Lenders and severity rates

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Matt at the OC Register has a new post about how banks account for loans that they hold on their books that are obviously worth less than their face value (through default, lack of investor purchase interest, etc.). He questions whether banks have adequately disclosed the deterioration in the value of their holdings from the effects of these events; further, he questions if they are truly holding adequate reserves to meet these devaluations and buybacks.

This is an important topic that I believe banks are getting way to much leeway on these days. From his post:

During the first-quarter conference call of IndyMac Bancorp
in Pasadena, an analyst said he had calculated the company had $224
million in buybacks in the period and noted a severity ratio of 10%. A
lender buys a loan back at par, or face value, and resells it for less.
The difference is the severity ratio. Also, when a lender sets aside a
reserve, as we discussed, that should be roughly equal to the severity
ratio.

A couple of thoughts on this severity ratio issue. Here it is in simple terms. Think of every loan having a value of 100. This is the par rate of the loan. If a loan is $250,000 and its value is 100 then when you sell the loan to someone they will pay you exactly $250,000 for that loan.

Since mortgages are sold in a competitive, open market, their value fluctuates as supply and demand for certain loan types increases or decreases. So some loans can be sold for 101 or 102 (or more) which would mean on that same $250,000 loan a buyer would pay the seller $252,500 or $255,000 to purchase the loan. It also works in reverse. If a loan is not very appealing or attractive to buyers then the loan has to be sold "below par," which can be anywhere that makes the loan attractive enough to be sold. To continue with the above example if that $250,000 loan was sold for 98 or 97 then the buyer would pay the seller $245,000 or $242,500 for that loan.

When mortgages become delinquent, or when mortgages are rated as too risky the devalue the loans so significantly that the loans become unsellable. They would require such a steep discount to buy that the seller just holds on to the loan and hopes that the market comes back to those particular loan products.

The severity ratio measures what the average price investors will buy the loans that have gone delinquent or that are otherwise sitting in the seller’s portfolio. So in IndyMac’s case, a 10% severity ratio means that on average their loans currently in the portfolio would be valued at 90. So on a $250,000 loan that means it could be sold for $225,000. A $25,000 loss for the seller. Now apply this to the entire portfolio of loans and you have a truer estimate of the portfolio’s value.

This is where the leeway comes in. There is no one doing an independent evaluation of this severity ratio on the mortgages being held by the seller. IndyMac decided its severity ratio was 10%. An outside auditor could decide that the ratio is closer to 20%.

No apply that severity ratio out to loans that IndyMac already sold (on the assumption that they are similar to the loans they hold themselves). If these loans are to come back to IndyMac from investors for not performing (delinquency, foreclosure, etc.) then IndyMac would have to buy the loans back at an average 10% loss for each loan.

Because sellers like IndyMac are required to hold cash reserves to cover anticipated buybacks the discount or severity ratio is exceptionally important in determining a sufficient dollar amount of reserves. If IndyMac is wrong on its severity ratio then it could be crippled by loan buybacks due to a lack of reserves. This is why that ratio is so critical. If the ratio is closer to 15% or 20% then their cash reserves are short by a huge amount. If the ratio is indeed 20% they need double the reserves they currently carry.

This severity ratio obviously has a very high impact on the true value and financial health of the company. It should be a number reported for all public lenders and should be independently verified to protect the investors of the corporation.