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

This time, we focus on the long-term effects--and one 5-star pick.

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In part one of our article, we discussed the short-term problems some of the larger banks would face from the subprime mortgage blowup, and how it affected the secondary mortgage market. As we have seen in the past week of earnings announcements, several banks, including  SunTrust (STI) and  Capital One (COF), had to write down the values of the mortgages they are preparing to sell, and  Wachovia (WB)  and  M&T Bank (MTB) chose to hold more mortgages on their balance sheets.

Now let's turn our attention to the long-term effects. With the jump in delinquencies and foreclosures in the mortgage market that helped contribute to the subprime and Alt-A mortgage business woes, we have to ask--did the credit standards become too lax?

Over the past decade, homeownership soared to record highs: 68.9% in the fourth quarter 2006 compared with 65.4% 10 years earlier. Most of that gain came from higher-risk borrowers. With that in mind, what has happened to mortgage credit quality? Once again, before we get to the impacts on the various banks, we need some background information.

What Happens to Bad Loans
Over the past 10 years, housing has been a terrific investment. According to the U.S. Census Bureau, the median price for a new home increased 5.8% annually from 1996 to 2006, from $140,000 to $246,100. This has been good news for banks. Even when banks write higher-risk loans, loaning all or nearly all of the purchase price, appreciation in the home's value reduced the chance of realized losses to near zero. A bank can either refinance the mortgage with the current owner, allowing the current owner to cash out equity to get through a rough financial patch, or the bank can foreclose and quickly sell the home, earning enough to make the bank whole for the value of the loan, not to mention the extra legal and selling expenses of foreclosure.

However, when housing prices are stable or falling, life is not so rosy for the troubled loan. The homeowner won't be able to refinance because there is no additional equity to tap in times of trouble. A bank can either get paid back when the homeowner sells the home prior to foreclosure or when the bank forecloses and sells the home on its own. However, the likelihood the bank will be made whole is much slimmer. The lengthy process of foreclosure and the lack of appreciation in the house's value will most likely cause the bank to take a modest loss. Nevertheless, unless there is out-and-out fraud, the bank is likely to recover most of the loan value.

ARMs vs. Fixed-Rate Loans
Even in the best of times, some people cannot make their mortgage payments. However, events are starting to align which we believe will drastically increase the number of people who cannot afford to pay their mortgages.

As housing prices soared, homeowners looked for new ways to be able to afford a house. Lenders were happy to accommodate, promoting different products that would reduce payments in the short term. Their primary method? Adjustable rate mortgages.

Adjustable rate mortgages (ARMs) are just like they sound. The interest rate can adjust throughout the life of the mortgage. Most come with a two- to five-year period of fixed rates at the beginning of the mortgage; often these rates are low "teaser" rates. The theory was that customers would be able to improve their financial situation with lower mortgage payments. By the time the lower-rate period was over, they could refinance to a fixed-rate loan. As a result, banks wrote these loans based on the borrower's ability to meet the initial payments, not his ability to make payments when the interest rate adjusts higher.

This is the first year that many of these ARMs written in the midst of historically low interest rates are due to reset. Moody's estimates $2 trillion of mortgages will reset this year. The cost of a mortgage can increase quickly. Imagine a homeowner with a $180,000 ARM who sees his interest rate go from the "teaser" rate of 3.5% to 7.5%. His payment would go from $808 to $1,258 per month, an extra $5,400 per year. The rapid increase in payment is often difficult on a family living paycheck to paycheck. This is going to happen all across the country.

More Bad News
Some banks went so far as to allow borrowers to pay whatever they wanted on their mortgages, even if it wasn't enough to cover the monthly interest due. These so-called Option ARMs gave customers flexibility. However, if they didn't pay enough to cover the interest due, they could end up with a higher, not lower, mortgage loan balance. In banking terms, adding the unpaid interest to the principal value is known as negative amortization. If a borrower is not careful, she can end up owing the bank more than what her house is worth. This puts the bank in a bad position; if the borrower defaults, the collateral isn't worth enough to cover the principal, let alone the foreclosure expenses.

Worse yet, these loans were particularly popular in areas where housing is not very affordable because of rapid price increases, such as California and Florida. In Los Angeles County, only 2% of homes were priced at an "affordable" level for the median-income family, creating a need for exotic mortgages. These are the same places that have been hit the hardest by the mortgage slowdown. Certain areas, like Napa Valley in California, have even had home prices decline. If these loans go bad, the banks are likely to lose more per loan than previous experience would suggest.

Impact on the Banks
Adding together the bad news--higher likelihood of default, plus higher probability of loss, plus higher severity of loss--equals problems for the banks' bottom lines.

Although banks tend to hold only the highest-quality loans in their portfolios and sell the rest into the secondary market, even higher-quality mortgages are starting to create problems. According to the Mortgage Bankers Association, the delinquency rate for prime loans was 2.57% in the fourth quarter of 2006, up from 2.44% just three months prior.

In order to protect themselves from rising interest rates, many banks hold ARMs instead of fixed-rate mortgages. These mortgages are having more credit problems, with a delinquency rate for prime ARMs of 3.39%. Since 2007 will be the first year that many mortgage interest rates adjust, we expect loan losses in many of the banks' portfolios to continue increasing as homeowners face rapidly rising mortgage payments.

At Morningstar, we tried to estimate just how bad could it get. In our worst-case scenario, we think 4% of the mortgages held by banks could default, translating into a 2% charge-off as the banks recover 50% of the value of the loan from the collateral. It's important to note that if mortgage woes extend to a souring job market and general market decline, this worst-case scenario may even need to be revised downward. Right now, charge-offs on the portfolios range from 0% to 0.54% of mortgage loans at the nine banks listed below. We believe the most likely scenario is that losses will go to 0.50% to 0.75%. This is still much higher than the past five years. Also, unlike our last discussion, this problem is not a short-term issue. Higher loan losses could haunt these banks for the next several years.

  Earnings Exposure to Potential Loan Losses
Company Mortgages Held
as of 12-31-06
% Change to 2006 Earnings 0.65%

% Change to 2006 Earnings

IndyMac (NDE) $6.519 billion $130 million 23% $42 million 7%
Washington Mutual (WM) $118.204 billion $2.364 billion 40% $768 million 11%
Capital One (COF) $12.587 billion $252 million 7% $82 million 2%
SunTrust (STI) $33.830 billion $677 million 20% $220 million 6%
J. P. Morgan (JPM) $59.668 billion $1.193 billion 5% $388 million 1%
National City (NCC) $24.775 billion $496 million 10% $161 million 0%
Citigroup (C) $160.800 billion $3.216 billion 10% $1.045 billion 3%
First Horizon (FHN) $7.973 billion $159 million 20% $52 million 5%
Wachovia (WB) $225.826 billion $4.517 billion 37% $1.468 billion 11%
* This table is an exercise showing our worst-case scenario estimates.

According to the chart above,  Washington Mutual (WM) and Wachovia have significant exposure. We will discuss Washington Mutual below, but Wachovia's numbers are skewed. Wachovia purchased conservative underwriter Golden West in 2006, which added significantly to its mortgage portfolio, but not yet to its bottom line. As a result, the effects of the increased charge-offs are exaggerated in the table.

At Morningstar, we realized some time ago that credit quality would deteriorate. Charge-offs are probably going to increase for the next several years. We have already built these higher charge-offs into our forecasts. We believe we have assessed the risks and adjusted for them. We would gladly recommend 3-star Capital One and 4-star  JPMorgan (JPM),  National City (NCC), and  Citigroup (C) if they got a little cheaper.

Let's Talk WaMu
Generalizations, such as those we made above, are often useful when talking about an entire industry. However, these generalizations can give a false impression of risk. While we said that banks "tend to hold only the highest-quality loans in their portfolios," that is not the case with Washington Mutual. The nation's largest thrift decided to hold riskier Option ARMs and subprime mortgages in its loan portfolio. The following table breaks out the particulars of Washington Mutual's portfolio.

 Washington Mutual's Loan Portfolio as of 12-31-06
Option ARMs repricing in 2007 $63.557 billion
Other ARMs repricing in 2007 $6.791 billion
ARMs repricing after 2007 $26.232 billion
Fixed-rate mortgages $2.899 billion
Subprime mortgages $18.725 billion
Total mortgages in portfolio $118.204 billion

Unlike the industrywide 15% estimate for mortgages repricing in 2007, almost 54% of Washington Mutual's borrowers will see their interest rates increase. In addition, these loans are the riskier Option ARMs, where borrowers have the choice to pay less than a full payment each month, letting the excess interest add to their principal instead. According to Washington Mutual's 10-K filing, the company's portfolio of Option ARMs has a principal balance $888 million ABOVE the original loan principal. In other words, almost $1 billion of the company's loan portfolio is capitalized interest from borrowers who did not pay enough to meet the interest payments on their mortgages.

In 2006, Washington Mutual charged off $181 million of mortgages, both prime and subprime, or 0.15% of its mortgage loan portfolio. Problems are starting to catch up with the company, and we think things are going to be a lot worse this year. According to a report by DataQuick Information Systems, notices of default by mortgage lenders in California were up 148% in the first quarter of 2007 compared with the year prior. This is bad news for Washington Mutual, as approximately 49% of its Option ARM portfolio is in California housing.

However, Washington Mutual protects itself from severe credit losses. Despite all the risks stated above, most borrowers have a healthy downpayment. We decided to run an exercise to see what would happen if housing prices dropped 10% nationally and Washington Mutual was forced to foreclose on 2.5% of its Alt-A loans and 3.5% of its subprime mortgages (for reference, the highest non-depression era fixed-rate mortgage loan foreclosure rate we found was 1.02%). With all of these dire assumptions, we find Washington Mutual's exposure to be only 0.50% of its subprime and Option ARM portfolio. The additional $421 million in losses would have reduced Washington Mutual's 2006 earnings by only 8%.

After accounting for the increased charge-offs in the mortgage portfolio and assessing the protection the company has built into its balance sheet, we do not hesitate to recommend 5-star Washington Mutual.

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