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More Pessimism Surrounds Bank Portfolios
Asset Backed Alert, Harrison Scott Publications Inc. (November 7, 2008)

A consensus is developing that many banks have understated how badly they'll be hurt by defaults among holdings of unsecuritized mortgages. Even as they have taken tremendous writedowns on portfolios of home-loan bonds since the housing market fell apart last year, some large and mid-size financial institutions are still booking their whole-loan investments at par or close to it. And that means they'll wind up with even bigger losses if predictions of heavy defaults among those credits prove correct.

Sources named Citigroup as one company that may be holding mortgages at values that don't fully take expected default rates into account. And that's after it logged $46.8 billion of debt-product writedowns since mid-2007.

Another candidate is Wells Fargo, which has avoided major loan-loss provisions so far. The company will take some loan-related adjustments for assets it expects to take on with its purchase of Wachovia, however.

Financial institutions have to mark down loan portfolios inherited through purchases of other lenders, even while often leaving their own mortgage books untouched. That said, many specialty mortgage lenders have bumped up loan-loss provisions on their own. So has Wachovia, while taking $8.8 billion of credit-crisis markdowns. Privately held regional banks could also take big hits.

Hints of what might be in store for home-loan portfolios can be seen among bonds backed by similar debt pools. In that area, 802 classes of securities experienced defaults during the third quarter of 2008, up from 635 in the second quarter and 303 in the January-March period, according to S&P (see "Rankings of Market Players" in "The Marketplace" section of for a full listing of defaulted issues).

Much of the discrepancy in the balance-sheet treatment of mortgage bonds and unsecuritized loans is due to the types of portfolios where those assets reside. Because bonds are placed in available-for-sale baskets, they must be assigned market values - which means steep writedowns these days regardless of default expectations. The same is true of loans held for securitization or sale.

Mortgage products designated as investments, on the other hand, are typically funneled into hold-to-maturity accounts or other non-tradable portfolios. That way, they can be retained at face value and their owners have discretion to set loan-loss provisions.

It's not like whole-loan portfolios are actually trading at par. Rather, most are changing hands at 40-60 cents on the dollar. One source said the midpoint of that range implies an expected default rate of 20%, which is above the current failure rate of 5-10% - and is far worse than reflected in banks' current balance-sheet treatment.

Defaults are expected to rise steadily over the next year. One indicator of impending losses is the rate of negative equity in homes across the U.S. Some 18% of mortgage borrowers owed more than their houses were worth on Sept. 30, and that figure could approach 23% before property values start increasing again, according to an Oct. 31 report from First American CoreLogic.

That trend would inevitably increase defaults among mortgage-related bonds, while reducing recoveries in the underlying loans. Initially, bond defaults were heaviest among issues backed by home-equity loans, because those credits are last in line for recoveries when borrowers default. In addition, servicers tend to write off second-lien debt more quickly than first mortgages.

During the third quarter, however, only about 20% of new defaults involved home-equity loan securities. The rest are tied to subprime, alternative-A and jumbo credits, mainly printed from 2004 to 2007. Many of the failing deals were brought to market by Bear Stearns, Credit Suisse and Lehman Brothers, although most major financial institutions have been behind at least some bond defaults.

The prevailing opinion is that the writedowns U.S. banks have already taken on such holdings have been adequate, with a worldwide total of more than $410 billion of markdowns on a range of debt investments. Some have become more aggressive with their adjustments in recent weeks, as the federal government has shown increased willingness to assist with recapitalization efforts.

Super-senior bonds backed by subprime mortgages are trading around 80 cents on the dollar. Junior pieces of the same deals are circulating at 20 cents, one trader said, reflecting strong expectations of defaults. Those values aren't necessarily translating for the portfolios of European banks, however. Last month, the International Accounting Standards Board and the European Union loosened up standards for marking assets to market, allowing institutions within their scopes to shield certain bond holdings from writedowns by designating them as longer-term investments. But some market players think the move will only delay losses. v



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