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Resolving the Mortgage Mess

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Bank of America (NYSE: BAC) announced last Friday that they were creating a new subsidiary, Legacy Asset Servicing, to handle their 1.3 million troubled mortgages. They hoped that their announcement would get buried under the snow -- and news about Egypt and the Super Bowl. Their wish seems to have come true.

What does this move really mean? Permit me a somewhat cynical view, based on sad personal experience with corporate bankruptcy -- as a director and investor.

Usually, the hardest part in a bankruptcy is for the broke party to recognize the situation, much less admit to it. Every bankruptcy candidate bitterly resists even thinking about the process. You would think that near or actual catastrophe would overcome this reluctance. But that is a logical, not a human, analysis. BAC, like all of its fellow large banks, still cannot admit publicly the magnitude of their problems and how close to ultimate disaster they came in the fall of 2008.

Most corporate bankruptcies start by trying a process known as reorganization under Chapter 11, after the part of the bankruptcy law involved. The company tries to make a plan that lets it continue in business, and gets temporary financing and relief from some of its obligations under the supervision of the bankruptcy court. During Chapter 11, the company has three goals: fix the problems that got it in trouble, stabilize its operations, and reposition itself to be a going concern after it emerges from the bankruptcy process.

The TARP process was the equivalent of Chapter 11, with the Federal Reserve and the Treasury acting as both the "debtor in possession" lender and the bankruptcy judge. When put that way, the flaw in the idea becomes immediately obvious: the roles of lender and supervisor are inherently in conflict with each other. The lender, seeking to minimize its risks, pushes for strict controls over the operation of the bankrupt party; the supervisor has to balance the demands of all parties, including other creditors, employees, customers, and public.

TARP clearly succeeded at one of the three goals of Chapter 11: stabilize operations. It did not, however, achieve the other two goals: fix the problems and reposition for the future. While the banks and the administration would like to declare success and move on, no bankruptcy judge would discharge the case at this point.

Often, Chapter 11 does not succeed: the problems are too big and there is not enough time, money, and good will available. Could this be the case with BAC? Here's a back-of-the-envelope analysis. Suppose that the average balance of the 1.3 million troubled loans is $200,000. Suppose that the best that can be done is to realize 50% of the nominal value of the loan. Suppose that every one of the remaining 13 million mortgages is perfectly good. Do the math, and that comes to a loss of $130 billion, just a whisker short of BAC's $144 billion market capitalization.

So what is this about? It could be the process of liquidation, which if it were done in bankruptcy court would be called Chapter 7 (again after the statutes involved). Chapter 7 is a complex set of rules, but it boils down to a few steps:
  • Step 1: separate good assets and obligations from bad ones.
  • Step 2: sell the good items for as much as possible.
  • Step 3: write the rest down to zero.
  • Step 4: disburse the proceeds, if any, as fairly as possible,
  • Step 5: close the doors.

BAC is doing Step 1. Clearly, they hope to survive the process, so that it is not Bank of America that will land at Step 5 and close its doors. This means that they are preparing to separate the Legacy Asset Servicing business from the BAC holding company at some future date.

The bet is that some investor or group of investors will buy the "bad bank", even if it's just for $1. The benefit for the remaining "good bank" is obvious: it now has clearly positive net worth and is better positioned for the future. Chapter 11 success, at last.

But what about the folks who buy the "bad bank"? The bet they would make is that they can manage the portfolio of troubled loans, foreclosures, personal bankruptcies, lawsuits, and claims better than BAC was doing. Just losing 49% instead of 50% on the portfolio would be an enormous upside. Of course, losing 51% instead of 50% would be an enormous loss, so this is not an adventure for the faint of heart or light of pocket. However, considering the low reputation Bank of America created for itself and its management prowess, this might be a really good bet for the right someone(s).

All this seems like a constructive resolution of a problem so huge that it threatens not only BAC's survival but the ability of the US economy to ever fully recover. BAC's announcement left me wondering:
  • Why hasn't every other major bank already done this?
  • Why is Bank of America leading what should be a parade?
  • Why didn't regulators, shareholders, and boards of directors force this action two years ago?
Inquiring minds want to know.

Disclosure: the author has been a Bank of America account holder since he was 6 years old and currently has a mortgage serviced by BAC. It is one of their good ones.