Four Banks' Pragmatic Mortgage Resolution

This is a story of four “Ws”: Wachovia Bank (WB), Washington Mutual (WM), Wells Fargo (WFC) and Wilmington Trust (WL). We have two dogs and two sweethearts, with the dogs trying to convince us that they too will eventually become sweethearts. The financial press only likes to faun over Wells Fargo, but I like Wilmington Trust better.

Wilmington Trust has a long history in the wealth management business, and its real estate troubles are limited to a few troubled land and developer loans. Wilmington Trust’s volatility is much lower than the rest of the group. A smaller version of Wilmington Trust is Bryn Mawr Trust (BMTC). Both banks cater to a very wealthy clientele.

The message I got from listening to the conference calls of all four was that they are in a much better position to resolve and prevent mortgage delinquencies than either investment banks or investors in MBS and CDO trusts. The banks own and service most of mortgages on their balance sheets directly – very few are in the form of securities. This allows the banks much more flexibility than their counterparts at Citigroup (C), Lehman Brothers (LEH) and Merrill Lynch (MER). The investment banks cannot force the trusts into providing pragmatic mortgage resolutions. There are too many conflicting stakeholders.

While all four banks claim that they hold no subprime, most of them have experimented in adjustable rates and home equity loans and lines. Wachovia and WaMu have large option payment ARM positions, incurring negative amortization. WaMu claims only 20% of its California mortgages are for properties in the troubled central valley. All tried to convince us that they were safer than we think.

So how are the banks using their flexibility to their advantage? Wachovia has eliminated prepayment penalties on the Golden West Pick-A-Pay mortgages, and is encouraging borrowers to refinance into GSE, FHA, and FMLB compliant mortgages. Wachovia then intends to sell these new marketable mortgages, clearing its book. Wells Fargo will freeze the adjustable rates on its home equity loans to the current rate or less. WaMu was the vaguest in disclosing how it will become more pragmatic, simply saying it would be. All four are reducing uncommitted home equity lines.

At current prices, I believe Wilmington Trust is the most conservative play and WaMu is the best speculation. Given the run in Wachovia and Wells Fargo, wait for a pull back. I do not think there’s an IndyMac in this group, but be cautious.

Disclosures: Author is long C, WB, WFC, WL and WM.

Comments

[1worldcurrency:]

If wfc freezes heloc rates, what happens when rates rise to prop up the dollar?

2008 Jul 24 05:42 AM

[Russ Krull:]

I didn't see anything about a rate freeze in the WFC earnings statement. They did say that at current short term rates, nearly all their ARMs will be resetting to the same or lower rates over the rest of the year.

2008 Jul 24 07:00 AM

[Jimmy Lathrop:]

I thought this was an extremely well-written article. It frankly dealt with the weakness in the sector and suggested how these four institutions may fare better in the long run. I especially enjoyed this extremely diplomatic sentence.

"While all four banks claim that they hold no subprime, most of them have experimented in adjustable rates and home equity loans and lines."

I think the word "experimented" encapsulates the problem in the sector as a whole. Some college kids "experiment" with drugs. Most turned out okay if it was just an experiment. However, crack and methamphetamine smokers have said that the addiction was immediate, with no experimentation phase, and the habit was hard to break, causing much distress, sometimes ending in death.

So what's the toxicity level of these suspect loans? The only way to determine the level of default or near default loans would be to increase communication with every customer of their loan products as their fortunes are intertwined.

Banks can no longer wait for loans to be 30 or 60 days late before they act to assist a homeowner, otherwise, they risk having their balanced sheet impaired through these nonperforming loans, death from a thousand needles. The advent of electronic loan processing made underwriting loans so impersonal, in order to forestall rising defaults, loss mitigation and customer relations will need to "get to know the customer all over again" so a realistic picture of a lending portfolio can be made. Only when banks truly know which loans are genuine and which are fraudulent or in need of renegotiation will uncertainty lift from the sector and clarity can be achieved.

The downside to this is that the costs of servicing these loans are labor intensive to make up for the lack of due diligence at underwriting. That will lower profits. But it will bring underwriters and borrowers closer together, restoring a traditional banking relationship with its risks and returns. If every bank could cultivate that relationship we wouldn't need the GSCs. But that would be the rational thing to do and as irrational people, it will never happen.

2008 Jul 24 09:01 AM