Gradient says, but more prone to write-offs, especially if there are increased delinquencies and defaults.
Then there’s the high level of gain-on-sale income in prior years “that may signal additional risks to come.”
Washington Mutual, the report says, ranked second behind only Countrywide in terms of its reliance on gain-on-sale. Countrywide has been on Gradient’s screen for four years because of a variety of earnings-quality issues.
As with Washington Mutual, Gradient now wonders whether there could be “hidden losses” among loans held by Countrywide for investment. While reserves as a percentage of nonperforming loans have been rising, hitting 63.4% as of Sept. 30, Gradient says they still lag behind peers, including Washington Mutual. Countrywide disagrees, and says that “when all of the relevant factors are considered, our ‘reserves’ are comparable to our competitors.”
Like Washington Mutual, Gradient says Countrywide suffers from “low quality income” related to negative-amortized loans. “Unfortunately,” the report says, in trying to determine its exposure, “Countrywide does not provide as much detail as other firms we surveyed.”
While the stocks of these companies and others have fallen considerably, Mr. Vickrey believes “a lot remains to be revealed.” Can’t wait.