Extrapolating Downey Financial's Option ARM Problems To WaMu

Last time I did an extrapolation like this, taking a charge at Wells Fargo (WFC) and applying it to what might happen at Washington Mutual (WM), I faced a near-mutiny among readers, especially those who thought WaMu had bottomed. Now that Washington Mutual has confirmed the data, let’s do this little exercise again, this time extrapolating what Downey Financial (DSL) disclosed on Friday to WaMu and others.

First, what Downey said: That non-performing loans (mostly among its loans held for investment) increased by $105.4 million, or 27% from a month earlier. That’s up from a 20% increase the month before and more than 15% the month before that. Most of these are Option ARMs.

Now, the extrapolation: If Downey is boosting non-performing loans (mostly Option ARMs) by such a large amount, on a rapidly rising rate of increase — and if Downey was considered among the best underwriters — other lenders with high Option ARM exposure become vulnerable. At WaMu, for example, 27% (the biggest chunk behind home-equity lines) of loans held for investment were Option ARMs. Other big Option ARM lenders include Wachovia Bank (WB), FirstFed Financial (FED), BankUnited Financial (BKUNA) and Guaranty Financial Group, which is being spun off from Temple-Inland. (It’s unclear whether the recent rise in WaMu’s expected loan losses for next year, to as much as nearly $8 billion, includes an increase in non-performing loans, relatively speaking, that Downey has disclosed.)

Here’s how a bear on these stocks views it — the same guy who previously brought us the original Wells Fargo/Washington Mutual extrapolation:

DSL was supposed to be the best underwriter. That’s why I owned it at one point. They were the lowest loan-to-value lender, which is interesting considering the data we are seeing now. The problem is that lenders did a horrible job tracking if there was a second lien behind them. Borrowers have so much leverage (first lien + second) and house prices are falling so fast, that they are just deciding to walk away from the home. This is something the Paulsen plan does not address. It’s not a question of being able to make the next payment…s looking at the value of your home and thinking "Wow, I am going to be under water for a long time…; better to get out now before the next guy does’." Classic prisoner'’s dilemma. The only way I think we can get out of this mess is by cramming down the mortgage. A very scary thing for the banks but the reality is there is too much leverage in US housing and prices are falling very quickly

Meanwhile, a buddy who develops custom homes in Steamboat Springs, Colo., says prices continue to rise there with second-home buyers continuing to stream in. Where’s the money coming from? “Baby boomers…a transference of wealth as they inherit money.”

The beat goes on…

Comments

[WAKEUP]

The baby boomers who inherit money are arriving at the party, i.e., buying those second homes, just in time to be arrested with the rest of the drunks.