RD's Picks

I got most of the information for this post from the company's 15 Apr conference call prepared remarks and the associated credit risk management appendix. IMHO, Washington Mutual has done a pretty decent job of laying their balance sheet cards on the table.

As you probably know, WaMu's assets are dominated by home loans and one of the graphics right at the front of their conference call prepared remarks caught my attention. The Case-Shiller home price index graph. Note that fall-off doesn't appear to be leveling off.

For the first quarter of FY08, Wamu lost $1.1 billion driven by increases in loan loss provisions. They increased their loan loss provisions by about $2.1 billion over the previous quarter.

Balance Sheet:

The balance sheet shows $242.8 billion loans held in portfolio with $4.7 billion for loan loss provisions, or 1.94%. There are an additional $23.6 billion of loan backed securities available-for-sale. I believe the difference is that loans held in portfolio are valued based on the cash flow projections, not the market value of the security. Securities available for sale are listed at market value. Perhaps someone who knows more about accounting will weigh-in and correct me if that's wrong. In normal credit markets, there wouldn't be much difference between those valuations. But, credit markets haven't returned to normal yet.

In other words, we don't really know what the loans held in portfolio are worth - and it doesn't really matter unless they need to liquidate some of them. But, bottom line is we really don't know what Wamu's (or any other financial firm's) true book value would be if everything were listed at market value.

50% of Wamu's loans are in CA and they account for 36% of nonaccruals. 7% of the loans are in FL and they account for 17% of nonaccruals. For the math challenged, that's over half the portfolio in two of the toughest housing markets in the US.

Wamu has non performing assets of $9.1 billion, 2.87% of the total. Most, 7.1 billion, are non-performing loans. The remainder is $1.3 billion of real estate owned and $670 million of troubled debt restructurings.

Troubled debt restructurings are just what they sound like. Borrowers and the bank renegotiate the terms of the loan to try and avoid foreclosure. The bank typically gives up some money on the deal, but it's better than foreclosing. Of the $669 million in this category, 54% or $363 million, are current with the new plan. Not a great success rate, but I don't know what's typical for the industry.

The prepared remarks include this gem, "Net charge-offs in the first quarter of $1.4 billion were up 83 percent from the fourth quarter of last year. Consistent with prior quarters the majority of net charge-offs came from our subprime and home equity portfolios. However, during the first quarter, we also saw a significant increase in the net charge-offs from the prime home loans portfolio to $330 million from $101 million in the prior quarter." (emphasis added) More evidence that housing troubles are extending beyond sub-prime.

The loans in the portfolio consist of:

$108.5 billion of single family home loans. 4% of those have a loan-to-value ratio of greater than 90%, 22% have LTV greater than 80%. Net charge off rate for single family loans is 1.2% and climbing.

$55.8 billion of option arms, $1.9 billion of that total is principal that exceeds the original balance, i.e. borrowers have taken the option to pay less than even the interest on the mortgage. Although not huge, that amount is growing. 7% of the option arms have LTV greater than 90%; 30% have LTV greater than 80%. Net charge off rate for option arms is 1.81% and has been climbing. $3.8 billion of the portfolio resets in 2008, $7.2 billion resets in 2009.

$61.2 billion in first and second lien home equity loans and lines of credit. 14% of those have a total LTV of greater than 90%, 32% have total LTV of greater than 80%. Net charge of rate is a whopping 3.12% and rising.

$17.3 of the loan portfolio is subprime. $15 billion is home loans, $2.3 billion is home equity. LTVs are very high for this portfolio. Net charge off rates are running at 8.55% for the combined portfolio.

Forecasts:

Wamu is estimating $12 to 19 billion of losses on home loans over the next 3 - 4 years. About $4 billion is already reserved, so $8 to 15 billion still needs to be covered. The low end of that range assumes another 13% decline in home prices nationally, 18% in California. The high end assumes 30% nationally and 35% in California.

WM could have increased loan loss provisions by about a billion dollars last quarter without running a loss. Given that they project needing $8 to 15 billion additional loss reserves over the next 3 or 4 years, they'll need to increase loss reserves at something like half a billion to a billion a quarter over that time span. That doesn't leave a lot for earnings. Of course, they could also apply most of the new money from the $7 billion recapitalization to loss reserves and start reporting narrow profits again shortly after that.

Recapitalization:

Wamu recently announced a $7 billion recapitalization, selling common stock, convertible preferred and warrants to TPG and other unnamed investors.

The Wall St. Journal reported the net result of the $7 billion capital infusion could result in issuing 804 million new shares. There are currently 866 million shares outstanding. $7 billion of new cash brings book value to about $29 billion, across 1.7 billion shares would be about $17 per share in book. That assumes the current book value holds. And that they won't need to do any more recapitalizations. Big, big assumptions. Tom uses the lower, net tangible assets in his post recapitalization price-to-book calculations and that's probably a better metric.

Conclusion:

For Wamu to do well, loan losses and housing price declines have got to level off.

I'm very concerned by the concentration of loans in troubled real estate markets, the high percentage of option ARM loans in the portfolio and what seems to be a high percentage of high loan-to-value assets. It's also concerning that the net charge off ratios still appear to be climbing.

I have no clue how the portfolio loans are valued, but suspect Wamu would be in serious trouble if they got in a bind and had to sell any of that paper. Even with the market for mortgage securities improving lately, I can't believe there are very many buyers for option ARM loans from California and Florida.

If things go according to Wamu's optimistic scenario and they only need to write down another $8 billion or so or loan value and if the business model can replace the assets with quality loans as they go, Tom's best case scenario of the stock being valued at two to three times tangible book after dilution, or about $24 - 36 a share after 3-4 years is plausible. Those are two pretty big ifs. BTW, they cut the dividend to a penny a share, so you don't get paid to wait.

If things don't go well, there's enough leverage to drive the share price to near zero. TPG and the other new investors' convertible preferred shares are probably in line ahead of the common stock. So, if things really turn south there isn't likely to be much left for the common stock shareholders.

WM is pretty speculative and is much further out the risk curve than I'm interested in going. If I were going to buy it, I wouldn't chase it up after last week's run. Wait until some new credit mess hits the news and pulls the price down, then buy - that's a good approach for any financial.

Bottom line, I think there are more tough times ahead for Wamu and that there are better investments available. Count me among the bears on this one.

Disclosure: I don't own any WaMu stock at time of posting.

ETA: They don't mention WM, but nice video summarizing last week's bank earnings reports from Morningstar.

Comments: View Comments |  Sunday April 20, 2008  |  Stocks: wm,