An Examination of WaMu
One casualty of the housing bust is without a doubt Washington Mutual or WaMu. This company is an important front to watch in terms of the future of the US economy, given that this bank holds $185 billion in deposits. There currently is a lot of schadenfreude on the internet, blogsphere and in my comment section about this bank ultimately failing. There are aggressive speculative bets being made against them, including puts trades with enormous 200% like implied volatility bets.
I have no axe to grind with WM, they are in my home town, and if anything I root for the home team, especially when they appear to be the underdog. The WM conference call can be read here, and slides that further paint the picture are here. I would have to remark that the level of transparency on these calls is decent, the Winston Wolfes are on the scene, and WM has plenty of brain tissue to clean up. They use the term “housing bubble” several times in the call. There is also alot of useful background from this call on the general topic of high risk mortgage lending.
“I’m Winston Wolfe, I solve problems.”
WM has about $26 billion in shareholder equity, and has already reserved $8.5 billion against losses or 3.53% of the loan portfolio. They categorize $11.2 billion as non performing and foreclosed, however $1.0 billion of that are restructured mortgages (called TDR, or “troubled” debt) that are performing at quarter end. So far they have not been especially aggressive charging off 180 day situations, only about $2 billion in 2Q. I will give WM the $1.0 billion back, which gives us a somewhat generous (to Wa Mu) Texas ratio of around 30%. WM projects based upon its models that they will ultimately suffer $19 billion in losses ($2 billion taken in 2Q), but spread out over the next three years or so. The company is suggesting that the estimated $6 billion or so in annual pretax earnings from the still performing portfolio will cover this and once again make them whole as the brain tissue and blood is cleaned up.
WM is also shrinking its portfolio, so far from $328 billion to $310 billion mid year. The goal is $290 billion at year end. This does reduce their capital requirement at about 1/2 billion per $10 billion shrinkage. There is major cost cutting underway, and they have significantly reduced HELOC credit lines available, and they no longer do pay option negative amortization ARMs. They look like a much more conservative lender now, and will stay so for some time. In the old Ponzi suspect areas, the loan portfolio breaks down as follows: $53 billion in option ARMs, $16 billion in subprime, $60 billion in HELOCs, and $10 billion in credit cards, totaling a gagging 500% of equity capital after subtracting the latest loss reserve.
WM was not a large subprime lender in the greater scheme of things, and there is now increasing evidence here and elsewhere that the hits are being taken and the burn out process is getting underway. Early stage delinquencies (30-89 days) trends in subprime have flattened since the fourth quarter, and surprisingly so have HELOC delinquencies, which actually dropped in 2Q. Management was forthright enough to suggest that the tax refunds may have been a temporary mitigating factor. Foreclosures in subprime in the 2nd quarter grew 11%, compared to 39% in 1st quarter. This is consistent with my article, the Bad Egg Theory. Card delinquencies are trending higher.
The aspect of WM situation that I am skeptical about is pay option ARMS. WM is modeling the recast of these as occurring at 5 years after origination, which then supports their spread out timeline of working through the losses. I have yet to hear a challenge of this assumption, but with the aggressive borrowers using pay options, I suspect this reset wave will be hitting far sooner. The saving grace in many bust locales is that the resets occur at 115% of the initial balance, instead of the early fuse 110%. Of course that just means when the bomb goes off later, the overall losses will just be greater.
The other aspect of WM’s modeling I am not accepting is their use of OFHEO housing price data from March, 2008 to calculate LTV coverages. OFHEO data is bogus and inaccurate, greatly overstating house values. If you look at slide 6 you will see that WM uses this to state that only 22% of their 2nd lien HELOC exposure is over 90% LTV and only 8% of their 1st liens are. A difference of 10 or 15% higher on this is going to be the story when this one goes down to the wire. Secondly when one actually looks at the regions where WaMu has the exposure (see slide 21) it paints a different picture about prices.
Finally, we come to the upslope of WM’s non performing and foreclosures. In the last year this has increased by $7 billion. If they go another year contained to this trajectory, then the $6 billion of pre-tax earnings will cover it and keep WM’s capital levels stable. WM is not in a position to see this spiking much higher beyond the $6-7 billion slope, as that would further reduce capital levels. I can make a case that WM will survive this debacle, and there could be an inflection point that makes it a great speculation. Unfortunately in this kind of stressed and predatory environment, certain dynamics take on a life of their own, and WM is without doubt a wounded beast. The issue of WM’s borrowing from the FHLB is discussed here. This looks like a real ongoing drama, and hopefully I have provided a matrix for tracking it.
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