HBC Makes a Courtesy Flush

Anyone hear that flushing sound? That was HSBC Holdings (NYSE:HBC) making a somewhat unexpected addition to its reserve for bad debts. It's trying to get out in front of what it expects to be a flood of bad subprime loans coming in 2007 and 2008, as interest rates on adjustable-rate mortgages reset at much higher levels.

To be more detailed, HSBC is adding $1.76 billion to its reserve, to bring its provision for loan losses up to $10.56 billion. The target that analysts had in mind up until this morning was $8.8 billion; this new provision is therefore a full 20% higher than expected.

Making the story more interesting is that the increase is entirely a result of the company's U.S. subprime mortgage lending unit. My colleague Seth Jayson has done an excellent job covering the residential real estate market over the past year and has expressed doubts about a number of the less conventional mortgages that became very popular in the past few years. HSBC's adjustment to its provision for loan losses is one of many recent signs, and the largest in absolute dollar terms, that these mortgages are rotting from the inside out.

However, to call HSBC's adjustment to its loan-loss provision a complete surprise or a shock is disingenuous, because as recently as a conference call in December, the company noted that its subprime loans in the U.S. were still under evaluation and that historical data wasn't proving useful in estimating future losses. The company didn't have specific guidance, but it was pretty clear that updates to its reserves were possible.

Joining HSBC in warning about the potential fallout from subprime loans today is mortgage REIT New Century Financial (NYSE:NEW). New Century shares are down a whopping 28% as I write this, while HSBC is down a mere 2.6%. That's the difference between being a diversified financial-services company and a REIT, which can't retain much capital, since it's focused on mortgage loans.

Also feeling the subprime pinch today -- and down 3%, 8%, and 12%, respectively -- are Countrywide Financial (NYSE:CFC), Accredited Home Lenders Holding (NASDAQ:LEND), and Novastar Financial (NYSE:NFI). Megabanks Wells Fargo (NYSE:WFC) and Citigroup (NYSE:C) also have exposure to the subprime market, but like HSBC, they are more diversified, and their stocks fell only slightly.

In some ways, it is a bit amusing that HSBC, with operations all over the world -- in economies considered a much higher risk, in some cases -- has managed to find itself with a large bad-debt problem in the United States. That's not to say people haven't been worried about the residential real estate market in the U.S. and the subprime portion of that market in particular, but for a bank that prides itself on having conservative lending practices, this is a big whiff. How this story continues to play out for HSBC and other banks will be very interesting to watch.

At the time of publication, Nathan Parmelee had no financial interest in any of the companies mentioned. At the time of publication he was ranked 79th out of 21,979 Motley Fool CAPS investors. The Motley Fool has an ironclad disclosure policy.