Wachovia: Lower Rates Are Working

| About: Wells Fargo (WFC)

Wachovia's (NASDAQ:WB) Chief Risk Officer, Donald Truslow, said Wednesday that mortgages still contribute “significant profits” and will continue to, even if losses from bad loans quadruple from current levels. Lower interest rates are reducing payment increases on ARM's, which will reduce delinquencies and charge offs, Truslow said. He expects losses in the portfolio to rise this year but he expects lower charges than industry peers, he said.

Much of the current doubts about the bank stem from its Golden West acquisition. Golden West’s principle business was making “option adjustable rate mortgages” that let borrowers make lower mortgage payments from month to month, deferring interest payments until future years. Two-thirds of Wachovia’s Option ARM borrowers paid the least amount possible in December, little changed from past practice, Truslow said.

Wachovia said Option ARM loans that were more than 90 days late as of Dec. 31 rose to $ 2. 8 billion from $ 675 million a year earlier. The sum was about 2. 3 percent of the $120 billion portfolio. Even at these levels, Golden West is producing significant operating income for the bank.

How significant can this be? In the recent earnings call Truslow said:

Most of the builds in the allowance for the Pick-a-Pay product is for the loans in those markets (markets that experienced the most rapid home price appreciation), where the estimated current loan to values have risen or are expected to rise above 95%, were originated over the last three years and are exhibiting a higher likelihood of the fall. So, when you carve out this pool of loans that constitutes about $8 billion of the $120 billion Pick-a-Pay portfolio. After the build in the allowance balances, the resulting reserves loosely allocated for the Pick-a-Pay portfolio total about 56 basis points or a little more than three times the largest historical loss rate that Ken mentioned earlier in the portfolio.

What did Ken (CEO Kent Thompson) say that Truslow mentioned?

...we have said since the Golden West acquisition, we looked at the Golden West experience of the early 1990s. At that time, California had 10% unemployment and 20% house price depreciation, and charge-offs peaked in 1994 at 20 basis points. Based on our portfolio today, that 20-basis point peak would translate to about $250 million in charge-offs. Our expectations for this year are that charge-offs will exceed that historical peak. But even if charge-offs reach three or four times that peak, our Pick-a-Pay portfolio will generate very meaningful bottom-line profits in 2008.

Essentially, even if the current housing market is far worse than 1990 and it very well may be, the Golden West deal will still produce significant profits and let's look at it, the loans at risk constitute 6.6% of a total portfolio. Investors seem to think this amount is far greater. With more rate cuts coming from the Fed, "problem" loans will diminish and others will not materialize.

Disclosure :Long WB.