Wachovia's Imprudent Takeover of Golden West

Includes: GDW, WFC
by: Brad Ginesin

Wachovia’s (NASDAQ:WB) impending $24 billion takeover of Golden West Financial (GDW) has made few waves since first announced in May, yet the merger still looks like it could prove to be a headache for Wachovia and its shareholders. It seems clear that Wachovia is overpaying, paying a premium for growth when the earnings outlook seems uncertain.

Golden West’s income stream is precariously positioned due to their leveraged exposure to the West Coast mortgage market, a market where volumes and prices are currently contracting. The earnings expectations and a P/E of 14-15 do not factor in these declines; whereas other financial institutions trade with a P/E between 9-11, and those most leveraged to the mortgage market currently trade with a P/E between 7-8.

Comparatively, last year, Country Wide Credit booked a billion dollars more in profit than Golden West, but has a smaller market value. Washington Mutual earned $2 billion more than Golden West (130% more), yet its market value is only about 75% higher.

Not only do the reported earnings at Golden West place the current P/E well above that of other mortgage lenders and at the high end of most financial institutions, but the reported earnings have been bolstered by aggressive accounting methods, impugning the quality of those earnings. On Golden West’s underwritten option ARM mortgages, the monthly interest that homeowners choose to defer and tack on to their principal, the company accrues as revenue. In the first half of 2006 this accounting maneuver generated almost 60% of their pretax income. These non-cash earnings locked up at the end of mortgages increasing in principal, while the underlying asset could be decreasing in value, should prove challenging for Wachovia in booking future loan loss provisions.

Although Golden West underwrites the highest rate of ARMs in the industry (99% of their new business last year), which have a higher default rate than fixed rate mortgages, their delinquency loss provisions are about in-line with the industry average. This exposes the company to a significant under-reserved situation as home prices decline and ARMs reset to higher payments, leading to more defaults.

This ill-advised merger should lead to underperformance for Wachovia. Wachovia is paying an excessive amount to acquire Golden West at an inopportune time. Paying this large a premium to book value and reported earnings seems imprudent. If the housing market continues its abrupt contraction, in all likelihood Wachovia will be dragged down by 15-20% from current levels over the next four quarters.

Disclosure: Author is short GDW