WaMu Acts Tough, but Are There Heavier Losses Around the Corner?

Apparently Washington Mutual (WM) is not as well capitalized as we were lead to believe. As recently as November 7, Washington Mutual management was intimating that it thought its capital was adequate. Now it is saying it needs to raise $2.5 billion in new capital through a convertible preferred issue, and will cut its dividend by 75%. The combination of dividend cut and preferred offering will increase capital by $3.9 billion.

Let's put that into perspective. WaMu had $20.4 billion in Tier 1 capital, according to data supplied at its Investor Day on November 7. Increasing capital by $3.9 billion would be 19% of its total Tier 1 capital. Again, as of November 7, WaMu claimed (coincidence?) to be about $3.9 billion over the "Well Capitalized Minimum" dictated by banking regulations. I think we must assume that WaMu is concerned that it will fall below this minimum without additional capital.

Why do I make this assumption? Well, maaaaaaaaaybe WaMu is just being proactive. Maybe it doesn't expect losses large enough to push its Tier 1 capital below regulatory levels, but it just wants to be safe. Maybe. But I doubt it. If that's all it was, why such drastic measures? Why raise $2.5 billion in convertible preferreds? Why cut the dividend 75%? Wouldn't you think if it just wanted to be safe, it'd just simply do the $500 million preferred and keep the dividend as is?

And what kind of losses would it take for WaMu to lose $3.9 billion in capital? Well, I estimated that in a scenario where mortgage defaults tripled their previous highs (which meant 27% for subprime and 4.5% for prime) and loss severity was consistent with a 20% decline in home prices, that WaMu would suffer about $4.8 billion in losses. Given that it had $1.3 billion in loss reserve, that left WaMu with only $3.5 billion in losses. Since it had a $3.9 billion cushion, it would still be over its "Well Capitalized Minimum." And of course, if you assume all those losses would occur over a multi-year period, the hit on capital would be even easier to withstand.

I think WaMu expects losses beyond its current capital cushion, and wants to raise enough capital to survive.

Here's a scary thought. When I estimated $4.8 billion in losses, I assumed a very extreme scenario. WaMu is acting like the extreme scenario is coming to fruition right now. But in thinking about it, does WaMu management actually expect 27% default rate on subprime in 2008? Probably not. I suspect, although I have no hard basis for my suspicion, that WaMu management is expecting losses in other channels than just subprime.

Likely suspects include:

• WaMu's $26 billion credit card portfolio. Perhaps many of the same borrowers have WaMu credit cards and WaMu home loans. Diversification?
• Stated income loans. WaMu has been coy about how much of its "prime" portfolio is stated income. I contend that stated income loans made to borrowers with high FICOs are often investment properties in disguise. There just aren't many people in the world who have a legitimate need for a stated income loan. Most of the people who got these kinds of loans, regardless of their FICO, did so because they wanted to hide something.
• Option-ARMs. These loans make up 53% of WaMu's "prime" loan portfolio. And granted, all these borrowers supposedly had high FICOs, but FICO isn't the whole story. What if these borrowers were largely first-time home buyers? Perhaps former renters looking to get into the high-flying west coast housing market. What if they intended to be a bit house poor, assuming that the home price appreciation would be worth short-term pain?

Obviously these are all "what if's" and I have no particular reason to believe WaMu's portfolio is worse than average. No reason other than this extreme capital raising plan.

WaMu is also likely to test whether a large bank can operate with a below-investment grade bond rating. Many investors, myself included, always assumed that banks were likely to do whatever it took to maintain a high credit rating, because cost of funds is so important to their basic business model. While WaMu does not currently have a junk rating, the cost of any new debt will be at junk-type levels. If WaMu can operate while paying junk-type levels on its debt, that will change many perceptions about banks and the value of a rating.

On the other hand, the onerous cost of debt will clearly be yet another challenge to WaMu's recovery.

Disclosure: No positions in WaMu.

Comments

[Pj568]

WaMu issues 7.75% convertible preferred while Citi pays 11% with theirs. The conversion price premiums seem similar. Why the big difference? Is WaMu in better shape than Citi? That's a terrifying thought!

[danga]

The mortgage I took out 2 years ago to buy my home was stated income. And I did have something to hide- very little income over the previous two years. But I also had significant assets and high FICO scores. I never missed a payment. My income picture has improved and I recently refinanced for 15 years fixed at 5.625%- fully documented. Is it possible that many stated income loans were made to individuals in similar circumstances( very good credit history, documented assets, but low recent income)?

[Randy Kirk]

I noted WalMu funds approximately 2/3 of its assets from deposits (mainly CD's) and 1/3 from loans -- this 1/3 from loans may be causing some concern. WalMu has a level of control over its deposit source of funds, but the loan portion, generally there will be a lot of covenants in there that WalMu may be close to hitting.

Also noted, WalMu is highly levered like most financial institutions at 14.3x assets to equity (or 22.8x assets to net tangible equity), at the end of 3Q07. With this sort of leverage, it does not take much movement in the price of assets to significantly impact equity.