Nat City Still Under Subprime Siege

The regional bank looks good for shuttling its subprime unit to Merrill in 2006. But it still holds some potentially bad loans.
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National City

(NCC)

may have sold subprime lender First Franklin in the nick of time, but the troubled bank is far from safe from leftover exposure to shaky loans.

Late Wednesday,

Merrill Lynch

(MER)

-- which paid $1.3 billion to buy First Franklin from Nat City in late 2006, before the mortgage and credit meltdowns -- said it

was shuttering

San Jose, Calif.-based Franklin. Merrill said it would cease originating loans through the lender and look to sell its servicing arm, Home Loan Services.

At the time of the deal, critics charged that the New York investment house was paying too much, too late for the subprime platform in a market where the faintest of cracks were starting to show. Just mere months later, in early 2007, the subprime mortgage meltdown began to fuel a housing crisis so large that some call it the worst since the Great Depression.

On the other hand, analysts and observers say the Cleveland, Ohio-based bank got lucky with the sale.

"Not only did the gain of the sale trigger

more than $1 billion that improved the company's capital position, but it also contributed to the losses being well below what it would have been had they held onto that company," says Terry McEvoy, an analyst at Oppenheimer. "The implications for owning a monoline mortgage company over the last 14 months would have triggered higher net charge-offs, a writedown of goodwill and possibly put the company in a more difficult capital position. So in hindsight their timing was spectacular."

But the bank's good fortune only went so far. While Nat City no longer owns First Franklin anymore, it is still shouldering risky loans made through the firm.

Nat City was left with approximately $7.5 billion in nonprime loans from First Franklin after the sale in December 2006. Of the company's $30 billion portfolio of residential real estate loans at the end of 2007, it still held just over $6 billion in nonprime mortgage loans -- all originated by First Franklin, according to its annual filing with the

Securities and Exchange Commission

.

McEvoy said that Nat City was "a little aggressive" at the time of the sale with its expectations for how much "runoff" it could expect from the portfolio each month. Runoff is the process in which a lender continues to hold on to existing loans until they come due or are sold, but does not originate any new ones. Originally, they had expected to run off in the range of $300 million to $400 million a month, according to McEvoy.

The company recently said it expects the "average runoff" of the portfolio to be approximately $150 million to $200 million a month this year.

McEvoy attributes the disappointing results with the inability of the subprime borrowers to refinance with another lender; hence the loans remain on Nat City's books. "The loss content will be noticeable at least through 2008," he says.

A Nat City spokeswoman could not be reached for comment. But in its fourth-quarter and full-year earnings results, in which it posted a $333 million loss, the bank acknowledged that the leftover First Franklin loans made up one of several portfolios it was concerned about. Brokered home equity loans and residential construction were the two other portfolios of loans proving to be worrisome as well.

Of the $6 billion subprime portfolio, Nat City has $4.5 billion worth of first mortgages and $1.5 billion worth of second lien mortgages, said Rob Rowe, Nat City's chief credit officer, during an earnings conference call in January. "The second liens have and will continue to drive the bulk of the losses," Rowe said.

"We believe that many of these second liens are behind first liens, which have or will rate reset by April 2008," Rowe added. "So we anticipate the pressure applied to this portfolio from first mortgage rate resets will abate later in 2008."

Nat City took a $691 million provision for loan losses in the fourth quarter, up 88% from the third quarter and more than double the provision in the fourth quarter of 2006. The company said the provision mostly reflected higher credit losses on two liquidating portfolios: the First Franklin loans and its $11 billion of broker-originated home equity loans.

Nat City is forecasting net loans charged-off to be in the range of $1 billion to $1.3 billion this year.

"The full impact of the softening economy, future levels of capital market liquidity and declining housing prices, especially on the National Home Equity and First Franklin portfolios, drives a higher than normal level of variability in our loss estimate," Rowe said.

Nat City wasn't the only bank that was able to shoulder its subprime exposure in the nick of time. The same month, crosstown rival

KeyCorp

(KEY) - Get Report

sold a $2.5 billion subprime portfolio held by a subsidiary, Champion Mortgage, to

HSBC

(HBC)

. HSBC was one of the first large financial services companies to spark the subprime meltdown slightly more than a year ago when it disclosed bearish news regarding the state of its U.S. consumer business.

Still, others weren't so lucky. Tax preparation giant

H&R Block

(HRB) - Get Report

, is in the process of winding down its subprime exposure through now-shuttered subprime lending unit Option One, which it spent more than a year unsuccessfully trying to unload beginning in November 2006.

Lauren Smith, an analyst at Keefe, Bruyette & Woods who covers Merrill Lynch, echoed the general sentiment among analysts on Thursday by saying in a note that the decision to shut down First Franklin was a "good move as subprime

mortgage-backed securities origination has come to a virtual halt."

"We also believe that this action highlights the benefit of the recent management change at Merrill. In our view, the previous administration would have been unlikely to close down this business so soon after paying $1.3 billion for it," Smith writes. Merrill said in January it had a total of $2.7 billion worth of subprime exposure at the end of 2007.

Merrill would not disclose how many loans were originated last year through First Franklin. Nor would it disclose any further details about the expected sale of Home Loan Services, according to a spokesman.