Why WaMu Must Confess

At first I hesitated about using the word "confess". The word implies guilt.

But that is the first impression I had when I examined Washington Mutual's (WM) 10-Q. The bank has in its latest report, $213 B in mortgage loans and $13B in non-mortgage loans. It also suggests that as of today, they are prepared to provide at most $2.2B in loan loss provision in support of that portfolio for 2007.

Let's just see how that number stacks up.

From "words on the street" and some back-solving on my own using WaMu's capitalized interest in their Option-ARMs portfolio, I estimated they own no less than $80B of Option-ARM.

For a newbie, Option-ARM is the type of mortgage where the first five year's payment is very low (1.25%), but the loan balance grows because the difference between the low initial rates and the mortgage market rate (typically the benchmark is jumbo rate) is added to the loan balance.

Nowadays Option-ARM is not expected to be around for much longer. Maybe it's the economics (default, risk premium, etc.), or may be it's just like fashion to come and go with the ages. But nobody wants it anymore, and that's a fact. I witnessed last week a prime Option-ARM pool traded at $89. That's 11% discount from face value.

The reason for the steep discount is not actually credit (yet). It has to do with the prepayment behaviors of Option-ARM borrowers, which slowed down noticeably in the past 3 months. You see, the last thing a financier want is to have an Option-ARM borrower default at the time he was supposed to either a) fund a new ponzi loan, or b) earn the higher interest rate after reset.

Anyway, that's too technical. But 11% off the $80B portfolio is still $9B. Let's just speculate and say that only less than half of the $9B is realized as losses, since WaMu services and owns the loan themselves and will fight tooth and nail to keep them paying the loans back. That number is still $4B, and is still a half billion bucks more than the entire 2007 earnings forecast of $3.5B.

To recap: Less than half the portfolio, very generously marked at half the impairment rate currently implied by the market, will adjust the income $4B downwards, or more than one year's worth of income. Just imagine what the rest would look like!

Being a private mortgage bank, WaMu can't afford to keep "low margin" prime loans on book. The rest of the portfolio is most likely Alt-A that they insist as Prime, Subprime, or Subprime that they call Alt-A. But no matter, the reality is the writedown is comparable to the Option ARMs book, and I believe, larger in some cases.

What about current management plan? Is there a possibility of growth when other players exit?

Unfortunately not in the mortgage landscape.

Originating the loans that can be sold to the GSE (Freddie (FRE) and Fannie (FNM)) will mean "working for free" (or may be "for food" at best). Originating risky loans will keep the capital tied up and thus contrary to the growth plan to begin with. And fundamentally, it is not reasonable to expect the US housing to be a source of growth a'la 2003-2006. By that I mean housing values go up like a "growth company", allowing banks to dispose the risky product risks and just retain the fat origination fees.

In short, no feasible growth plan was presented as of early this morning, Sept 9, 2007, when the WaMu CEO Kerry Killinger spoke in front of investors in Lehman Brothers mortgage banking conference. The guy knows it's over and kind of hinted that the "mark down" process will begin soon.

So what's my price target? It really depends on my mood. Since I am reasonably sure WaMu either take 2-3 years worth of income in writedown at once, or spread it painfully over longer period of time, only time will tell.

But consider this, if somehow they emerged in 2010 with $3.50 earnings a year (the top estimate for 2007 before revisions), and a historical P/E of 10 and cost of capital of 10%, then it implies that WaMu is 30% overvalued. (The accumulation of 10% below cost of capital over 3 years out to 2010).

By that I am saying WaMu's logical price range would be around $25.

Still my analysis hasn't stated the worst of WaMu. WaMu isn't some deadbeat REIT like New Century (NCBC). It isn't a bit player like Indymac (IMB). It's a huge thrift, a bank. It's dependent on trust much more so than those guys and should have gone at length to present them to their investors.

Having me to confess their sins for them isn't the best way to win their investors' trust.

Disclosure: Author has a short position in WM

Comments

[Uncle Bill:]

Nice call, but perhaps a little early this time. With a 43 option implied volatility, the options market sees a little more than 20-point trading range in the issue. That's about 3.4 points per standard deviation. Right now WM is 44%-- about 1 1/2 standard deviations -- below it's 90-day mean. We'd rather see the stock closer to its mean price if we're going to short. Sideways movement over the next couple months, or a rally soon, would make the short look better. Fundamentally, we're with you. impliedrisk.blogspot.c...

2007 Sep 11 10:50 PM

[Ive had enough:]

I work at WAMU and wanted to let you know that Freddie is buying the option arms from them. Not every one gets the same offer. I guess it probably depends on past business and relationships.

2007 Sep 12 03:02 AM

[kdo:]

I thought Freddie wouldn't buy jumbo, which I'd think most of WAMU loans are. Is this not right, or are they just buying non-jumbo ARMs?

2007 Sep 13 01:17 PM

[Isaac:]

No need to back into the amount of Option ARMs, since they report them in their 10Q (page 36). Total Option ARMs were $53.455bn, of which $1.3bn represents unpaid principal in excess of the original principal balance of the loan.

If one were to look historically at market prices during a crisis of financial assets and compared the implied loss with the actual future performance of the same asset class, would the market likely over or under estimate the severity of loss? I understand you cut your number in half as a schwag at conservatism/realism, but I would be curious to know the true relationship in a historical context. The Option ARMs are held in portfolio (for investment as opposed to for sale) so are not marked to market. Only actual losses in excess of allowances already booked will cause a hit to earnings.

It may be useful to note that 96.5% of the Option ARMs had 80% LTV or less at June 30 (10Q page 44). 3.1% had LTV between 80-90%, and 0.4% greater than 90% LTV. A very drastic economic downturn would have to occur for those loans at 80% of collateral value to experience significant losses, even assuming their are some over-valued numbers in California, Florida and Nevada properties. There are $1.6bn of loans with LTV between and 80-90% and $190mm with LTV greater than 90%. These are very large numbers and areas for concern, just not the $9bn or even $4bn number that you tossed out. This approach probably makes more sense in trying to estimate potential losses than attempting to make a connection between market value and losses realized in WaMu's loan book.

Your short is likely the right bet as the mortgage situation will get worse before it gets better. There are too many resets on the horizon to believe otherwise, but the order of magnitude, at least in WaMu's Option ARMs, is probably lower than your estimate. I would caution you to remember that WaMu's dividend yield is already north of 6%, and it will provide a floor to the stock at some level. Additionally, WaMu is unlikely to trade below book value unless the wheels completely come off the bus, which would imply $27 a share.

2007 Sep 12 11:30 AM

[Isaac:]

No need to back into the amount of Option ARMs, since they report them in their 10Q (page 36). Total Option ARMs were $53.455bn, of which $1.3bn represents unpaid principal in excess of the original principal balance of the loan.

If one were to look historically at market prices during a crisis of financial assets and compared the implied loss with the actual future performance of the same asset class, would the market likely over or under estimate the severity of loss? I understand you cut your number in half as a schwag at conservatism/realism, but I would be curious to know the true relationship in a historical context. The Option ARMs are held in portfolio (for investment as opposed to for sale) so are not marked to market. Only actual losses in excess of allowances already booked will cause a hit to earnings.

It may be useful to note that 96.5% of the Option ARMs had 80% LTV or less at June 30 (10Q page 44). 3.1% had LTV between 80-90%, and 0.4% greater than 90% LTV. A very drastic economic downturn would have to occur for those loans at 80% of collateral value to experience significant losses, even assuming their are some over-valued numbers in California, Florida and Nevada properties. There are $1.6bn of loans with LTV between and 80-90% and $190mm with LTV greater than 90%. These are very large numbers and areas for concern, just not the $9bn or even $4bn number that you tossed out. This approach probably makes more sense in trying to estimate potential losses than attempting to make a connection between market value and losses realized in WaMu's loan book.

Your short is likely the right bet as the mortgage situation will get worse before it gets better. There are too many resets on the horizon to believe otherwise, but the order of magnitude, at least in WaMu's Option ARMs, is probably lower than your estimate. I would caution you to remember that WaMu's dividend yield is already north of 6%, and it will provide a floor to the stock at some level. Additionally, WaMu is unlikely to trade below book value unless the wheels completely come off the bus, which would imply $27 a share.

2007 Sep 12 11:30 AM

[Isaac:]

No need to back into the amount of Option ARMs, since they report them in their 10Q (page 36). Total Option ARMs were $53.455bn, of which $1.3bn represents unpaid principal in excess of the original principal balance of the loan.

If one were to look historically at market prices during a crisis of financial assets and compared the implied loss with the actual future performance of the same asset class, would the market likely over or under estimate the severity of loss? I understand you cut your number in half as a schwag at conservatism/realism, but I would be curious to know the true relationship in a historical context. The Option ARMs are held in portfolio (for investment as opposed to for sale) so are not marked to market. Only actual losses in excess of allowances already booked will cause a hit to earnings.

It may be useful to note that 96.5% of the Option ARMs had 80% LTV or less at June 30 (10Q page 44). 3.1% had LTV between 80-90%, and 0.4% greater than 90% LTV. A very drastic economic downturn would have to occur for those loans at 80% of collateral value to experience significant losses, even assuming their are some over-valued numbers in California, Florida and Nevada properties. There are $1.6bn of loans with LTV between and 80-90% and $190mm with LTV greater than 90%. These are very large numbers and areas for concern, just not the $9bn or even $4bn number that you tossed out. This approach probably makes more sense in trying to estimate potential losses than attempting to make a connection between market value and losses realized in WaMu's loan book.

Your short is likely the right bet as the mortgage situation will get worse before it gets better. There are too many resets on the horizon to believe otherwise, but the order of magnitude, at least in WaMu's Option ARMs, is probably lower than your estimate. I would caution you to remember that WaMu's dividend yield is already north of 6%, and it will provide a floor to the stock at some level. Additionally, WaMu is unlikely to trade below book value unless the wheels completely come off the bus, which would imply $27 a share.

2007 Sep 12 11:30 AM

[WAMU Victim...:]

Washington Mutual Bank (under their WAMU, FA pseudonym) paid taxes twice on the wrong property mortgaged to another bank. (I have copies of the checks with the wrong tax ID they disclosed in Court) They refused to accept any payments until I paid for WAMU's mistake. When I notified WAMU of their error asked them to correct it pursuant to RESPA 12 USC 2605 and resume accepting my mortgage payments they dug in their heels and pushed for foreclosure instead of fixing their mistake. sued them in Court and they still refused to correct their errors. This case was dismissed on a technicality, but the judge made them pay their own legal fees. WAMU consistently violates 12 USC § 2605 RESPA Servicing of mortgage loans and administration of escrow accounts.
This has gone on for years. WAMU does not follow the terms set forth in the Deed of Trust. WAMU's corporate policy is to push the edge of legality until they lose in Court. For Kerry Killinger, it is just a numbers game as to how much money they can take vs. how many people are willing to spend the cash to fight them on their crooked practises. WAMU has huge servicing issues and their people are not smart enough to understand the law, much less comply. Kerry Killinger is gambling that you won't notice. WAMU,the ENRON of Mortgage Banking.

2007 Sep 25 11:47 AM