Regulators Cracking Down on Subprime Lenders

Several banks could be hit, investors and analysts say.
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In a move that could hit banks that do a lot of higher-risk consumer lending, federal banking regulators Monday threatened to impose tough new rules on securitization, the practice of packaging loans into securities that are then sold.

Banking institutions that could be hurt by stricter securtization guidelines include

Bank One

(ONE) - Get Report

,

First Union

(FTU)

,

Provident Financial

(PFGI)

and

GreenPoint Financial

(GPT)

, according to one investor and an analyst. Provident Financial said the regulators' report won't hurt the bank, while the other three institutions didn't make anyone available for comment.

The

Federal Deposit Insurance Corporation

, the

Federal Reserve

, the

Office of the Comptroller of the Currency

and the

Office of Thrift Supervision

said in a statement Tuesday that they wanted to remind bank executives "of fundamental risk-management practices that should be in place at institutions that engage in securitization activities." Bank One's stock was down 2% Monday, Provident's fell 1%, First Union slipped 0.5% and GreenPoint jumped 3.4%.

A tougher stance was expected after the regulators recently came under fire in the recent failures of Woodland Hills, Calif.-based

Pacific Thrift & Loan

and West Virginia-based

First National Bank of Keystone

, which were both active securtizers of subprime mortgage loans.

Balancing Act

The regulators' chief concerns are the parts of securitization issues that remain on banks' balance sheets. These are called retained interests and continue to expose banks to the loans included in the securitization. These retained interests are important for investors, since their value can affect key capital ratios and earnings.

But the regulators now say they may reduce the amount of some retained interests that can be used when determining capital ratios, or the level of funds held as a reserve for the bank's operation. They also indicated that certain types of retained interests may be removed from capital calculations altogether. "We haven't hammered out if there will be

capital limitations on all retained interests or just subprime ones," says a spokesman for the FDIC who declined to say when the regulators may decide to actually issue new rules.

If less retained interests can be included in capital calculations, then some banks may have to reduce share buybacks to shore up capital ratios, says Charles Peabody, banks analyst with New York-based

Mitchell Securities

, which doesn't underwrite. Peabody has a sell rating on Bank One.

Peabody says that Bank One's retained interests, totaling some $15 billion, are equivalent to around 75% of the bank's capital. He says that Bank One provides much less information than other banks on how it values its retained interests.

Details, Details

The regulators' report also says they are mulling whether to make banks give more details on how they value their retained interests. "Reported values for retained interests should be reasonable, conservative and supported by objective and verifiable documentation," their statement says.

If regulatory examiners find that a bank has not been conservative enough in valuation estimates, it may have to write down the value of its retained interests, which would hurt earnings by reducing revenue.

A bank stock hedge fund manager who requested anonymity thinks that Provident Financial, GreenPoint and First Union may be writedown candidates, due to their exposure to subprime mortgage loans and possibly overoptimistic valuation of retained interests. (The hedge fund manager is short Provident and First Union and has no position in Green Point.)

Provident's finance chief, Chris Carey, says his institution won't have to write down any of its retained interests if the regulators implement new rules. "There's nothing new in the release today and we are fully compliant with it," says Carey. "Our accounting conventions are very conservative," he adds.

The hedge fund manager says First Union, which acquired its subprime exposure through its 1998 acquisition of the

Money Store

, did a transaction in the third quarter that obscures the value of its retained interests. In a third-quarter filing with the

Securities and Exchange Commission

, the bank said that it transferred nearly all its investment in mortgage retained interests, worth $774 million, to a trust along with over $8.7 billion of mortgage-related securities. The hedge fund manager says that First Union doesn't have to show the value of the retained interests once they are transferred to the trust, which issued a security back to the bank.

GreenPoint isn't vulnerable to a writedown, says Michael Hodes, banks analyst at

Goldman Sachs

, which has done recent underwriting for GreenPoint: "I don't see the bank in the aggressive camp. I'm pretty comfortable with the way

their retained interests have been handled and disclosed." (Hodes rates the bank a hold.)

Any new rules could affect a relatively small number of banks, says the FDIC spokesman. Of the 10,200 FDIC registered banks, only 129 have retained interests that exceed 5% of their Tier One capital ratios.