The Wall Street Journal-20080131-More Subprime Pain in Store- UBS Write-Downs- Insurer Downgrades Point to More Unraveling

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More Subprime Pain in Store; UBS Write-Downs, Insurer Downgrades Point to More Unraveling

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After racking up more than $100 billion in mortgage-related losses in recent months, banks and their investors had hoped they were out of the woods. They aren't.

UBS AG's warning yesterday that its 2007 write-downs would be $4 billion higher than it predicted last month signaled that further pain may lie ahead for Wall Street banks still vulnerable to the U.S. housing sector's strife.

Meanwhile, tough times for bond insurers such as MBIA Inc. and Ambac Financial Group Inc. may spell trouble for banks that rely on those firms to insulate their mortgage holdings from losing value.

Those concerns were in the spotlight yesterday as Oppenheimer & Co analyst Meredith Whitney warned that Wall Street faces at least $40 billion in losses if the insurers see their credit ratings cut or file for bankruptcy protection.

"When it becomes clear [as we think it will] that more charges are on the horizon, we believe the market will take another turn for the worse," Ms. Whitney wrote.

Fueling the concerns, Standard & Poor's predicted yesterday that the carnage might spread to a wider range of financial institutions, with total losses potentially exceeding $265 billion.

Citigroup Inc. and Merrill Lynch & Co. may be the most vulnerable to the next wave of write-downs.

The two firms were the leading issuers of complex investment vehicles called collateralized debt obligations, whose values have deteriorated as more borrowers defaulted on mortgages. Together, Citigroup and Merrill already have absorbed a total of nearly $45 billion in losses on exposure to CDOs, leading each to replace its chief executive and seek multibillion-dollar cash infusions from investors around the world.

But the banks are hardly immune to further erosion. They each have billions of dollars in remaining exposure to CDOs, pools of debt sliced up according to levels of risk. Their values are expected to continue dropping, and yesterday S&P took negative action on nearly 2,000 CDOs backed by mortgages. "We don't think the CDO market has hit bottom yet," said David Yan, head of CDO research at Credit Suisse.

Wall Street's bigger fear at the moment is that the ailing bond insurers will infect the banks. Bond insurers sold contracts to the banks that essentially protected the value of some of their CDO holdings. That insurance covers about $125 billion of CDOs world-wide, according to Tanya Azarchs, managing director in S&P's financial- institutions ratings group.

The problem is that the CDOs' downward spiral is threatening to swamp the insurers. Credit-ratings agencies have downgraded some insurers and are warning of future cuts. Yesterday, Fitch Ratings downgraded FGIC Corp. to double-A from triple-A, citing its failure to raise $1.3 billion of capital.

The so-called monolines' strong credit ratings underpin the value of their insurance contracts. As a result, banks need to take into account the lower value of the insurance as they gauge the value of their CDO holdings. That sets the stage for further write-downs at the end of the current quarter.

Still, with interest rates falling, the share prices of some financial institutions had gained nearly 20% recently. "A lot of investors want to believe [the fourth-quarter losses] were the end," said Joseph Mason, a finance professor at Drexel University's business school. "We're definitely not done here."

A few banks have booked modest losses already to account for their exposure to the insurers, with Merrill this month taking a $3.1 billion hit and Citigroup writing down $935 million. UBS, in its earnings warning yesterday, said that about half of its $4 billion in new losses stemmed from its subprime exposure, but it didn't disclose the source of the remainder.

Industry experts say banks so far have been writing down their CDO holdings under the assumption that the insurers won't face sharp ratings downgrades. For investors, that may prove overly optimistic.

In a worst-case scenario, Citigroup could face losses of as much as $10.3 billion, with Merrill on the hook for as much as $10 billion, and UBS staring at as much as $8.7 billion, according to Oppenheimer's Ms. Whitney. Industry-wide, she said, write-downs could mushroom as high as $75 billion.

Merrill Chief Executive John Thain sought to dispel the concerns. He told investors at a conference yesterday that Merrill has about $3.5 billion in net exposure to the insurers. Citigroup said this month that it has about $10.5 billion in "hedged exposure" to CDOs, but not all of that is in the form of insurance from the monolines. A Citigroup spokeswoman declined to comment.

Other analysts noted that if S&P and Moody's Investors Service downgrade Ambac and MBIA by one level, they will still enjoy relatively high double-A ratings. In that scenario, banks exposed to them are likely to set aside reserves to cover their exposure, but it probably won't lead to massive one-time hits, according to Brad Hintz, an analyst at Sanford C. Bernstein & Co.

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Andrew Dowell contributed to this article.