Prime looks terrible

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“Prime looks terrible.” Those are the words of Jaime Dimon, CEO of JP Morgan Chase regarding the future of prime mortgage loans. Wall Street analysts were ecstatic at the largely positive news in JP Morgan’s earnings report even though earnings were down by more than half compared to a year ago. Yet, Dimon attempted to lower enthusiasm by pointing out the high hurdles to clear in coming months.

JPMorgan has weathered the subprime downturn better than many of its peers. But on Thursday, it said it charged off 5 percent of its subprime mortgages in the latest quarter, resulting in a hit to earnings of nearly $200 million.

And the mortgage contagion may be spreading from subprime to prime mortgages, which were given to people with the best credit histories.

“Prime looks terrible, and we’re sorry,” Mr. Dimon said on Thursday’s conference call with investors. “We can say it eight times. It looks terrible.”

Around three-quarters of the firm’s prime mortgages are “Alt-A” and “jumbo” mortgages. Alt-A mortgages were written to people with relatively strong credit histories, but whose income was not verified. Jumbo mortgages were written for those borrowing more that $417,000.

Prime mortgages are supposed to have a very low chance of defaulting. For example, in the second quarter of 2007, the firm wrote off just 0.05 percent of its prime mortgages, for a charge of $4 million. That rose to 0.91 percent in the latest quarter, amounting to a $104 million charge-off.

A tripling of the losses stemming from its prime mortgages would mean a $300 million loss. It would force the firm to increase its reserve pool, belting down even more capital to soak up the markdowns.

As it is, JPMorgan had to beef up its reserve pool for bad loans by $430 million in the second quarter. This ties up the bank’s capital, making it harder to invest in other things such as loans to consumers — or increase dividends to shareholders.
New York Times, 17 Jul 2008

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An increase in writedowns in higher classes seems inevitable. On Tuesday, I said

There are three obvious places to look:

  1. Other mortgage areas beyond subprime that have been ‘tainted’ by the subprime mess and that are showing signs of distress.
  2. Other credit classes that exhibited the same levels of euphoria during the upswing
  3. Other unrelated credit classes that might be affected by a negative feedback loop that credit contraction has on the real economy.

As far as Mortgage classes go, Alt-A is the class to watch now. This class between sub-prime and prime is now exhibiting many of the hallmarks of distress previously seen in sub-prime before it cratered. (See my posts under the label Alt-A for more). IndyMac, now bankrupt, was a major provider of mortgages in this sector. In April, Moody’s began downgrading Alt-A Residential Mortgage-Backed Security (RMBS) bonds.
Financials: catching a falling knife

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Therefore, at a minimum, we should be expecting Alt-A performance to worsen significantly in the coming months. Dimon is signaling further that even Prime mortgages will see significant deterioration. The pain in financials is far from over.

See Credit Crisis Timeline for a complete list of writedowns by institution.

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