Banks: Gauging the Subprime Spillover

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From Standard & Poor's RatingsDirect

While we believed that credit losses would revert to more normal levels, which would result in lower earnings, profitability pressure on mortgage lenders also has resulted from increasing funding costs, due to the seizing up of the ABCP markets. Our recent rating actions on financial institutions reflect a tipping point, with liquidity concerns outweighing credit quality concerns. This development was at the heart of our negative rating actions on Countrywide Financial (CFC) and Thornburg Mortgage (TMA).

Needed: Strong Funding and Liquidity

In our view, the rapid curtailment of mortgage liquidity is the key risk for financial institutions in the near term. For example, this lack of liquidity is forcing many companies to dramatically downsize their mortgage operations. Most recently, Capital One Financial (COF) announced the closing of its Alt-A mortgage unit, GreenPoint Mortgage Funding, and Lehman Brothers Holdings (LEH) announced it was closing its subprime mortgage unit, BNC Mortgage.

In our opinion, the two factors that will sustain financial institutions through this crisis are strong funding and liquidity—both predominantly featured in our long-term ratings criteria. The majority of our rated institutions have either been affirmed or downgraded modestly. An orderly unfolding of the credit cycle is already reflected in the ratings and, generally, our assumptions account for losses in one financial quarter.

The market consensus is that the broader economy remains quite sound and the corporate credit sector is showing stable performance. Inevitably, some are benefiting from the market turmoil. Hedge funds that shorted the mortgage markets have outperformed their peers. And, while subprime mortgage volume is much lower for most lenders, business at some of the largest mortgage originators has increased as they fill market need created by those exiting the business.

Watching the Key Indicators

The overhang of subprime stress in the mortgage markets and its impact on the broader credit markets was addressed by President Bush in a speech given in the last week of August. The White House argued that pending modernization of the Federal Housing Administration, legislation should be passed and that the tax code should be altered so those who are refinancing their homes will not be penalized.

Should key economic indicators such as unemployment rates, gross-domestic-product growth, or interest rates take a negative turn, however, financial institutions' problems likely would be compounded. In fact, if the market dislocation continues for an extended period at the pace we have observed to date, or if the economy starts to head toward a hard landing, further rating changes on financial institutions are likely. Companies vulnerable to a downgrade in the current environment include the following institutions, each of which is on CreditWatch Negative: Thornburg Mortgage, Residential Capital, H&R Block (HRB), and Countrywide Financial.

On the other hand, the large majority of our rated financial institutions hold stable ratings outlooks. We expect even those with significant mortgage exposure, as long as they are sufficiently diversified, to manage through the current turmoil. This list includes, among others, HSBC (HBC), Wells Fargo (WFC), and Wachovia (WB). A third group comprises organizations entering the third quarter with strong capital positions, diversified funding sources, and a track record of credit discipline. Our recent upgrades of Morgan Stanley (MS) and Deutsche Bank (DB) put these organizations, among others, firmly in that category.

Wagner and Quintanilla are credit analysts for Standard & Poor's Ratings Services.
S&P Ratings senior writer Mike Brewster contributed to this report.