Is WaMu the Next Bear Stearns?

News that Texas Pacific Group is preparing to infuse Washington Mutual (NYSE:WM) with $2 billion in new capital, part of a reported $7 billion raise from existing institutional holders, confirms our view, expressed by IRA CEO Dennis Santiago in a press briefing Monday, that the realignment of bank capital structures is progressing apace. Our main worry, however, is that the shrinkage of bank credit availability that seems to be part of this process may worsen the economic environment and push the bottom in valuations for financials further and further away.

Says Santiago:

It's one thing to avoid additional exposure. It's quite another to run your economic gas tank dry. The sharp drop in consumer borrowing reported by the Fed Monday adds to our worry beads. The fundamentals clearly say there's a floor to this crisis. The danger is overshooting it.

Before we explore the WM/TPG transaction, we relate a few reader comments about last week's profile of Freemont General (NYSE:FMT), the troubled CA industrial loan company ("Fremont General Corp: Welcome to the Subprime Dead Pool").

James at the Office of Thrift Supervision writes that "FMT's primary regulator was the FDIC. FMT did not have a federal thrift charter and OTS had no regulatory role with FMT. For the record OTS has a very good record with respect to dealing proactively with subprime lending risks over the last few years."

Point taken and copy corrected.

Of note, a number of our friends at OTS have been in touch recently to talk about creating advanced analytics metrics to support safety and soundness. Indeed, OTS has some of the best interest rate and credit analytics in the regulatory community. We just wish OTS would shed the belief that thrifts are "special" and publicly release all of the data provided in the Thrift Financial Reports.

Specifically, the OTS refuses to release specific loan category and aggregate loan maturity data for thrifts, ostensibly for competitive reasons, and this even though such data is publicly available for all commercial banks! By withholding this data from analysts, the OTS makes it impossible to calculate WAMs of thrifts like WM for Basel II benchmarks, including the profiles in The IRA Bank Monitor.

Memo to James, Tom, Michael, et al at OTS: Surrender the loan maturity data!

Bob Feinberg writes that "The reason why the FDIC came down on FMT is some combination of the fact that banks want to get rid of ILCs any way they can, and the FDIC wants to maintain some vestige of credibility as a regulator. Applying Prompt Corrective Action to a bank that's not a member of 'the club' is a safe way to do that. It shows how PCA would work if the regulators actually did it, but the chances of regulators regulating banks are about the same as the chances that a kangaroo will play the tuba."

While regulators may be shy about applying PCA to mainstream banking institutions, especially banks with big lobbyists and PAC war chests, the folks at TPG certainly seem to be unafraid of "prompt" deal doing, even though banks like WM are, in our view, just beginning to enter the most serious period of credit losses. Could WM be the next Bear, Stearns (NYSE:BSC)?

Is TPG's Dave Bonderman, a former WM director, trying to come to the aid of the besieged WM management team before the widely anticipated April 15 AGM? Reading through the decidedly defensive management presentation in the WM proxy, it strikes us that this may be a particularly difficult meeting for WM Chairman and CEO Kerry Killinger. We hear that one of the heavy hitters of the financial crisis management world just canceled all engagements next week to be in Seattle, equipped with requisite fire control apparatus.

The reasons for the growing crisis at WM are self evident, at least to us. At the end of 2007, WM's lead unit reported ROA of just 0.08% and ROE of 1.04%, significantly below peer and even below ING Bank FSB, the perennial laggard among large thrifts. For the same period, WM reported 94bp of loan charge offs, 1.7 standard deviations above its peer group average of 32bp.

A big reason for the divergence from the peers is the 1,000bp or 10% of defaults thrown off by the subprime credit card business acquired by WM in 2005 when it purchased Providian National Bank. Click here to see a chart of the aggregate loan default activity for WM and its asset peers going back to 1989. Note the sharp departure by WM from peer loan default experience since the close of the Providian transaction.

Eric Dash of the New York Times reported Monday that WM expects "a sharp increase in loan charge offs" in its credit card business. So do we. In fact, just ponder where WM's credit card business will be at the end of 2008 given current default experience and the trend since 2005, a period when bank default rates were at historic lows. In September of 2005, just before the acquisition by WM closed, Providian National Bank reported only 767bp of charge offs, suggesting that the business has deteriorated significantly since coming under WM management. More, the Loss Given Default for Providian in Q3 2005 was just 84%, quite respectable for a subprime lender, vs. 95% at year-end 2007 under WM management just two years later. Yuk!

Q: Do you think that Mr. Bonderman, the expert TPG deal team, or the other investors participating in the $7 billion capital raise reviewed the historical experience for the Providian business as part of their deal diligence? Do you think any of them know that WM's small credit card portfolio has one of the highest default rates in the industry? By comparison, GE Money Bank, the subprime unit of General Electric (NYSE:GE), reported 482bp of default in 2007 or half that of WM's rancid credit card book.

The Economic Capital model in The IRA Bank Monitor projects a Maximum Probable Loss of 171bp for WM's aggregate loan book in 2008, but as with most banks, this estimate reflects low default rates over the past several years. We expect the MPL for WM to rise as 2008 progresses. More ominous, while WM's EC to Tier One Risk Based Capital ratio calculated by The IRA Bank Monitor comes in at just 0.48:1, on its face an indicator of low risk, this result is a significant increase vs. 2006, and suggests that the WM risk profile is deteriorating.

Nearly 50% of the WM EC factor as of 2007 is driven by the bank's investment portfolio. In 2006, the EC factor for WM's securities portfolio was actually negative, but now it accounts for more than $4 billion of the $10.9 billion in Economic Capital calculated by The IRA Bank Monitor. The trend in EC illustrated by The IRA Bank Monitor simulation is as important as the absolute amount calculated. The shift in visible risk factors may suggest some movement in underlying, invisible factors. Thus we wonder: why did the folks at TPG decide to pull the trigger now?

We fear that the answer may be that, like Joseph Lewis' investment in BSC at the end of 2007, veteran deal makers like TPG are suffering from near-sightedness, a sort of risk myopia that comes from spending too many years operating in the bubble. Smart, self-confident bankers of a certain vintage just can't seem to accept that there may be no near-term bounce in 2008-2009. Go back and re-read our interview with Josh Rosner this week.

As we have noted in the past, the big weakness of the WM business model is dependence upon non-core funding to support its $370 billion in lead bank assets. WM's ratio of core deposits to total assets slipped nearly 10 points to 57% at the end of December vs. 67% a year ago. Like BSC, WM seems to be suffering from slow erosion on confidence among institutional depositors. Unlike, BCS, however, WM has access to funding from the Federal Home Loan Banks. Advances are now equal to 20% of total assets vs. 12% a year ago.

Despite our critical analysis, we'd be happy if we could tell you that WM is going to be fine and that the end of the meltdown in financials is clearly in sight. But frankly, each time we look at the bank loan default data and the considerable distance still left to go before we arrive at 10-year average levels, the more convinced we are that the bottom of the concrete containment building is still a long, long way off. Pass the iodine tabs please.

Disclosure: none

Comments

[kurt walter:]

WM management is horrible.

2008 Apr 09 05:01 PM

[pochovilla:]

Rumor has it that a male kangaroo bought a tuba on Ebay with the Providian Credit Card. Says he won't pay a nickel until he learns to play the thing.

2008 Apr 09 10:08 PM

[helplessobs...:]

After the WM bailout the FHLB will have to be put on credit watch. Oh! I forgot they have a lot of Countrywide Financial paper to shore up their balance sheet.

2008 Apr 11 01:32 AM

[UpNAmpd:]

WaMu is still advertising no money down, no/low document mortgages in my area (Bayside, NY). Doesn't leave much hope for those who would've thought they'd have learned by now....

2008 Apr 11 07:49 AM

[who noze:]

wa mu is to be commended on their FEEE atm machine i tried it and it came up $2.00 please w// an opt to cancel i checked to see if i had the ight machine there was a big sign saying FEEw// an arrowpointing to the machine iwas using incidently i bght a cd w// an option of to increase the cd amount any tyme w// the same terms i went in about 2 wks later w// more money they told me tp come back next mo. UND WHOM DO U TRUST THESE DAYS

2008 Apr 13 09:12 AM