As we discussed in our April post, Bankruptcies on the Rise and the Evolving U.S. Debt Burden, bankruptcies have been rising at an alarming rate this year. The trend is likely to continue—it will be interesting to note how the situation evolves (since 1st quarter) when the U.S. Judiciary releases second quarter figures in the coming weeks.

In the meantime, more and more consumers are taking advantage of a loophole in Chapter 13 bankruptcy proceedings to effectively remove the debt of their second mortgages. Bankruptcy courts can reclassify 2nd mortgages as unsecured if the appraised value of the home is less than the amount owed on the 1st mortgage—in essence, when there is no value securing the 2nd.

For example, a borrower has a $200K first mortgage and a $40K second mortgage; the borrower’s home only appraises for $180K. Thus, since there is no equity, or value, to secure the second mortgage—the borrower can file suit to have it removed.

With unprecedented decline in home values across the nation, one lawyer estimates at least 20% of his clients would qualify for a reclassification (Liening on banks: Second mortgages are next housing crisis, New York Post, 7/11/10).

If you have a significant portion of assets in second mortgages, we recommend stress testing what could happen to your risk profile should a significant amount be charged off due to continued credit risk and bankruptcy proceedings.

Furthermore, everyone should consider what could happen to the broader economic landscape should 20% of the nation’s $1 trillion second mortgage market be put at risk of reclassification.

The recent news about the European bank stress tests has us thinking about when a stress test isn’t a stress test.  By now, you may have heard that out of the banks tested, 7 out of 91 failed the “stress tests”.¹  That is a 92% pass rate, and should earn the European banking system an A grade, right?  As it turns out, there are many critics of these tests.  For example, only trading securities were subject to market devaluations, so all held-to-maturity securities were excluded from the tests.  Further, some of the economic “stresses” were little more stressful than the current environment.

For example, “The worst-case scenario envisioned…the overall euro-zone economy shrinking 0.2% this year and 0.6% the next year.   In some of the 20 countries that conducted the tests, regulators figured that property values would keep rising or hold steady in a worst-case economic scenario…”  In Austria, for example, properties under the stress test were assumed to increase 2% this year and 2.7% next year.²  Try telling a “sand state” credit union that a 2% increase in property values is a stress test.

Why this interest in Europe’s stress tests?  As regulators/governments publish the results, it could provide consumers with a sense of security and hope that may not be justified—ultimately adding more confusion to an already delicate environment.  We often find that appropriately managing expectations is nearly half the battle.

When you decide to conduct stress tests for your organization, don’t shortchange yourself by designing a test that can be easy to pass.  AND, don’t limit your stress tests to what is probable.  Again, nobody thought the cascading events that occurred over the last few years were probable.  It’s the improbable that is currently bringing long-standing organizations to their knees.

¹Cozy Stress Tests Fail Confidence Test, The Source, 07/26/10

²Europe’s Stress Tests Relied On Mild Assumptions, Wall Street Journal, 07/26/10

The question that many credit union leaders are asking themselves lately is, how far do we reach for yield?  With 10-year Treasury Rates rounding near 3% recently, how far can the balance sheet be pushed to make up for a squeezing margin?

Consumers at large are facing a similar dilemma when it comes to managing their own balance sheet.  How much risk is too much?  And with the world turning on its head, with perceived threats of war on the Korean Peninsula and dark concerns about the financial stability of European markets, that question is becoming harder to answer.  Even as consumer confidence is up on news of positive job forecasts, the Dow has tumbled below 10,000—not crossing that threshold since February 8^th of this year (Dow Falls Under 10000 as Risk Is Shunned, WSJ, 5/25/10).

As the world continues to become more complex, and as ripples from the financial crisis and new developments in world affairs unfold, be mindful of consumers’ tendency toward safety.  While many credit union leaders cannot imagine another influx of low-cost funding, the perceived chaos in the world around the consumer could theoretically cause just that.  Consider stress testing what could happen if you experience another flight to safety of similar (as well as greater) magnitude combined with anemic loan demand to see the impact to your net worth ratio.  If net worth is at high risk of dropping below Well or Adequately Capitalized, identify viable steps you can take to be prepared.