Housing casts shadow on prospects for banks
>>>While researching NEW (through Schwab) I saw this MarketWatch story linked to NEW. It is dated today, and while it sounds familiar, I don't think it was posted before. See especially my highlites about the notion that banks have spread risk by selling the mortgages they originate, but have bought it back through general real estate or mortgage backed backed securities. A lot of this article is regurgitation, but it is well worth the read - twice.
"The housing market is going to go down, and it's going to go down hard,"
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7:00 AM EDT September 2, 2006
NEW YORK (MarketWatch) -- With the $10 trillion housing market weakening fast, in defiance of the assurances of most pundits just a year ago, investors are starting to question the confidence among banks about their ability to weather a housing downturn.
Just a few months ago, homebuilders, the National Association of Realtors and most Wall Street analysts were still predicting a soft-landing in housing, in the same reassuring way they used to say last year that housing would remain strong in 2006.
But after the freshest figures - which showed sales of new homes sales plunged 21.6% in July from the year earlier, inventories of unsold homes soared and prices fell - there is little debate that the housing market is stumbling much faster than most expected.
Similarly, conventional wisdom, at least as officially voiced by banks and Wall Street analysts, has so far held that banks' earnings would be only modestly impacted as the mortgage business continued to soften.
But "this is the most inflated housing market in the post-war era," said Paul Kasriel, chief economist at Northern Trust. "If we're to have a severe recession in the housing market, it would seem to me that the banking system cannot escape significant losses."
As signs of trouble have started to emerge among mortgage lenders, the market has started to reflect some of these concerns. The Philadelphia KBW Mortgage Finance Index has now dropped 10% from its May highs and is down slightly for the year so far.
But, so far, banks have only seen modest drops over the past few weeks. The Philadelphia Bank Index has lost less than 2% from its early August highs but is still up 7% on the year.
The potential for bad loans, which force banks to take a loss on their books, has been barely mentioned as credit quality has remained solid through the first half of 2006, according to most banks.
Growing exposure
Banks and analysts can point to history to justify their confidence. After all, in the late 1980s-early 1990s, most banks were diversified enough to weather a recession-induced housing downturn.
The slump put out of business a number of small regional banks throughout the country and some larger banks also took big hits. But thanks to "considerable skill in containing credit losses," most of the big and medium-sized banks fared well, according to a study by the Federal Deposit Insurance Corporation.
Yet, in the latest housing boom, banks have entered uncharted grounds with the new and exotic types of mortgages they extended to buyers who would not have been able to buy a home under traditional standards.
In addition, the level of the banks' exposure to real estate is unprecedented, representing close to 60% of their earnings either directly or indirectly, according to Northern Trust.
Similarly unprecedented is the size and importance of real estate relative to the entire U.S. economy. The dollar volume of single-family home sales, excluding condos, represented 16.3% of the gross domestic product in 2005.
Finally, the large extent to which cash-strapped homeowners have relied on debt and risky exotic options to finance both their mortgages and their consumption, is also "off the scale," said Kasriel.
Losses related to waning demand for mortgages have already emerged at Countrywide Financial Corp. , Fifth Third Bancorp , National City Corp. , Golden West Financial Corp. , which is being acquired by Wachovia Corp. , and most recently at First Horizon National Corp. .
But some analysts predict that both the housing downturn and losses for the banks could get much worse.
On the credit side, problems might start surfacing as homeowners at the lower-end of the income spectrum start defaulting on their mortgage payments, which would force lenders to take charges for unanticipated losses or to boost their reserves for expected loan losses.
Those facing the most immediate risk are mortgage lenders that have specialized in, and have kept on their books, exotic-type mortgages in so-called subprime markets, where homebuyers fail to meet the strictest lending standards.
At the end of the first quarter, the top 10 issuers of subprime mortgages in the U.S. in terms of volume were, respectively, Wells Fargo & Co. , HSBC Holdings unit Household, New Century Financial Corp. , Ameriquest, Countrywide Financial, Freemont General, H&R Blocks's Option One, General Motors' GMAC, Citigroup unit CitiMortgage and Washington Mutual , according to the industry newsletter Inside Mortgage Finance.
Defaults rising
Fresh anecdotal evidence of defaults came last week not from a bank but from H&R Block, whose shares fell 9% after it annoucned an unexpected $102.1 million charge related to its Option One mortgage business.
Option One, which specializes in mortgage loans to borrowers with credit scores at the lower end of the spectrum, said the losses aimed to cover loans it could be required to buy back should a borrower default on the first payment.
Banks have yet to report similar losses. But "there is the word out there that defaults are rising very sharply even on first payments," said Bret Witter, vice president at investment advisor Witter & Westlake.
In California, one of the hot markets where home prices had soared in recent years, defaults surged 67% in July from the year earlier.
Mortgage-lender National City said recently that, while it has refrained from entering the more risky areas of mortgage-lending, it has seen a marked increase in first-payment defaults on loans, while average balances in checking accounts are dropping and there are more and more overdrafts.
"The consumer is getting stretched big time now," said David Daberko, National City's chief executive, at a Keefe Bruyette Woods banking conference two weeks ago.
Higher interest rates, record-high gasoline and energy prices, and now the prospect of declining wealth once provided by home equity, is pinching overly indebted consumers.
Compounding risks, mortgage lenders have responded to declining demand for more secure prime mortgages by making headways into the more profitable, and more risky, subprime markets.
To do so, they have relied on the same type of no-money-down, adjustable-rate and interest-only-type mortgages that have helped fuel the housing boom over the past five years.
Banks and many analysts said the banks are largely hedged from defaults because on average, they keep only about 20% of the mortgage-loans they originate and sell the remaining 80% on the market as mortgage-backed securities (MBSs).
In the case of subprime mortgages, the numbers vary. Both Washington Mutual and Countrywide, the largest issuer of mortgages in the nation, roughly sold 92% of their subprime loans to the market through the second half, keeping only 8% on their books.
New Century, by comparison, specializes more in subprime and keeps 22% on its book.
"They say they've cherry-picked the best loans to keep on their books and sold the rest to the market," said Ryan Batchelor, a banking analyst at Morningstar. "They hope they've shifted most of the risk to the securitization market."
Resetting rates
But for the loans still on the books, the risks are compounded by the new and exotic types of mortgages that have mushroomed in recent years.
For a bank, the key protection in case of default comes from the value of the home itself, which might now be losing value at a fast pace in parts of the country, especially along the coasts, where speculation ran high over the past few years, said Witter.
His firm, which has researched banks' exposure to the housing downturn, sees widespread systemic risks in the banking system, not only from the way exotic mortgages are piling credit risks on homeowners, but also the way banks have accounted for them.
Adjustable-rate and interest-only options on mortgages have allowed homebuyers and homeowners to, at first, pay much less on monthly payments while increasing the overall size of the loan over its lifetime, a so-called negative amortization.
As rates reset, typically after four years, some homeowners might be faced with monthly payments that can, in some cases, double.
In addition, should home prices decline as they seem poised to do, many might end up owing more than the value of their homes, leaving the bank or mortgage lender sitting on a potential real loss in case of foreclosure.
Witter notes that banks have been booking this negative amortization as earnings, adding that it doesn't make financial sense. Washington Mutual, for instance, booked $203 million as capitalized interest recognized as earnings from negative amortization in its option ARM portfolio in the first quarter.
"What they're doing is increasing risk significantly and accounting for it as earnings for now," Witter said. "But we don't know whether they'll ever get that back three or four years from now."
WaMu, for its part, defended the practice by saying it followed generally accepting accounting principles, which require the bank to consider losses inherent in its portfolio. Its option ARM portfolio, it said, has a high credit rating, and is constantly monitored by the bank.
"Our practice of not offering Option ARM loans through our subprime channel and of selectively selling Option ARM loans to the secondary market have further limited the potential for credit risk in our Option ARM portfolio," said WaMu spokesman Alan Gullick.
But as shown by the loss of business at luxury homebuilder Toll Brothers , it's not only home owners in the lowest income brackets that may have trouble, Kasriel said.
According to the Mortgage Banking Association, adjustable-rate mortgages, or ARMs, averaged roughly 30% of all first mortgage originations in 2005. The association estimates that $330 billion worth of ARMs will adjust in 2006 and $1 trillion worth will reset by the end of 2007.
Industry analysts worry that many homeowners might experience "payment shock" as rates reset, especially if home prices fall.
Hedging risk
Witter believes that even if banks have passed on most of the risk to credit markets, they're not necessarily hedged because many banks turn around and buy MBSs. Banks and financial institutions, he said, have a 43% exposure to U.S. mortgages, whether directly by holding the loans or by owning MBSs.
These securities haven't yet seen any credit downgrades resulting from the latest slump in housing. But the major agencies such as Standard & Poors and Moody's said they are keeping a close eye on them.
They have also steadily increased the requirements for mortgages to keep investment-grade ratings over the past few years. Yet, "we do not have a lot of empirical data as in the past for such things as [interest-only loans] in the subprime market," said Navneet Agarwal, an analyst in the mortgage-backed group at Moody's.
Even if all the risky loans are now in the market, or sliced and diced in MBS portfolios, "someone has to get hurt at some point," said Northern Trust's Kasriel.
Banks and Wall Street firms often take the opposite sides of bets to serve the needs of their clients, be they hedge funds, pension funds or other large investors that are the biggest buyers of MBSs and of the derivative products they buy to hedge associated risk.
"Everybody claims that they're hedged," said Kasriel. "But who's taking on the risk? Banks may have lent money to those that insure hedge funds or mortgages. Once one of them goes broke, you realize you weren't hedged after all."
Many banking analysts, including Punk Ziegel & Co's Richard Bove, said that it would likely take a widespread economic recession, which would impact employment, for defaults to surge in a way to create huge losses for banks and to shock the financial system as a whole.
But Bove sees problems for the banks coming from another angle. "The housing market is going to go down, and it's going to go down hard," he said. "Will the banks see billions of dollars of losses from housing? No. "Will it be a huge drag on the economy and hurt everybody including banks? The answer is yes." |
