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How Mortgage Troubles Impact U.S. Banks -- Part One

We explore possible near-term effects on profits and stock performance.

If you have picked up the paper in the past month, you know that the subprime (also called nonprime) mortgage business has blown up in recent weeks.  New Century Financial , one of the largest players in the industry, filed for bankruptcy protection on April 2. At first, it seemed like the problems were confined to the low-quality subprime business, mainly stemming from firms that were funding mortgages with short-term borrowings. However, we're starting to see problems creeping into higher-quality mortgages, and as a result, we've identified two short-term risks for our bank coverage universe.

A Primer on Mortgages
Before we get into the problems, we first need to go over some mortgage basics. Most banks do not write subprime mortgages and instead cater to borrowers with higher-quality credit. Most banks also sell the majority of the mortgages that they originate. They earn a fee and sell the actual loan into the secondary market, often to the government-sponsored entities  Fannie Mae (FNM) and  Freddie Mac (FRE). Fannie and Freddie buy conforming mortgages, which are the traditional, 15- or 30-year fixed mortgages made to borrowers with FICO credit scores of at least 620 (called prime borrowers) who also have documentation showing income and assets. This type of mortgage is still the most popular, accounting for 37% of all mortgages originated in 2006.

Moving down the scale, we get to Alt-A loans. These are mortgages for prime borrowers who for some reason do not provide all the documentation that the government-sponsored entities require in terms of income, employment history, etc. These low-documentation or no-documentation loans are popular with the self-employed. According to Inside Mortgage Finance, Alt-A mortgages accounted for $400 billion (13.4%) of all mortgages that were originated in 2006. Most banks write Alt-A mortgages, but they sell them into the secondary market to generate fee income.

How Will the Subprime Blowup Affect the Major Banks?
We don't believe that the problems in the Alt-A market will get as bad as those in the subprime market, but we believe that the fears the subprime blowup created in the market and deteriorating credit quality will result in problems for the banks. In the short run, the banks that write Alt-A mortgages could be hurt in two ways: Banks won't be able to sell the mortgages into the secondary market, and/or they will have to repurchase the mortgages that they already sold into the secondary market.

Selling Alt-A Mortgages
Most of the $400 billion in Alt-A loans originated in 2006 were sold into the secondary market. However, the recent subprime mortgage blowup has scared investors away from mortgages, including Alt-A mortgages. Banks, which have continued to originate loans, are faced with two choices. They can sell the mortgages for unattractive prices, taking an immediate loss on the loans, or they can write them down to fair market value and hold them in their loan portfolios.

If a bank chooses to sell the mortgages, we estimate, in a worst-case scenario, that the loans will sell for just 98.64% of their value. Add the cost of making the loan and selling it for a 1.36% discount, and a bank will take a real and immediate hit to its income statement. For instance,  SunTrust  originated $10.1 billion of Alt-A mortgages in 2006. Selling at a 1.36% discount would cost the bank a whopping $137 million, or $0.38 per share. This might seem like a major problem, but we estimate that the loss would have lowered SunTrust's 2006 earnings by only 7%. The largest impact would be at  Indymac , where writing Alt-A mortgages to sell into the secondary market is its primary business. We estimate that Indymac would lose almost 3 times what it made in 2006. Investors should note that this is just an exercise; in reality, Indymac would stop writing loans if all it could do is sell them at a loss.

The following table shows some of the top Alt-A originating banks, and our estimate of the earnings impact if forced to sell all of their 2006 originations at this severe discount.

 Estimated Earnings Impact of Alt-A Liquidation

2006 Alt-A Originations

Estimated Loss % of 2006 Earnings
Indymac  $70.2 billion $954 million 278%
Wash. Mutual (WM) $25.3 billion $344 million 10%
Capital One (COF) $18.3 billion $249 million 10%
SunTrust  $10.1 billion $137 million 7%
J.P. Morgan (JPM) $9.4 billion $128 million 1%
National City  $8.7 billion $119 million 5%
Citigroup (C) $8.2 billion $112 million 1%
First Horizon (FHN) $7.3 billion $99 million 21%
Wachovia  $6.6 billion $90 million 1%


We do not believe that selling the Alt-A loans at current market prices is the best action the banks could take for their shareholders. Most banks, and all of the major banks, have enough capital to hold the mortgages in their loan portfolios for the short or long run. The only exception from the nine listed above might be Indymac. As long as the underwriting on the Alt-A mortgages is sound, the banks will be able to make money, not lose it, by holding the mortgages. It would simply take time, as the bank can either collect interest income over several years by holding the mortgage, or wait for the market to recover before selling.

Consequently, we believe that banks will write down the Alt-A mortgages they currently have for sale and hold them in their portfolios at fair market value. Because of accounting rules, banks would record the same type of loss as if they sold the mortgages (see prior table). However, this would be only an accounting loss; while it would hit earnings, it does not destroy any economic value. Assuming that underwriting remains sound, banks should recognize enough income in the long run to more than offset this loss.

In other words, banks would earn a long-run profit on the Alt-A mortgages in this scenario. If Mr. Market gets emotional at the appearance of a loss, it could create excellent buying opportunities in an industry that rarely gets cheap.

Repurchasing Bad Loans
What about the loans that banks have already sold? That's right--banks can still be on the hook even after they sell a mortgage.

When a bank sells a mortgage it attaches a temporary money-back guarantee. Basically, a bank guarantees that borrowers will pay on time for the first 90 days after the loan is sold. If they don't, the bank will repurchase the loan. Consequently, the bank would have a nonperforming loan that it would either choose to hold and work out or sell at a discount to the original loan price. Either way, when it repurchases the loan, the bank will have to write it down to fair market value and take a loss.

We are already seeing this occur in the market.  Fulton Financial (FULT) recently announced that it would need to repurchase 8.9% of the $247 million in Alt-A loans it sold into the secondary market. Fulton recorded a $5.5 million loss on the repurchase. Based on this information, the fair market value of these loans is just 75% of their original value.

The good news is that only loans sold in the last 90 days are eligible for this forced repurchase. After the subprime mortgage blowup, banks quickly tightened their credit standards (Fulton actually decided to stop originating the loans). Consequently, this is a very short-term risk. However, we expect that every bank writing Alt-A mortgages will have to repurchase some of their loans and face some small charge.  M&T Bank (MTB) was forced to repurchase an undisclosed amount of Alt-A loans, taking a $6 million charge. If a stickler for credit quality like M&T is facing this issue, we expect that every bank is having similar problems.

As a result of the tighter credit standards, we expect the number of bad loans to be dramatically reduced going forward. Therefore, if we do not hear about losses in the second quarter of 2007, this problem will not likely happen. While these numbers will vary significantly based on the soundness of the underwriting, we used Fulton's experience to extrapolate what could happen to the largest banks. We assumed that only 90 days worth of its loans are still at risk for repurchase.

According to our calculations, this is a minimal risk for many of the diversified banks. The thrifts and banks with large mortgage operations, like Indymac,  Washington Mutual (WM), and  First Horizon (FHN), have greater exposure. We worry about these banks, but believe we used a worst-case scenario to show the maximum loss they could incur.

 Estimated Worst-Case Scenario for Alt-A Mortgage Repurchases

2006 Alt-A Originations

Bad Loans Estimated Loss % of 2006 Earnings
Indymac  $70.2 billion $6.243 billion $1.561 billion 455%
Washington Mutual (WM) $25.3 billion $2.252 billion $563 million 16%
Capital One (COF) $18.3 billion $1.629 billion $407 million 17%
SunTrust  $10.1 billion $898 million $225 million 11%
J.P. Morgan (JPM) $9.4 billion $837 million $209 million 1%
National City  $8.7 billion $778 million $194 million 8%
Citigroup (C) $8.2 billion $732 million $183 million 1%
First Horizon (FHN) $7.3 billion $645 million $161 million 35%
Wachovia  $6.6 billion $588 million $147 million 2%

Concluding Thoughts and Long-Term Effects
We believe that we have assessed the risks that the mortgage exposure has created and also adjusted for them. We continue to recommend 5-star Washington Mutual. We would also recommend 4-star  Capital One (COF),  J.P. Morgan (JPM),  National City ,  Citigroup  (C), and First Horizon if they got a little cheaper.

Readers should note that the risks we have written about are short-term risks. Credit problems in the overall mortgage market create the potential for even bigger longer-term problems. We will explore the potential credit quality problem in part two of this article in coming weeks.

Jaime Peters does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.