WaMu's Disclosure: Not Enough For This Investor

Long time readers know I have been a holder of Washington Mutual (WM) bonds since early in the subprime debacle. I recently sold my position. Those who have followed WaMu bonds know that I've lost on that trade... badly.

When I put the position on, I did a deep dive into WaMu's mortgage and mortgage servicing portfolio. It looked like there could be some big losses there, but after having assumed that 25% of their subprime portfolio was foreclosed upon and still finding their capital was adequate, I was a buyer.

In the interim, WaMu has made even more disclosures about their mortgage portfolio, none of which altered my view that their capital would wind up being adequate. Of course, WaMu wasn't making those disclosures for their health. They were making them because management believed more communication with investors would improve the market's outlook for the company. If you are a company being unfairly punished by contagion, increasing disclosure is the right play. The market is afraid of the unknown, so you're better off leaving as little unknown as possible.

However, there were some key things that WaMu did not disclose, chief among them is what percentage of their held-for-investment [HFI] portfolio was stated documentation loans. In fact, I personally asked CEO Kerry Killinger to disclose this statistic at WaMu's Investor Day on November 7, and he refused.

So what we have is a company making many disclosures, and yet holding something important back. One has to assume that what they've held back would reflect badly on the company.

And then there is the matter of New York Attorney General Andrew Cuomo's allegations. In short, he alleges that WaMu pressured eAppraiseIT to inflate home appraisals. If New York prevails, it's possible that investors in WaMu-originated MBS could "put back" their securities. In essence, force WaMu to buy back their MBS at par. Given that non-Agency MBS issued since 2006 are pretty much universally under water, that would be quite expensive for WaMu. However, I think there is a long way to go between what's been alleged and proving fraud at the securitization level. Not the least of which is WaMu's attempt to put all legal risk on the appraiser for accurate appraisals. Plus it would appear that WaMu has enough capital to handle repurchasing the bonds, and therefore almost any result wouldn't cause bankruptcy.

But regardless, I have a deeper problem with what New York's allegations say about WaMu's practices. Even if it were to be found that WaMu management never encouraged any kind of favoritism among appraisers, at least not in any overt way that could be proven legally, my concerns run deeper.

As an investor, I rely on companies to report their financial condition accurately and honestly. Sure, I know they are going to spin things and may at times be overly optimistic about their prospects. But the hard numbers need to be reported accurately and honestly. If not, then all bets are off. Once a company starts down the dark path of cheating on their financials, forever will that dominate their destiny.

Was WaMu's overly aggressive appraisal practices an isolated instance? Were their lending practices otherwise completely forthright? Or are inflated appraisals just one example of pervasive dishonest practices?

And you can see where the dark path leads. If WaMu was willing to look the other way on appraisals, what about stated income loans? Obviously that is an area where dishonest lenders have room to maneuver.

Now you might argue that WaMu had no motivation to poorly underwrite loans they are holding for their own portfolio. Perhaps, but during the 2nd and 3rd quarter, WaMu wound up moving a large number of loans from "for sale" to "held for investment." This means that there were a bunch of loans they wanted to sell, but couldn't. Besides, when the housing market was hot, a little fudging here and there to get loans approved didn't look like it would ever hurt anyone.

Unfortunately, once you build a culture without integrity, you might wind up hiring loan officers willing to make all kinds of misrepresentations to close loans. So even if one figures that WaMu management would have intended to underwrite good loans for their own investment, that might not be what they wound up getting.

There are plenty of other areas where there is room to misrepresent reality to investors. Might WaMu be making loan mods to borrowers bound to default? Loan mods are fine and good for borrowers who have a good chance of remaining current after the mod. Borrowers who have no hope need to be foreclosed upon. But maybe WaMu wants to make their loan performance stats look better than they really are.

Now you might think I'm extrapolating a lot of dishonesty from one accusation. But of course, once I'm sure a culture without integrity has infected a company, it's too late. See Enron or Refco or Arthur Andersen.

Ethically, I can't invest in a credit unless I can estimate both the risks and rewards of the investment. If I'm going to suffer a default, I need to be able to look my clients in the eye and say I did all the analysis I could, and I was just wrong. Once there is evidence of fraud, all ability to estimate risks is gone. And if I ignored evidence of fraud, and subsequently there was a default, how could I look my clients in the eye and say I did all I could?

Comments

[Chancer:]

The failure of the financial institutions to "come clean" with investors and opting for a long drawn out "drip, drip, drip" is prolonging the pain and hurting the economy.
I favor a new FASB requirement that limits the ability of public companies to value their investments absent an objective standard. They should be required to write down 50% on the first pass when there is no independent objective. After such a sizeable "hit", further write downs of 10% to 20% would have only minor consequences.

2007 Nov 20 12:13 PM

[Praiser:]

What you dont know is that WAMU had a big layoff of all their residential appraisers. eAppraiseIT took on all of these people and made some of them regional appraisal managers in charge of residential appraisers in designed regions around the country. Those regional managers some of which obtained their appraisal license from WAMu worked hand in hand with WAMU loan originators to twist the arms of decent appraisers. When that wasnt enough, WAMu insisted upon eAppraiseIT using only those appraisers on a desired list. Not the original approved list to which most decent appraisers are named. This list was and is a "Buddy List" of appraisers who will make a WAMU deal work at any cost. Whehn the NY Attorney General started his investigation into eAppraisIT, they placed a hot-line email link on their site for appraisers to blow the whistle on appraisal fraud. I in fact spoke directly to Anthony Merlo who was the President of eAppraiseIT at that time about a reginal manager twsiting my arm to change values so the deal would work for WAMU. Mr Merlo never got back to me like he said he would and in turn I was removed from the eAppraiseIT list of appraisers. The regional manager is still in place, and I contand this guy is up to his neck in appraisal fraud. Bank of America is no different, and in fact has an office inside the eAppraieIT office in Danbury MA. eAppraiseIT is only an appraisal management firm, and they are hurting appraisers nationwide. They rape over half the opriginal appraisal fee, and First American is such a large company -- if you dont work for them you have no business. They have a huge sales staff who went out and obtained all the work from all the large banks. Its just another middle-man in the process, and their biggest claim to fame was the idea that they some how could be in the forefront of stopping mortgage fraud by managing all appraisers. This needs to stop. I contend regional databanks of appraisers needs to set up, and from thosew databanks -- appraisal assignments need to originate. The reason you will never see this is because banks have all the money and all the power in Washington DC.

2007 Nov 20 02:08 PM

[Accrued Int...:]

Thanks to all that commented. I guess the real question is whether WaMu was any different than the whole industry, and whether NY can elevate merely choosing an appraiser to a criminal act. We may all agree that having favored appraisers stinks to high hell, but getting an actual conviction is something else. We'll see.

2007 Nov 22 06:15 PM

[Accrued Int...:]

Thanks to all that commented. I guess the real question is whether WaMu was any different than the whole industry, and whether NY can elevate merely choosing an appraiser to a criminal act. We may all agree that having favored appraisers stinks to high hell, but getting an actual conviction is something else. We'll see.

2007 Nov 22 06:17 PM

[MD_Big:]

As an appraiser, I can confirm the 'insiders network' that eAppraiseIt supported, to the exclusion of those of us on the outside. For real estate, until we uncouple those with commission and bonuses from the appraisers (who must be impartial, and work for a flat fee only), there will continue to be pressure and repurcussions (less explicit as new laws are put in place, but pressure and consequences nonetheless).

As the previous writer noted, some kind of 'blind draw' system is required to allow independent appraisers to remain independent and stay solvent despite sometimes having to be the messenger who must 'deliver the bad news'.

2007 Nov 20 08:20 PM

[HurtByAmeri...:]

I like the way you wrote that, Very Good Job! I would not bet 1 cent on WAMU. :)

2007 Nov 22 09:56 AM