‘Subprime Flu’ Heads to Australia; Who’s Holding the Bag?

If the rosy earnings numbers from BofA and others today have you scratching your head about just who’s really left holding the bag on the US subprime (and Alt-A?) mortgage mess, you might want to look overseas. To China, right? Nope. Japan? Perhaps. But if you guessed Australia (and admit it, you didn’t) — you’d surprisingly be correct. The Land Down Under is apparently feeling some of the heat from trouble in the ABS markets here in the States:

For a sign of how far Wall Street’s subprime problems have spread, you can’t get much further than Sydney, where one of Australia’s largest and most prominent hedge funds is in crisis after its investments related to U.S. mortgages went sour. Basis Capital Funds Management Ltd., which had nearly $950 million in assets under management as of May … is one of the leaders of the hedge-fund boom sweeping Australia, which has become the biggest center for such funds in Asia. Two Basis funds invested in instruments related to U.S. subprime mortgages posted steep losses last month, prompting Basis to restrict investor withdrawals. The firm has appointed accounting firm Grant Thornton LLP to help it restructure as creditors press for repayment of loans. Citigroup Inc. and J.P. Morgan Chase & Co. earlier this week moved to sell some Basis assets, including subprime-related bonds used as collateral for loans, according to people familiar with the matter.

Speaking of holding the bag, the Wall Street Journal also takes an interesting look at how the housing slump is forcing banks and other lenders to up the loss reserves on their balance sheets, noting that even stalwart BofA — who has very little exposure to the subprime mortgage market — has ratcheted up its loss reserves as of late.

The bank nearly doubled its provision for expected credit losses to $1.81 billion from $1.01 billion a year earlier, citing probable losses in growth areas such as home-equity and small-business lending.

While every bank is busy cranking up phantom reserve losses, Mathew Padilla over at the Mortgage Insider isn’t sure it’s enough for some lenders, noting that Downey Financial’s loss reserve ratio has inexplicably slid downward in the face of a quickly-growing portfolio of non-performing loans. Downey is heavily leveraged into the California mortgage market, and is an Alt-A lender with a specialty in Option ARM lending — not surprisingly, it has watched REO inventory skyrocket more than 70 percent during the second quarter. Downey has also watched its loss coverage ratio slide from 143 percent of 60+ day delinquencies in June 2006 to a seemingly meager 38 percent of 60+ day delinquencies in June this year. I’ll let that sink in a little bit, and I’ll also note that New Century did the same thing before going belly up. I’m not implying that Downey is in trouble, of course — the company still reported a profit for the second quarter, albeit a 32 percent drop versus year-ago levels. But that profit number would certainly have been much lower had Downey boosted its loss reserves further. And perhaps it should have: fewer and fewer delinquent borrowers (esp. option ARM borrowers, many of whom are upside-down on their mortgage) will be finding a solution in loss mitigation, and delinquencies seem likely to only increase further in the quarter ahead. The great thing about loss reserves, of course, is that they aren’t real losses and that there isn’t really an accounting rule specifying a specific amount to be set aside for future expected losses. But there’s also an unavoidable and often painful reality about future losses, whether expected or not — eventually they have to become part of the present tense.

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