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How Mortgage Troubles Impact U.S. Banks -- Part One

We explore possible near-term effects on profits and stock performance.

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If you have picked up the paper in the past month, you know that the subprime (also called nonprime) mortgage business has blown up in recent weeks.  New Century Financial (NEWC), one of the largest players in the industry, filed for bankruptcy protection on April 2. At first, it seemed like the problems were confined to the low-quality subprime business, mainly stemming from firms that were funding mortgages with short-term borrowings. However, we're starting to see problems creeping into higher-quality mortgages, and as a result, we've identified two short-term risks for our bank coverage universe.

A Primer on Mortgages
Before we get into the problems, we first need to go over some mortgage basics. Most banks do not write subprime mortgages and instead cater to borrowers with higher-quality credit. Most banks also sell the majority of the mortgages that they originate. They earn a fee and sell the actual loan into the secondary market, often to the government-sponsored entities  Fannie Mae (FNM) and  Freddie Mac (FRE). Fannie and Freddie buy conforming mortgages, which are the traditional, 15- or 30-year fixed mortgages made to borrowers with FICO credit scores of at least 620 (called prime borrowers) who also have documentation showing income and assets. This type of mortgage is still the most popular, accounting for 37% of all mortgages originated in 2006.

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Jaime Peters does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.