TSC Ratings: Bad Mortgages on the Rise

Editor's Note: TheStreet.com earlier this month announced the purchase of certain assets of Weiss Group to form "TheStreet.com Ratings." Here is the first article from Melissa Gannon, director of insurance and bank ratings. Let us know what you think of the article by clicking here.

First comes boom, then comes bust, then comes bankers' headaches. Yes, the downturn in the housing market is translating into a rise in the number of nonperforming mortgages in the nation's banks and thrifts.

Following steady increases throughout 2005, nonperforming residential mortgage loans leveled off a bit in the first quarter, at $21 billion, but are still up a whopping 50% over the same period in 2005.

With the exception of New England and the Middle Atlantic states, banks in all regions of the country experienced double-digit increases in nonperforming residential mortgages.

The Pacific region and the West South Central region, which includes those states affected by Hurricane Katrina, experienced the largest increases.

Publicly traded banks with the largest year-over-year increase in nonperforming mortgages naturally include some of the largest banks in the country. Problems at Wells Fargo Bank (WFC Quote) started sooner than at other institutions, with trouble beginning to appear back in 2003.

The problems leveled off in early 2006. Most of the rest of the industry's players experienced the beginning of their downturns last year, including JPMorgan Chase and Citigroup (C Quote).

Is the industry in trouble? Not by a long shot. Total nonperforming loans have continued to decline from their peak in 2002 of $69 billion, and stood at $49 billion at the end of the first quarter of 2006.

At the same time, the industry's profits have grown every year since 2001; in the first quarter, the industry earned $37 billion, an 8.7% increase over the $34 billion profit reported in the first quarter of 2005.

The unknowns, of course, are the movement of interest rates and the extent of the downturn in the housing market. If interest rates resume their rise and home sales continue their decline, then we can expect to see an increase in troubled mortgages.

Which banks are most likely to be affected by a further deterioration in the housing market? Those whose loan portfolios are largely made up of mortgages. Banks and thrifts with large mortgage holdings that overwhelm their equity capital and loan-loss reserves include:

High Exposure
Bank	Mortgages ($Bil)	Mortgages as % of Total Loans	Mortgages as % of Capital and Loan-Loss Reserves	Holding Company
World Savings Bank(Oakland, CA)	$112.5	93.5%	1,210.4%	Golden West Financial (GDW)
Citicorp Trust Bank (Wilmington, DE)	33.6	89.9	1,153.2	Citigroup (C)
Downey S&LA (Newport Beach, CA)	16.0	97.2	1,101.5	Downey Financial (DSL)
Countrywide Bank (Alexandria, VA)	59.5	83.5	1,056.4	Countrywide Financial Corp (CFC)
Flagstar Bank (Troy, MI)	10.3	84.0	1,037.2	Flagstar Bancorp (FBC)
Source: TSC Ratings

All of these publicly traded institutions are financially sound, but continued growth in nonperforming loans, in conjunction with tightening margins as interest rates rise, will put a strain on earnings going forward.

Banks With Largest Rise in Nonperforming Mortgages
		Nonperforming Residential Mortgages ($Mil)		Nonperforming Mortgages ($Mil)
Name	Holding Company	3rd Qtr 2006	3rd Qtr 2005	3rd Qtr 2006	3rd Qtr 2005	$ Change	% Change
Washington Mutual Bank	Washington Mutual (WM)	2,753	1,456	2,813	1,602	1,211	75.6
JPMorgan Chase	J.P. Morgan Chase (JPM)	1,668	663	1,899	978	921	94.2
Wells Fargo	Wells Fargo & Co. (WFC)	3,117	2,202	3,317	2,486	831	33.4
Citibank	Citigroup (C)	844	243	860	244	616	252.4
US Bank	U.S. Bancorp (USB)	773	154	920	339	581	171.2
Source: TSC Ratings

While bankers at some financial institutions may begin to reach for the aspirin, an increase in the number of troubled loans is only one of the many factors used to evaluate financial safety.

Steady earnings and strong capitalization mitigate the impact of subpar loan portfolios, so financially secure institutions have time to increase reserves and tighten lending practices that may have become too lenient during the boom.

Meanwhile, banks considered financially weak are far more likely to experience a migraine as they face the prospect of further loan defaults.