Balance sheet fiction continues unabated, as evidence mounts that banks are creating bogus loan modifications to avoid having to write down loans and destroy capital.
A recent article in the Wall Street Journal, here, highlights how accounting manipulation has increasingly become the tool of choice for dealing with a souring economy. Regulators, the Federal Reserve, the Treasury, and those with clearly vested interests have largely failed in their efforts to stimulate the broader economy. The one remaining tool in the toolbox, though, remains their most potent: create more fiction and re-write those facts which are inconvenient.
“Extend and pretend” has become de rigueur at banks and other financial institutions, financial sleight-of-hand which masks bad loans by purportedly modifying loan terms or providing repayment assistance. These modifications prevent the need to immediately write-down the loans or fully reserve for them. By forestalling these write-downs, banks avoid further destruction of their capital positions, which have been decimated by the economic firestorm.
Many of these loan modifications are shams, and are not designed to protect the commercial project’s viability. Instead, these bogus loan modifications ensure that banks maintain the loan as performing assets and prevent further weakening of their capital.
As the FDIC grapples with an uncertain economy, spurious loan modifications and the fictitious balance sheets they create may purposely delay efforts to close many of the 1000 or so troubled banks that are projected to be shuttered by the FDIC in the next few years. Efforts to delay these closings will, in turn, postpone the FDIC’s own financial Armageddon and taxpayer bailout.
Evidence of Extend and Pretend is high:

Restructurings of “nonresidential loans stood at $23.9 billion at the end of the first quarter, more than three times the level a year earlier and seven times the level two years earlier.”
Regulators have developed new guidelines, which allow banks to record loans as   performing even if the value of the underlying property has fallen below the loan amount.
About “two-thirds of bank commercial real-estate loans maturing between now and 2014 are underwater.”
Banks currently hold some $176 billion in souring commercial real estate loans.
At the end of the first quarter, “44.5% of debt restructurings were 30 days or more delinquent or weren’t accruing interest”, meaning that nearly half of the modifications were themselves failing, a figure likely to rise as the economy continues to worsen.

Restructuring a loan where the underlying value of the property is below the loan value is essentially a bet that the economy will improve and re-inflate the underlying asset value. A bet remains a bet, though, and judging by Wall Street’s recent performance in spotting the recent financial land mines, this too will end in another taxpayer bailout in the near future.
Fictitious balance sheets ultimately prevent banks from lending, as non-performing loans generate no cash flow and prevent banks from expanding their lending to other, more qualified borrowers. This, in turn, prevents small businesses and the overall economy from expanding. Ultimately, the banks will write-off the loans, necessitating capital enhancements or taxpayer assistance.
The only winners are the bank officers and employees, whose bonuses are tied to the “performance” metrics that are blatantly false. The banks’ shareholders lose once their true financial condition is revealed. In short, there are practically no winners in this process, which merely delays FDIC takeover of these failed banks.
Some analysts continue to insist that parallels with Japan’s “Lost Decade” are coincidental, and that the US economic crisis is distinguishable from Japan’s crisis. They note that structural differences exist between Japan and the United States.  The resulting crisis brought on by propping-up failed banks, though, remains the same: zombie banks unable to lend or properly conduct business, open for business in only a strict, technical interpretation.
The fiction being created also draws parallels to the exploding crisis at Fannie Mae and Freddie Mac. Before being placed into a federal conservatorship and effectively nationalized, these two mortgage behemoths continued to insist that their balance sheets and loans were properly valued and adequately reserved. We know how that turned out, unfortunately. Fannie and Freddie will ultimately become the costliest bailout in taxpayer history.
The most amazing thing about the current crisis is our collective ability to suspend disbelief, or framed differently, our inability to be sufficiently skeptical when faced with historical antecedents. We have been lied to repeatedly, for many decades, regarding the true financial condition of our corporations and banks. The S&L crisis, Enron, Freddie Mac, Fannie Mae, Global Crossing, the current housing bubble, our pension liabilities, all are examples of our collective national hypnosis and delusion regarding the true condition of our financial system. Our national conceit blinds us to the fact that our system of financial reporting is fundamentally broken, and is no more accurate than a game of darts. We maintain trust in a broken system that has bankrupted our country and its pensions, and remain steadfast and loyal to the folks running this system. When will we learn?

The US housing market remains on federal life-support as recognition of the government’s housing liability will wreck its balance sheet
If there was ever any doubt that the US housing market was being artificially supported by the federal government, new statistics dispel this. A recent Bloomberg article, here, highlights how dependent the US housing market has become on federal assistance.
Fanny Mae and Freddie Mac, already financial wards of the state, may ultimately require $1 trillion dollars in federal bailout funds. This sobering statistic belies the very notion that the US housing market operates as an efficient, free-market enterprise, and that housing values are based on arms-length transactions.
The fact is, the housing market is currently anything but arms-length or free-market. Gross price valuation distortions have occurred within many asset classes in the last 10 years, including commercial and residential real estate. These distortions occurred for many reasons, but were primarily due to the near freefall of credit standards that now threaten our banking system. Easy money distorted prices, and now threatens the survival of hundreds, if not thousands, of banks.
Fannie and Freddie own or guarantee 53 percent of the nation’s $10.7 trillion in residential mortgages, and have sold $1.4 trillion in mortgage-backed securities to the Federal Reserve and the Treasury Department since the crisis began. The liabilities assumed by the housing giants remain off the federal balance sheet, an accounting fiction that grossly underestimates the government’s long-term debt exposure.
The fact remains that unless housing prices quickly rebound, a proposition that is highly unlikely, private investment in the securitized mortgage markets will remain anemic, at best. With home prices continuing their decline, mortgage default rates accelerating, and housing inventory increasing, the housing market will continue in virtual freefall.
Fueling this pessimism are recent reports, here, (WSJ) that home starts fell by 17 percent in May, and that the rental market has strengthened as the homeowner-renter calculus has shifted favorably to rentals. This subtle change in psychology will seriously challenge, for at least the next decade, the notion that homeownership is always preferable to renting. The US’s near-neurotic obsession with home-ownership is largely to blame for this mess, and lawmakers consider this issue the third-rail of politics. Fanny and Freddie were only able to increase the percentage of people who own their homes by significantly lowering credit standards, a fact conveniently ignored by housing market pundits and legislators.
The reality is that for many people, renting a home is the far preferable choice. This notion, though, would turn the “American dream” on its head, and become an admission of social and cultural failure. Americans have wailed over this home-ownership ideal for decades, and held it out as the gold-standard and benchmark to other Western societies. This ideal, though, has been revealed for the failure it is. The Wall Street Journal’s David Wessel recently examined the US’s housing mortgage-finance system, here, and concluded that the US has overemphasized the virtues of home ownership. He notes that Americans are addicted to a “unique and costly strain of mortgage, a 30 year fixed rate loan that can be paid off at any time without penalty.”
The coming months and years will see ever increasing delinquencies, defaults and foreclosures. Fanny and Freddie will continue to draw on ever-increasing resources for their survival. Lawmakers, facing re-election pressures this year, will continue to emphasize the broken ideal of homeownership for all. The Federal Reserve and Treasury will continue to print money and subsidize the vast homeownership machine. The market, though, may finally realize that there is no end in sight to federal support, and recognize that the housing giants’ liabilities have actually become liabilities of the federal government. This end to the accounting fiction will be painful, as recognition of this liability may ultimately downgrade the financial viability of the dollar and of the US government. Practically, there is no end to this quagmire. We’re stuck.

Michael Burry, who accurately predicted the housing calamity long before anyone else, offers insight into the behavior of crowds, and those that move against them.
Michael Lewis’ article in Vanity Fair, here, is a short tease for his new book, The Big Short, which exposes how Michael Burry, a hedge fund manager, accurately predicted the housing debacle far in advance of the actual crisis. The Vanity Fair article reveals how Burry single-handedly outmaneuvered Wall Street’s elite, and how this success has not ingratiated him to those he took to task.
Burry, a Stanford educated physician, is undoubtedly very smart, but this is not why Burry was able to see what others could not. It is Burry’s questioning, contrarian nature that led him to perform substantial due-diligence into as assumption that others had taken for granted: that housing was on an epic, sustained run that would never cease.
Burry’s story is a tale of two unique, if interrelated, phases. The first phase involved Burry’s tenacious slog through a thicket of documents, prospectuses and textbooks, looking for clues to the impending disaster and performing bank credit analysis on the home loans that he was analyzing, the same analysis that should have been performed by the issuing banks, but wasn’t. The second phase, convincing Wall Street to create financial products so that he could short the market, was pure genius.
Michael Burry’s analysis of the housing market and his conclusions are due primarily to his dogged due-diligence, pure and simple. This effort was nothing short of herculean in scope but otherwise unremarkable and tedious, and was the product of Burry’s tireless review of thousands of documents. Once completed, though, this due-diligence provided Burry the platform for the unshakeable faith in his ability to detect patterns and draw conclusions from within the housing bubble, and ignore the conventional and usually mistaken wisdom of crowds.
What did Michael Burry see in the housing crisis and what patterns and conclusions did he reach?

Burry began learning about the bond market early in his career, learning all he could about credit and how America borrowed money.
He then began learning about subprime-mortgages and reading mortgage bond prospectuses. He learned that the mortgage bonds were backed by subprime mortgage loans for which underwriting standards had virtually collapsed. Subprime loans had been issued in a nearly infinite pastel of variations, most having as their common theme placing people into homes that they likely could not afford.
Burry then concluded that lending standards were virtually nonexistent, and that the subprime loans backing the bonds would eventually begin defaulting in massive quantities. Loan volume was inversely correlated with loan standards: as lending standards went down, loan volume substantially increased.
Degradation of lending standards occurred primarily because the banks no longer kept the loans on their balance sheet, but sold them off to be packaged into the bonds.

For all his genius, Burry’s conclusions regarding the housing market were unspectacular, largely predictable, and the product of study and due-diligence. Surely, anyone with even a modicum of common sense and intelligence could have replicated this analysis. But no one did.
Burry’s true genius, though, was in fashioning a methodology, an instrument really, through which he could short these housing bonds directly, without having to short the peripheral stocks involved in the housing industry, such as homebuilding companies or materials suppliers. Initially, he began buying credit-default swaps, a form of insurance that would pay in the event of default, on companies he thought might falter in a protracted real-estate downturn. This, though, was dangerous, as there was no guarantee that the companies would actually default or go bankrupt.
The most direct way of shorting housing and the bonds that affected them was to purchase credit default swaps on the subprime bonds themselves. Credit default swaps on subprime bonds, though, did not exist in 2004. Eventually, Burry persuaded Deutsche Bank and Goldman Sachs to sell him the credit default swaps he so badly wanted. The rest of the story played out exactly as he had anticipated: the housing market collapsed and so did the subprime bonds associated with it. This is how Michael Burry turned due-diligence into hedge fund success.
None of this, though, would have happened without Burry’s insatiable appetite to digest, read and synthesize information, his ability to analyze and relate seemingly mundane bits of information into a weave. What personality characteristics did Burry possess that might influence or otherwise enhance these abilities?

An obsession with fairness.
An obsession with topics that interested him.
The ability to work, focus and concentrate.
A drive to be productive.
The ability to recognize and make sense of complex patterns.
An innate sense of the correctness of his convictions, while completely opposed to prevailing wisdom.

The first five of these personality characteristics are shared by tens of thousands of smart, capable individuals throughout the world. The last one, though, is tenaciously difficult to acquire or possess: the ability to stand against others and dare to be right.
Why did Burry possess this ability and why did he alone stand and fight against overwhelming conventional wisdom? Because Burry alone had done the due-diligence required to prevail, and he alone understood the coming debacle. Where others guessed, he knew, where others vacillated or wavered, he stood firm. All because of the grinding, dirty slog through a seemingly impenetrable forest of documents.
The lesson drawn is not Burry’s genius in creating a unique financial product with which to short Wall Street. This is hedge fund politics at its best. The lesson for the rest of us lies in understanding the degree to which simple, predictable, and thorough due diligence under-pinned his entire effort, which in turn provided Burry the unshakeable belief in his early convictions that the entire housing market would soon collapse. This in the face of the greatest asset-price inflation ever witnessed, which made housing contrarians like Burry extremely unpopular and subjects of ridicule.
Michael Burry did not guess or speculate with disproportionate amounts of his hedge fund’s investment. No, Michael Burry understood his subject-matter so well that he was sure that he bet correctly. Not even his own investors believed he was right, and many sought to withdraw from the hedge fund.
Of course, Burry was right, as he asserted in this recent New York Times editorial, here, but no one really acknowledged this, not now, not then. Burry became this debacle’s Cassandra, cursed by the knowledge of imminent collapse but reviled for being right. Still, I would rather be right.