WaMu: Speculative Value Play

At Friday's closing price of 4.05, Washington Mutual (WM) is attractive as a speculative value play, based on a price to tangible book ratio of .32 and a Price to Normalized Earnings of 1.8.  For many years WaMu was popular with institutional investors and traded in a range of 35-45 per share before plunging to under 4 this year. The signs of trouble were there – the mortgage operation experienced difficulties starting in 2004, when the housing bubble was in full bloom, and promised corrective actions never resulted in expense reductions or meaningful improvements in the troubled segment.

Confronted with an impending capital crisis, WM raised capital in April, at the expense of considerable dilution to existing shareholders, from  private equity firm TPG.  Their buy in occurred at 8.75, so at today's price the small retail investor can outwit the smart money, paying less than half of what TPG paid.  Admittedly smart money has had trouble in financials recently, witness Warburg Pincus paying 31 per share for MBIA (MBI).  However, it is always good to pay less than the smart money paid. Also, private equity normally does due diligence before getting involved, so the investor who comes in later has the implied value of an impartial outside review. 

Normalized Earnings  - In the transcript of the 2^nd quarter conference call, Kerry Killinger states that WaMu continues to earn 6 billion per year pretax and pre-provision; that is, before making provision for expected credit losses.  It is reasonably likely that WaMu can avoid raising further dilutive capital, so using the 6 billion figure, reducing it for taxes at 35%, and dividing by current shares outstanding I develop a normalized earnings per share of 2.29.  If and when that becomes a reality, a P/E of 12 gives a per share price of 27.

Tangible Book Value – on this basis, I come up with a target price of 25, based on a historical average multiple of 2.3 X 11.03 tangible book value per share.  Again from the conference call, management expects to take charge-offs of an additional 17 billion, of which 8.5 has been provisioned. Noting that these are expected future losses which have not yet materialized, I would offset them with the future 6 billion per year  pretax pre-provision earnings and look for the company to operate at break-even over the next year and a half.  Thereafter, WaMu should be able to earn 2.29 per year.

Short term catalysts - I owned or controlled shares of WM on and off from 2004 through 2007, with modest profits.  However, the company from time to time would attract rumors about possible buyouts –  it was a Canadian bank, I forget the name.  When this happened, the shares would rally briefly and then give it back. At today's prices, such rumors could reappear and might develop a factual basis.  In any event, such sudden spikes would make a nice opportunity to take profits while waiting for the turnaround to materialize. Kerry Killinger has not endeared himself to shareholders, based on poor performance.  Should a change of management occur, it would be welcome and might generate a rally, as well as future improved fundamental performance.

Risks to the best case scenario consist of possible loan losses above projections, a liquidity incident in the form of a run on the bank, or a more diffuse set of problems arising from concerns about management – the people who created the current serious difficulties are still in charge.

Option ARMS - the most questionable area of the loan portfolio is the Option ARMs, many of which are in California or other distressed real estate markets.  In the conference call slide presentation, WM demonstrates that they are reducing the amount of loans outstanding and that resets are for the most part years in the future.  LTV at an average 72% is fairly good compared to what I have seen in some of the MBS I have looked at. As a soft point, they do have 14% Option ARMs with LTV greater than 90%.  FICO scores are an average 683, troublesome if coupled with high LTV, in my opinion.  Without displaying undue enthusiasm, I think the Option ARMs are one way to muddle through – just put off taking the losses until the situation improves.

Capital Adequacy and Liquidity - As of 6/30, WaMu had a strong capital position: from a regulatory point of view their Tier 1 risk-based ration stood at 8.44%, 244 basis points above well-capitalized.  Readily available liquidity stood at 40 billion.  After the Indy Mac incident there is always the possibility of a run on the bank, but such runs will be minor annoyances for well-capitalized banks. 

Hypothetical Capital Raise – By way of dealing with the what ifs, here is my math on a hypothetical capital raise of another 7 billion, the same amount as was raised in April.  I assumed the new shares would cost 3.18, reducing today's 4 price similar to the first raise, when new shares sold for 8.75 vs. the 11 price they were trading at in April.  Figures are in millions, except per share amounts and ratios:

Beginning tangible book value	18,802
Capital to be raised	7,000
Ending tangible book value	25,802
Beginning shares outstanding	1,705
New share price (4 X 8.75/11)	3.18
New shares to be issued	2,200
New shares outstanding	3,905
New tangible book value per share	6.61
Average price/tangible book value per share	2.3
Share price target after hypothetical raise	15.20

Conclusion - WaMu has been very volatile, and I have been trading in and out: as of today  I am long a small amount of stock and also some September 5 calls.  I am positive on the long term potential here, regard risks as manageable, and plan to accumulate a position over time while monitoring earnings as they come  out.  It will be important to see if future developments support the idea that WM can muddle through on the Option ARMs.  In the meantime, a small position in WaMu is a good way to play for a recovery in financials.

Disclosure: Long WM shares and options.

Comments

[H-Bomb]

Just to get things started:

Woe is me.
The sky is falling.
This is the worst catastrophe since, well, like ever.
Buy gold, food and ammunition.

I think that about covers the what will be said here moments from now, but, hopefully, with far more wit and brevity.

[H-Bomb]

Ugh. That superfluous comma has undone me entirely.

[Greg Weston]

1/3 of book is a great deal until you realize that WM has not written down the value of its performing loans, which are going sour at breakneck speed. Check out my articles on other banks with OA portfolios for more details, much of this applies to WM too.

[22thoroughbred]

I agree with the author, not every bank will be insolvent, as the stocks seem to predict. I have started building a portfolio of about 8 banks that have dropped substantially, one in particular went from $4, where I bought about 6 weeks ago to $16 (FED) I don't expect WM to do the same, but if you build a posn. over time there will be some fantastic gains to be made, will WM survive, maybe / maybe not, but don't let the forecasters on TV scare you, they all blow the same way, and when WM hits $10, they will all say what a good buy it is and how strong the stock is. Diversify and research.

[dcxavier]

The most questionable area of the loan portfolio is the HELOC/seconds. They already write off more on the seconds than they do on all the primary loans, which include Option ARM's. Seconds take 100% of the loss before the primary loan loses one cent.

WM hasn't written down the value of the non-performing loans either. Banks have great flexibility about when to write down the value of the loans. There are numerous anecdotal reports about WaMu refusing short sales, I believe because it would force them to recognize a loss. By refusing an offer, they can keep the non performing loan at full value on the books.

Clueless KKK estimates that WM will lose $19B on mortgages, note that does not include upcoming billions in credit card losses which started last quarter. Compare delinquency rates and loss provisions with Capital One to see what I mean. So why don't they reserve the $19B? It would put the bank below minimum Tier 1 capital requirements if they did. One good puff of wind would topple this house of cards.

[js_mcknz]

lottery tickets are cheaper.

[Manuel Morante]

I believe that wm is a bargain at this price of $4.24 a share they clearly are one of the largest banks is the us. Although they are heavy into loans wm will go up in price towards November and after the elections a significant price increase in the shares should be expected Ive been looking into this stock for a while, done a alot of research, its almost a for sure thing. Buy wamu under $5.00 a share hold on to it you wont regret it!!!!! Trust me.

[22thoroughbred]

"its almost a for sure thing" "trust me" Manny, this is the real world, you're either too young or not intellectual enough to be in the market with talk like that..give a thesis or go back to school.

[Daniel Jacome]

good article, I see where you are going, but 1) you assume 2.3x TBV per share is the right multiple -- is it?Mean reversion doesnt always work, if that is what you are implying.... and 2) at a post raise TBVPS of 6.60, its really trading @ ~ .6x TBV ($4/$6.6), so it doesnt look too cheap after you take into consideration your scenario.

[Just The Facts]

I agree with the previous poster that said fortunes are to be made now in our financials. Diversification is key, as always. Basically, I view it as a bet on whether or not America survives. I've decided to bet a little of my money on America.


As the nation's largest thrift, WM is on my "buy" list. And especially so, at 10 cents on the year-ago dollar. To protect against individual failures, I'm spreading my investment over quite a few financials that are now available for 5 to 10 cents on the dollar. If they ALL fail, then any equity investment is worthless and nothing will matter anyways. But if our financial system recovers and our nation survives, then this is a "once-in-a-lifeti... opportunity for the average investor to get rich. Each surviving business will pay out 3 to 5 times as was lost on each business that went under. Short a total collapse of our entire system, this is a "no brainer" investment!


Of course, I think shorting opportunities still exist today in our financials. They could be played as a "hedge" against financial Armageddon, if one were so inclined. Just look for names trading at MORE than 10 cents on the year-ago dollar. And the higher, the better!


:)

[Just The Facts]

Oh. And I'm hanging onto that gold I have buried in my friend's yard.


Just in case I'm wrong!


;)

[Netoriginator]

Out all of the players in the negative amortized loan (option arm) WAMU was one of the wost for due diligence. Their wholesale divisions threw all sensible decisioning away in favor of a credit score.

When the dust settles (and it has not yet) I think WAMU will be one of the biggest thuds in the sector. The thud being the sound made when it all crashes down around them.

If you take all of their non-performing loans including loans that are 60 days or more behind in payments against their cash reserves you will see that they are in trouble.

[tom2987]

Great Article

Remember that WAMU has gone from the $40's to $4. I mean, come on. All the negatives that the shorties mentioned above have been factored in the price already in spades (and the rumors, exhuberant negitivity, etc) . Add Cramer and his non stop bla bla bla booyahing because he hates WAMUs MGT because they won't kiss his ass,, all the "oh me too" negative articles, etc. it's a miracle WAMU hasn't had a run on it.

This tells me people are starting to ignore the talking heads and realize it is the US's largest savings. There won't be a run on this bank. Too big. Sure, it made some errors, but it's working it's way through them. Go long.

[notsosmart]

dont have the courage even at this price.wait &c for now.

[msgtb]

Buy and financial stock at your own risk. The sky isn's falling just the current financial system of the world. Look and what Dr. Greenspan is saying. I would love to hear input from Mr. Paul Volcker. If he had been in charge of the Federal Reserve this disaster would have not happened.

[tom2987]

Do you even remember Volker? Do you remember the Carter years?Volker has been saying the sky was falling for 30 years now. And he almost did make it fall in the 70's.

Greenspan misses the limelight and basically only gets into the news now by professing gloom and doom.

[notsosmart]

this site is so entertaining.

[Bugs]

WaMu will raise no more capital selling common or preferred shares. TPG has a clause requiring some horrific payment if their shares are diluted by WaMu. I can't remember the details but the author, a former insurance agent and accountant should have known this. His analysis of WaMu selling more shares is very suspect.

[bigmike99]

Where does one get the specific numbers (in dollars) on WaMu's non-performing loans? in the SEC filing? or the "slide show" stats? or from another location?

And even if some of the loans are non-performing, unless they are all HELOC, there is still security for the non performing loans, right? So the loss is not total. Compare this to credit card non-performers where the non-performer has nothing to lose except his credit and the bank has no security. WaMu non-performers would lose their credit, their home, have to move, have trouble renting or buying a new home because of bad credit..... they may pay slowly, but they do have more incentive to pay. And in the meantime WaMu can carry the delay with cheap federal funds at its disposal.

Under these rather nebulous circumstances why would any bank be required to report non-performing loans. it's a "duh" in a regular economy; it's more of "duh" in a down economy. The HELOC 2nd's and the credit card segments are the biggest risk factors

[bigmike99]

255300: No apologies are necessary; inside information is always useful ...and enlightening. Thanks.

[TomArmistead]

TPG and some other investors have 18 months during which they can't sell their shares. These restricted shares, total 273 million, have anti-dilution protection. If applied to my hypothetical scenario it would decrease tangible book value per share by 31 cents. Not horrific, and not permanent.


On Sep 03 05:29 PM Bugs wrote:

> WaMu will raise no more capital selling common or preferred shares.
> TPG has a clause requiring some horrific payment if their shares
> are diluted by WaMu. I can't remember the details but the author,
> a former insurance agent and accountant should have known this. His
> analysis of WaMu selling more shares is very suspect.

[automaticeye]

I have had trouble making picks in this space and getting the timing right. Any negative news causes fast extreme price drops in individual names. You still have to be concerned about Common Stock holders getting washed out to $0. Instead I went long UYG and it has been rewarding so far. Reason: Double return on the entire rising tide, despite some impending bank closings.

[otbricki]

ABK has shown that the right play on a financial can be very rewarding. There is something to be said to putting some money into a selection of beaten-downs.

[Jimmy Lathrop]

The article pitches eight strong innings but the comments from Just the Facts close out the game. I'm sold.

[E Nuff Sed]

People are forgetting the 7 Billion capital raise Wamu in April at $8.75 a share from TPG capital (not exactly naive investors). Also, Charles Leonondis made the point at Bloomberg today that option ARM (or "pick a payment" loans) were made at high interest rates in the first place and now with the cost of capital coming down even further - Wamu capacity to absorb defaults has increased.

The upside at this stage is great - and the shares can easily quadruple - while the downside at $4 is limited. Hence this is the good opportunity to roll the dice.

Another small california bank FED with a large portfolio of negative option ARMs - it recently quadrupled from its low. Wamu may do the same.

[Niel]

The analysis above regarding raising new capital is completely wrong. They would need to reprice the TPG shares at the newly issued share pricie and pay TPG back the difference. In effect any new investor would essentially be assuming TPG's risk for very little gain. Nobody is going to invest their money in this situation to take over someone else's known risk. Which means they would have to give more shares to the new investor. Realistically, WaMu is unable to raise new capital through equity.

[TomArmistead]

TPG and certain other investors own a total of 273 million restricted shares, which they cannot sell for 18 months. If WaMu dilutes them during that time, they are entitled to compensation, which would cost other shareholders 39 cents a share if computed on the difference between 8.75 and 3.18. But that only applies for 18 months: further, if WaMu were trading at the 11 it was at when TPG bought in there would be no dilution and hence no compensation to pay. As noted previously, it is not permanent and not horrific.
On Sep 06 03:28 AM Niel wrote:

> The analysis above regarding raising new capital is completely wrong.
> They would need to reprice the TPG shares at the newly issued share
> pricie and pay TPG back the difference. In effect any new investor
> would essentially be assuming TPG's risk for very little gain. Nobody
> is going to invest their money in this situation to take over someone
> else's known risk. Which means they would have to give more shares
> to the new investor. Realistically, WaMu is unable to raise new capital
> through equity.

[Niel]

I think you may be computing it incorrectly. The hit against the new capital goes directly against the shares issued against the new capital, so to compensate for this risk, they would have to dilute existing shareholders a lot more than $.39 per share to compensate the new investors for their risk, According to your numbers they would only be giving the new investors around %13 percent stake in the company for their $7billion. That is what TPG got at $8.75. New investors are going to get a lot more of the company than %13 for their $7billion at this stage.

You also seem to be forgeting that over $4billion of any raised capital immediately goes out to TPG in the form of cash.

[wamuhomeowner]

This horrible company paid taxes twice on the wrong house and refused to correct their books. Washington Mutual Bank allows non-accountants access to the loan histories and forced us into foreclosure and bankruptcy while refusing to modify the loan or even correct their books. None of their math adds up even to this day and their officer admitted multiple mistakes on their master loan history under oath before the bankruptcy judge.

[Greg Weston]

Ouch!

My comment above about not trusting the numbers of these Option Arm banks was spot on.

Finally, at long last, banking regulators are taking heed. Now the OTS is cracking down on WaMu, and the stock is down 20% on a day most financials are up big.

[Insiderman]

For wamuhomeowner: Where was your attorney in all this?

What about government intervention? Any thoughts about the government letting the largest thrift fail?

[WeeklyTA]

hope you sold

[bullrider718]

nice call.

[CreditCardDebtSettlement]

Looks like the governement is going to control a lot more banks. Why do they keep on piling up the debt. This website helps you control your debt.