Big Banks May Be the Biggest Losers In 4Q07 With More Write-downs Expected

Implications: Shares in some of America's biggest banks slumped to their lowest level in several years on fears they may have to write-down multi-million dollars more from their exposure to risky mortgages, CDOs, (collateralized debt obligations) SIVs (structured investment vehicles) and leveraged loans. Banks that posted the biggest credit and trading write-downs in 3Q07 is Merrill Lynch at $8.40 billion; Citigroup's $6.5 billion; Goldman Sachs $1.71 billion; JP Morgan Chase $1.64 billion; Bank of America $1.46 billion; Wachovia $1.30 billion; Morgan Stanley $940 million; Bear Stearns $700 million and Lehman Brothers $700 million. Its difficult to know the extent of the big banks' problems because it is almost impossible to put a value on the credit derivatives sitting on banks' books. The ABX Derivatives Index tied to sub-prime mortgages has hit new lows in recent days, which may signal the value of mortgage backed securities held by banks is weakening and could bring more write-downs in 4Q07.

Analysis: Blue chip banks are holding their breath to see what happens to the US housing market in which many of their off-balance sheet vehicles are invested and they may have to swallow a bitter pill of their own making and write-down more losses in 4Q07 and beyond. Changes in the mortgage market over the summer were unprecedented as ARMs readjusted on sub-prime mortgages and foreclosure filings skyrocketed and Countrywide Financial Corporation who is the largest mortgage lender lost $1.2 billion over the summer because the amount of money Countrywide set aside to cover losses from risky loans went through the ceiling.

1. With the market in a nose dive mortgage originators may likely continue to play it safe in the foreseeable future as they try to avoid losing more money, which means fewer home buyers will qualify for loans and the tightening of underwriting standards may also play a role in the steady drop in mortgage origination in 2008 and mortgage origination volume has declined since 2006

2.  SIVs (Structured Investment Vehicles) may have also played a major role for the big banks and in Citigroup's large write-downs because Citigroup built up billions of assets in SIVs, which allowed Citigroup to use the short-term commercial paper market to raise money to back long-term investments such as mortgages, however when investors became aware that SIVs were not held on balance sheets and never declared and SIVs were tied to the risky sub-prime market, investors panicked over the risky sub-prime mortgages and the funds to finance SIVs dried up and as a result Citigroup wrote-down $6.5 billion in sub-prime losses

Take-away:  Citigroup, Bank of America, JP Morgan and Wachovia are putting together a "bailout" fund to buy assets from the off-balance sheet vehicles (SIVs) but progress has been slow. European banks Deutsche Bank, HSBC and UBS may also join the group to acquire mortgage assets held by SIFs (Structured Investment Funds) and resell the assets to investors. It sounds like a good plan in theory, however, 4Q07 may prove to be the "grinch" for big banks when they have to anty up and report earnings and/or losses and may report additional write-downs in 4Q07.