Wake-Up Call: Lehman's Mortgage Marks

By DAVID REILLY and PETER EAVIS

The weekend's momentous developments -- Lehman Brothers Holdings' looming collapse, Merrill Lynch's merger talks with Bank of America and American International Group's plans to sell assets -- all have one thing in common: The firms couldn't deal with tens of billions of dollars in mortgage exposure left on their balance sheets from the credit boom.

Anyone else holding large amounts of tainted mortgages has to worry. Lehman's potential unwinding, along with any aggressive actions by Merrill and AIG to offload mortgage assets, could mean widespread losses as other banks mark down their own holdings.

Even before this weekend, that threat had weighed on financial stocks.

It started last week with Lehman, which surprised markets with savage cuts to the value of its residential-mortgage holdings. These were sharply lower than previous values, or marks, and helped drive Lehman's $3.9 billion loss for the quarter ended in August.

Investors were quick to connect the dots. If Lehman set a new benchmark with those values, others with big portfolios could be in for more pain, especially AIG and Citigroup.

If AIG sells relatively attractive assets like its aircraft leasing business, it may be able to plug a hole resulting from marking down its mortgage book. For instance, applying some of Lehman's latest marks to AIG's holdings could result in at least $15 billion in additional write-downs to the insurer's residential portfolio, which has a face value of $88 billion.

"We consider those kind of broad, simplistic comparisons to be unreliable," an AIG spokesman said. "We have a thorough process for pricing and marking our portfolio."

Citi, meanwhile, could face around $7 billion in additional write-downs if it applied Lehman's math to only its "Alt-A" portfolio of mortgage-backed securities. The banking giant hasn't come under the same pressure as AIG or other financial firms in recent days, but has taken big hits over the past year due to certain toxic holdings.

How severe were Lehman's marks? Consider that even longtime bears on the stock thought the firm was finally marking its residential portfolio to realistic levels last week.

Lehman Chief Financial Officer Ian Lowitt said on the firm's investor call that the firm was marking Alt-A exposures at about 39% of face value, compared with about 63% at the end of the second quarter. Alt-A mortgages are loans given to borrowers who, while not necessarily subprime, lack documentation to verify their financial condition or other information.

The firm took nearly as big a hit on subprime securities and those backed by second-lien loans, or those second in line to an original mortgage. The value of these holdings hit 34% of face value, from 55% at the end of the second quarter.

That isn't to say that other firms will blindly follow Lehman's lead. Marks are influenced by a range of factors, including the year the mortgage-backed securities were issued, the characteristics of the underlying borrowers and the extent to which securities are exposed to loan defaults. In addition, other firms may have insured their holdings against losses.

Still, Lehman has thrown down a marker. At the end of June, AIG's marks on Alt-A securities were about 67%. Citigroup, meanwhile, appeared to be valuing its $16.4 billion in Alt-A exposure at just over 80 cents on the dollar.

That could put Citi's shares under more pressure. However, there might be a silver lining to firms taking deep marks. It could actually set the sort of prices that finally lure more buyers to distressed mortgages.