Thoughts on the impact on third quarter earnings from the crisis in subprime mortgages

Implications: Several banks will be closing their third quarter soon. The credit crisis intensified in the third quarter - what impact should we expect to see from the bankruptcies, plummeting market values, the virtual demise of the collateralized debt obligations market etc. - Some banks will write down goodwill related to acquisitions of mortgage companies, and book charges to earnings.  Market capitalization of typical subprime mortgage company is about a third of the book equity, so the impairment could be sizeable - The rating agency downgrades of residential and asset backed securities will cause some banks to write down the book value of their investment securities. For the banks that were also warehouse lenders for failed CDO deals, this charge could be significant

Analysis: Several Wall Street banks will be closing their third quarter in August. The credit crisis intensified in the third quarter - what impact should we expect to see from the bankruptcies, plummeting market values of investment securities and loans, the virtual demise of the collateralized debt obligations market etc.

- Some banks will write down goodwill related to acquisitions of mortgage companies, and book charges to earnings. Market capitalization of typical subprime mortgage company is about a third of the book equity, so the impairment could be sizeable. For instance, Merrill Lynch ('ML') has approximately $1 billion of goodwill on its books from the purchase of First Franklin, a subprime mortgage lender that it acquired in late 2006. Merrill's mortgage banking activities are mostly in its thrift subsidiary - Merrill Lynch Bank & Trust, FSB. The thrift sub lost $111 million in the first six months of 2007 - it posted a profit in 2006. Merrill is required to evaluate goodwill for impairment every year. I think they will be forced to write down the goodwill related to the First Franklin purchase. How big could this writedown be ? Substantial -  subprime mortgage lenders such as Accredited Home Lenders ('LEND') or Novastar Financial ('NFI') have market caps that are about 30% of the book shareholders equity. These companies are comparable to First Franklin - both originate loans primarily through the wholesale channel. Another bank that could be forced to write down goodwill is Morgan Stanley ('MS') - MS has about $350 million of goodwill on its balance sheet related to purchase of Saxon Mortgage, another subprime mortgage lender, that is also primarily a wholesale lender

Companies are required to evaluate goodwill for impairment once a year, so the writedown may be delayed, but I believe it is inevitable.

- The rating agency downgrades of residential and asset backed securities will cause some banks to write down the book value of their investment securities. For the banks that were also warehouse lenders for failed CDO deals, this charge could be significant. the large banks - Lehman, Merrill, Goldman - all have sizeable on balance sheet investments in securities that are subprime mortgage related. They also extend warehouse lines to issuers of CDO's. When some of the warehouse lines were pulled, the banks took the CDO collateral - generally asset backed securities - onto their books. Rating agencies downgraded several mortgage related securities in the beginning of the third quarter. Rating downgrades of an investment security will force an other-than-temporary impairment of the carrying value. An other-than-temporary impairment will be a charge to earnings. Expect to see some impairments in investment securities in Q3