15 September 2005

Katrina, Banks and Landlords.

Listening to the radio today, I heard an interview on NPR with the President of a local Southern Mississippi bank. This got me thinking about the systemic influences that Hurricane Katrina is going to have on the banking industry.

Everyone remembers the Christmas special "It's A Wonderful Life". In that movie, the protagonist explains that banks don't keep deposits sitting in some vault. Your deposit goes into a mortgage on someone else's home. The interest coming in on that mortgage pays the interest due on deposits and the expenses of running the bank. The only significant change that has occurred in the commercial banking industry since the time when that movie was set is that now most deposits are insured by the Federal Deposit Insurance Corporation (FDIC).

Banks take reasonable measures to make sure that loans are paid. They make sure that borrowers are employed and have good credit. They take the property as collateral and make sure that there is an "equity cushion" to prevent the bank from bearing the risk of fluxuations in the value of the property. In a conventional residential loan, this cushion is typically at least 20% of the purchase price. In a conventional investment property loan, this cushion is often 50% of the purchase price. In low downpayment mortgages, mortgage insurance is often obtained. Finally, borrowers are required to insure their properties with homeowner's insurance and, if they are in a flood plain, with flood insurance.

Current estimates are that half of the homes in New Orleans did not have flood insurance, since the levees that guarded them took them out of the flood plain where it is typically required. Many of the uninsured buildings in New Orleans would have been subject to substantial mortgages. Except to the extent that ad hoc disaster relief funds make property owners whole, the banks who hold those mortgages are going to face massive losses that are likely to cause smaller banks to fail. Banks run a tight ship and simply don't have sufficient reserves to handle the loss of much of their principal in secured loans. Without the collateral, many of the debtors, who have lost homes and jobs, will be unable to pay in any fashion. If they go bankrupt under Chapter 7, they will have to turn over the land and ruined buildings to the banks holding the loans, and will have the remainder of their obligations discharged. Ironically, the only defaulting loans where the banks have some chance of being made whole may be the low down payment loans with mortage insurance.

Also somewhat oddly, to the extent that people without flood insurance are not made whole through disaster relief aid, one of the main sources of relief to the region may end up being the FDIC. If a bank fails, because its mortgage assets have become worthless, FDIC will step in and insure most of the bank's deposits as a multi-billion dollar cost, in many cases making payouts to local depositors that far exceed the failed banks' assets.

Another story on NPR mentioned that two-thirds of New Orleanians are renters and not homeowners (compared to a national homeownership rate of almost two-thirds). This is relevant to both banks and to tenants. In the case of buildings ruined by the flooding of New Orleans, which includes the vast majority of rental housing in the city, the likely approach taken in the landlord-tenant relationship will be to discharge landlord and tenant alike of any further obligation under those leases. Tenants will seek new homes from scratch. Landlords will try to decide what to do. Landlords without flood insurance or ad hoc federal aid may have to simply surrender the land to banks and make up as much of the difference from their personal funds as they can, as few landlords are completely insolvent. Also, since landlords often own more than one property, and since middle class residences in the older part of the city are probably most likely to have survived the storm (and hence will likely simply be rehabiliated) the pool of property owners and repossessing banks who decide how to rebuild New Orleans may be far smaller than one might expect. If each landlord owned just 10 units, and 10-12% of them surrender the properties to foreclosures, perhaps 10,000 landlords will dominant the reconstruction process, and that in turn would likely be dominated by a couple of thousand property owners who own the bulk of those properties.

For all the grand plans of civic leaders and community members, the future shape of the city is going to be largely decided on a case by case basis, by those property owners and repossessing banks, and it isn't at all obvious that they will be inclined to build as much low income housing as existed before the Hurricane. Revised zoning and building codes will guide their decisions, but the city can't force someone to rebuild (without condemning their property and paying for it, something New Orleans may have difficulty doing at the moment as the City currently has no cash on hand, and the State is working hard to fend off rumors that it too might have to itself go bankrupt). The biggest incentive to build new low and moderate income rental properties to replace those destroyed may come not from city zoning requirements, but from strings tied to federal aid for those who did not have flood insurance. Those conditions, of course, have not yet been set, although the President's speech this evening from New Orleans may set the tone of that debate.

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