Lenders Face Still More Misery

Phantom profits, flimsy reserves—why the losses will keep piling up

by Mara Der Hovanesian

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WaMu CEO Killinger says the bank is working to keep up its reserves Jonathan Ernst/Reuters

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Cristian Northeast

Investors breathed a sigh of relief on Mar. 11 when the Federal Reserve offered to lend troubled banks as much as $200 billion in Treasuries. Still, the Fed's lifeline won't fix the root of the housing market's problems—falling prices and rising defaults. So it is unlikely to save mortgage lenders from the next wave of losses, those buried deep in the minutiae of balance sheets.

A closer look at the books of big lenders reveals several weak spots that haven't yet shown up in the financial results. At many banks, bad loans are piling up faster than the amount of money they're setting aside to cover them. Meanwhile, housing lenders booked income on vulnerable exotic loans and mortgage securities before they collected the money—paper gains that may be reversed through writedowns. Plus the values of some troubled loans, which have been trimmed modestly so far and shown up in previous losses, could still be overstated.

Why haven't these items hit lenders' bottom lines? Largely because of the ambiguity and complexities of the accounting rules. Banks have a lot of wiggle room when it comes to reporting the profits and values of complex loans and securities. For one thing, their earnings can far exceed the amount of cash coming in the door. At the same time, their losses aren't always based on hard numbers but rather on debatable judgment calls. With the housing market showing no signs of recovery anytime soon, it's becoming clear that some of their assumptions have been overly optimistic.

Lenders, most of which report first-quarter profits in April, will probably realize more pain as auditors and analysts scrutinize balance sheets. That could touch off another round of banks scurrying for capital or cash from outside sources to shore up their businesses. "Every day there's a new revelation, an 'Oh, by the way, I forgot to tell you about this other problem,'

" says Donn Vickrey, co-founder of Gradient Analytics, a Scottsdale (Ariz.) research firm specializing in forensic accounting.

Thin Cushions Against Losses

Reserves for bad loans appear to be one of the biggest pressure points. Financial firms upped those stashes of money by more than 130%, to $68.2 billion, last year. But their rainy-day funds are not nearly keeping pace with the subprime storm. At Wachovia (WB) , the amount of loans in default—those where the borrower is behind by 90 days or more—jumped 203% last year, to $5.7 billion. But the bank increased its loan-loss reserves by only 34%, to $4.7 billion, over that period. Gradient Analytics estimates an additional $4.75 billion worth of loans at Washington Mutual (WM) will go bad in 2008. That would more than deplete its $2.75 billion in reserves. "We're working very hard to be sure we have the appropriate level of capital in place," WaMu Chief Executive Kerry K. Killinger said in a conference call in January. Wachovia declined to comment.

There are no firm rules about the size of the cushion banks need to cover troubled loans. But according to the Federal Deposit Insurance Corp., the industry now has 93¢ of reserves for every $1 of bad loans. It's the first time since 1993 that the value of loans past due has exceeded the reserves. Given how fast the housing market is falling, analysts and regulators figure banks need to add significantly to that pile of money. Any increase in those reserves will eat away at earnings."As conditions deteriorate, we are encouraging institutions to increase reserves at a rate that keeps pace with projections for [bad] loans," FDIC Chairwoman Sheila C. Bair said in congressional testimony on Mar. 4. "The attention banks have been giving to boosting reserves needs to continue."

Another emerging problem: phantom profits. During the housing heyday, banks aggressively sold risky adjustable-rate mortgages known as option ARMs. Under the terms of those loans, borrowers pay less than the total interest owed each month. Yet lenders report the full amount of interest as income by adding the shortfall to the borrower's outstanding balance. In essence, banks are counting their chickens before they hatch.

"The Benefit of Hindsight"

Companies don't disclose the full details on such loans. Countrywide Financial (CFC) earned at least $561.7 million on option ARMs in 2007. It was one of the few bright spots for the lender last year, which reported an overall loss of $704 million. WaMu recorded $1.42 billion from such loans during that period.

But those gains at Countrywide and WaMu may soon be wiped out by writedowns. Other types of subprime mortgages already have reset en masse to higher rates, triggering defaults and wreaking havoc on banks' earnings. At Countrywide and WaMu, option ARMs are only now starting to reset.

The resulting situation could be ugly for them judging from the fate of early entrants into the option ARM game, including Downey Financial (DSL) , IndyMac (IMB) , and FirstFed Financial (FED). Frederick Cannon, a bank analyst with Keefe, Bruyette & Woods (KBW) estimates that a third of FirstFed's Option ARMs now resetting will default this year while similar loans at IndyMac are going bad at a faster rate than other mortgages. Downey began to ease the terms for borrowers in option ARMs last summer. But the troubled debt at the lender jumped nonetheless from 1.53% of assets in June to 4.79% by yearend. IndyMac declined to comment. FirstFed and Downey did not return calls for comment.

If WaMu and Countrywide experience the same sort of problems, they will face significant writedowns and reverse years of gains. "The benefit of hindsight shows that income was clearly overstated," says KBW's Cannon. Says a WaMu spokesman: "It's difficult to project delinquencies, but the credit profile of these loans would not have historically been defined as high-risk." Countrywide said its financials conform to accounting standards.