Mortgage cramdowns could slam banks' balance sheets

Will the "cramdown" provisions of President Barack Obama's plan hurt banks even as they help beleaguered homeowners?

Among the steps Obama outlined during a news conference in Phoenix during which he unveiled his new housing plan is a provision that would let bankruptcy judges reduce the principal outstanding on a homeowner's mortgage as a way to lower monthly payments. That could really help people who are 'under water', or owe more to their lender than their house is worth. But it could be very bad news for banks and others who have invested in securities backed by mortgages.

Bad bets on mortgage-backed securities are already contributing to banks' woes. Many financial institutions reaped fat profits during the housing boom by packaging mortgages into bonds and collateralized debt obligations. When the bubble burst, a lot of banks were still carrying tons of these investments on their balance sheets. As foreclosures began to spike, they had to take massive losses and set aside additional capital.

With home prices still falling and foreclosures mounting, investors are increasingly worried that big banks like Citigroup and Bank of America are even more troubled than they appear. U.S. banks have already announced more than $750 billion in credit losses since the middle of 2007, according to data compiled by Bloomberg.

Some analysts now worry that mortgage cramdowns may make matters worse. Research by Fitch Ratings last month found that some $223 billion in highly rated investments backed by prime and so-called "Alt-A" mortgages -- about 31 percent of the total outstanding -- could be hurt by cramdowns. That could lead to downgrades, which could force banks to set more capital aside to cover potential losses -- capital which is in short supply these days.

So while avoiding foreclosure might help homeowners who owe more than their houses are worth, it might not be such a boon for the banks, wrote Frederick Cannon, an analyst with Keefe Bruyette & Woods in San Francisco. The reduced payments after a cramdown might not bring in as much money as the bank would get by foreclosing on the property and selling it, he wrote in a report last month.
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