Credit Losses Smack Sovereign

FBR downgrades the bank after it warns of a third-quarter profit hit.
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Sovereign Bancorp

(SOV)

slipped 3% after an analyst downgraded the bank following its warning of a third-quarter profit hit from the tough credit environment.

Friedman Billings Ramsey analyst James Abbott cut his rating on Sovereign to underperform from outperform -- which was the equivalent of a buy rating -- because of concerns about its consumer loan exposure and capital levels.

Sovereign's "thin capital levels worry us considerably more than other lenders do with consumer exposure," Abbott wrote in a note on Monday. "Sovereign is very thinly capitalized ... leaving very little room for error. We believe the current economic environment suggests that 'error' is more likely than not, and Sovereign and others are likely to experience prolonged charge-offs."

On Friday afternoon, Philadelphia-based Sovereign joined the throng of banks warning that volatility in the mortgage and credit markets this summer, as well as deterioration in the consumer credit environment, would cut third-quarter profits.

The bank said its third-quarter provision for credit losses will more than triple to $155 million to $165 million from $51 million in the second quarter.

Approximately $50 million of the provision increase is related to losses in its correspondent home-equity loan portfolio.

Sovereign began exiting the correspondent home equity business last year. While it has sold a majority of the loans in the portfolio, it still had approximately $491 million worth of loans, most of which were to nonprime borrowers, as of June 30.

Sovereign said the remaining rise in the provision is due to credit losses in its indirect auto lending portfolio and to losses related to construction lending and commercial real estate loans.

Sovereign also is taking a $35 million charge related to losses on financings that it provided to a number of mortgage companies that have declared bankruptcy or defaulted on certain agreements, as well as mark-to-market adjustments on some loans held for sale.

Abbott expects higher provisioning for credit losses "to be a recurring theme," he writes. He raised his provision estimate for next year by $196 million to $350 million.

Joseph Fenech, an analyst at Sandler O'Neill & Partners, also predicts that Sovereign will see greater credit losses.

"The magnitude of the provision increase was certainly well beyond our expectation," wrote Fenech in a note Monday.

Yet, "the fact that the company did not comment at all on other aspects of the quarter or the credit outlook is concerning to us, perhaps suggesting more is to come," he added.

Shares of Sovereign recently were down 43 cents to $17.30.

Last week,

Citigroup

(C) - Get Report

and

Merrill Lynch

(MER)

warned that third-quarter results would be hit by huge writedowns on mortgage-related securities and leveraged loans, as well as higher credit costs.

Washington Mutual

(WM) - Get Report

said its profits in the third quarter would be down 75% from a year ago. WaMu's results were hurt by a $975 million provision to its loan loss reserves, as well as $410 million in writedowns.