HSBC may preview credit woes

When British bank HSBC Holdings PLC reports third-quarter results for its U.S. business this week, it will provide an early look at what could be in store for U.S. mortgage lenders, banks with big holdings of securities tied to subprime home loans and even the broader U.S. economy.

That picture isn’t likely to be pretty.

HSBC’s American consumer-lending unit, HSBC Finance Corp., is the classic canary in the coal mine when it comes to identifying new problems in the market for subprime loans, or those that were made to borrowers with weak credit.

A year ago, the bank, in a little-noticed securities filing, flagged some unexpectedly high delinquencies in its subprime-mortgage book that in February led to an increase in bad-debt costs. That proved to be the beginning of a crisis that spread around the globe, engulfing most of the world’s largest banks and big mortgage lenders such as Countrywide Financial Corp.

Now, some analysts are expecting another unpleasant disclosure from HSBC’s U.S. consumer-lending business, one of the biggest subprime lenders in the country. Robert Law and Raul Sinha, London-based banking analysts for Lehman Brothers, said they believe HSBC might have to boost its reserves against souring subprime loans at HSBC Finance’s mortgage-services division by $2.4 billion, to a total $4.5 billion. The unit, formerly known as Household International Inc., was acquired by HSBC in 2003.

The level of reserves suggests that by the end of this year, losses to defaults over the life of the loans could wipe out about 14 percent of a loan portfolio totaling $41.4 billion, according to Messrs. Law and Sinha. That would confirm some of the more pessimistic forecasts of how the subprime market will fare. The Lehman analysts initially had projected losses of 8 percent. Lehman has an ”overweight” recommendation on HSBC shares, the firm’s highest ranking. The analysts said they believe HSBC’s access to emerging markets is one factor that outweighs the problems in the U.S.

”HSBC has proved to be one of the most frank, or perhaps realistic, of all the players in the consumer-finance space,” said UBS AG banking analyst Alastair Ryan. ”If their message is indeed that things have again turned for the worse, others will follow.”

HSBC’s results also could have bigger implications for the U.S. economy. Some analysts expect the losses at HSBC Finance to prompt a slowdown in lending at its 1,260 U.S. branches and other lending outlets, which provide mortgages, auto loans and credit cards to retail customers. That is an area that economists have been watching closely for signs of contagion from the credit crisis. Any pullback in such lending could curtail U.S. consumer spending, which has been the country’s main driver of economic growth.

UBS’s Mr. Ryan estimates that HSBC Finance’s book of consumer loans outstanding will shrink or remain flat in 2007 and 2008. That follows an expected 4 percent decrease between 2006 and 2007. In auto finance, he believes that loans outstanding will increase 3 percent between 2007 and 2008, compared with 6 percent growth between 2006 and 2007.

All told, Mr. Ryan estimates HSBC Finance’s loan portfolio will total $165.8 billion in 2008, compared with $182.5 billion in 2006. He has downgraded HSBC shares to ”neutral” from ”buy.” UBS has provided advisory services to HSBC.

A spokeswoman said HSBC doesn’t comment in the period leading up to a financial report. Unlike its parent, which reports detailed financial results twice a year, HSBC Finance files results quarterly.

HSBC’s outlook matters in large part because the bank’s U.S. operations stand at the very beginning of the subprime-mortgage chain. Aside from being a major lender, HSBC Finance has a large portfolio of second mortgages, which tend to be among the first to go bad.

Losses at the U.S. finance unit have been indicative of broader shortfalls among subprime mortgages, which then filter through to the ratings of subprime-backed securities and collateralized debt obligations, or CDOs, which divide pools of securities into slices with different levels of risk and return.

In February, for example, HSBC said souring subprime-mortgage loans had forced the bank to add nearly $2 billion of its funds set aside for 2006 to cover bad debts. At the time, HSBC was alone among big commercial and Wall Street banks in signaling big problems. At about the time of HSBC’s statement, though, lender New Century Financial Corp. said it expected a fourth-quarter loss, helping set off a stock-market rout.

Within months, Wall Street firms and hedge funds that had invested in securities backed by mortgage loans were reporting losses, too. More recently, credit-ratings firms, analyzing the performance of the underlying loans, issued warnings and downgrades on a slew of securities and CDOs, triggering a new wave of losses among banks with big holdings of the securities. Merrill Lynch & Co., for example, boosted its third-quarter write-down to $7.9 billion to cover debt-pool and subprime holdings. Citigroup Inc. announced potential write-downs of as much as $11 billion in the fourth quarter.

HSBC was ”one of the first banks to flag the potential subprime fallout,” says Lehman’s Mr. Law. Since February, HSBC’s stock price in London trading has fallen almost 10 percent, settling Friday at 840.5 pence ($17.58), or about 11 times projected per-share earnings for the coming year.

Friday on the New York Stock Exchange, HSBC’s American depositary shares fell 2.3 percent to $87.93, giving the company a market value of about $207 billion. Shareholder activist Knight Vinke Asset Management is targeting the bank and has cited the problems in the U.S. lending business.

In recent days, other financial firms have trumpeted new concerns about next year. Last month, Morgan Stanley analyst Betsy Graseck said in a report that she expected ”contagion from subprime housing to prime housing to auto to card loans.” Capital One Financial Corp., a large-credit-card issuer, reported Friday an increase in loan charge-offs and delinquencies in October. Last week, home lender Washington Mutual Inc. predicted a bleak outlook for 2008 U.S. mortgage originations, predicting a drop to $1.5 trillion from about $2.4 trillion this year.

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