Bank writedowns of $10 billion ahead?

NEW YORK — Wall Street turned on itself Friday, as one widely watched analyst said investment banks face $10 billion or more in writedowns this quarter from bad mortgage debt and another downgraded much of the banking sector on similar fears.

The downgrades and the commentary renewed fears of a repeat of August, when stocks sank, credit markets locked up and banks slashed the value of their investment portfolios.

Deutsche Bank analyst Mike Mayo predicted late Thursday night that the investment banks will need to take another $10 billion in writedowns in the fourth quarter, with hits of $4 billion each at Citigroup and Merrill Lynch and a total of $2 billion at places like Wachovia and Bank of America.

But after a Wall Street Journal article Friday morning suggested Merrill Lynch could be under investigation over its handling of mortgage debt, Mayo issued a new note, downgrading Merrill to "Hold" from "Buy" and saying it could face $10 billion in writedowns on its own.

The problem at the banks stems from their exposure to complex instruments known as collateralized debt obligations. So-called CDOs combine slices of different kind of risk; many include pieces of bonds backed by subprime mortgages. As those mortgages have gone into default at rising rates, the bonds have lost value and the CDOs have as well.

That trend has shown no signs of abating, which has meant fresh rounds of charges by banks to recognize the decreased value. Writedowns related to declining mortgage debt values have already exceeded $25 billion this year, and any more could cause serious damage, Mayo said.

"If there are much higher CDO writedowns, Merrill may have additional credit rating downgrades and may need to find a partner to give it new credibility and financial strength," Mayo wrote in a research note Friday.

The trigger for Mayo's pessimism was the Journal story. The Journal reported Merrill Lynch struck deals with hedge funds to take certain positions that did not transfer risk but merely delayed when Merrill Lynch would have to disclose its exposure to that risk.

According to the Journal, Merrill engaged a hedge fund to lend a "Merrill-related entity" $1 billion. This normally means the hedge fund would assume the risk of the Merrill-related entity failing to repay debt. However, Merrill guaranteed it would buy the loan a year later. Thus, Merrill assumed the risk without reporting the company's exposure on its own books.