Exposures at Default: Wachovia and Washington Mutual

Includes: WFC, WMIH
by: Christopher Whalen

Last August, we published a comment about the likely increase in credit card defaults with the deflation of the real estate bubble ('Will the Housing Slump Raise Consumer Defaults?', The Institutional Risk Analyst, August 27, 2007). The comment includes the link to the video of Angello Mozillo doing his "in the bank" interview with Maria Bartiromo.

But on Friday (02/01/08), Krishna Guha and Gillian Tett of the FT published some interesting reporting suggesting otherwise ("Last year's model: stricken US homeowners confound predictions"), namely that consumers may let their mortgages go into default but keep paying their credit cards and auto loans.

Guha and Tett relate that many of the default models used by the ratings duopoly assume that consumers would continue to service mortgages, but allow their credit cards and auto loans to default. But instead, 2005 and 2006 vintage production, loans which have little or no equity and frequently featured some of the more aggressive terms of the bubble period, are going into default while these de facto tenants continue to make payments on their credit cards and car leases.

This situation should be no surprise to readers of The IRA , who know that the combination of no or negative loan defaults and rocketing real estate valuations is certainly not positive for investors or financial institutions. Specifically, when the old "80/20" rule, meaning 80% borrowed and 20% cash down, became 80% borrowed in the primary mortgage and 20% in the HELOC, and all this with the full knowledge of the lenders, you knew this story would not have a happy ending.

Which brings us to Wachovia Bank (NYSE:WB), which acquired a member of the mortgage specialization peer group called Golden West Financial in 2006. As of December 31, 2007, the bank unit formerly known as World Savings FSB was renamed Wachovia Mortgage FSB. The option adjustable rate mortgage or negative amortization ARM was the primary real estate loan for this $135 billion mortgage bank.

WB reported a whole 41bps of defaults in Q4 2007, including $299 in consumer real estate loan charge offs. The thrift now known as Wachovia Mortgage reported just 2bp of charge offs (annualized) at the end of Q3 2007 vs 20bp for the mortgage specialization peer group. Wachovia Mortgage bank had a Loss Given Default of 95% against this very low default experience. The Q4 TFR is not yet available for Wachovia Mortgage FSB.

With an efficiency ratio of just 26% and a gross lending return just shy of 800bp, 1.5 SDs above peer, in Q3 2007 Wachovia Mortgage looked like one of the most profitable and low-risk parts of WB. But is this picture of efficiency and prudence too good to be true? Is the very quiet option ARM portfolio inside WB a sleeper in terms of credit default risk? Think of the film Aliens and you get the idea.

Here's our question: Will the fast sinking price floor in the real estate market eventually cause Wachovia Mortgage to catch up with and even exceed mortgage peer default rates? Remember, the mortgage specialization peers for Wachovia Mortgage reported 20bp of annualized defaults in Q3 2007, a number which is up sharply in Q4 and could rise 10x by Q4 2008, in our view. Near term peak charge offs for the peer group were just 26bp in Q4 2001.

Meanwhile, as shareholders of Countrywide Financial (NYSE:CFC) decide whether or not to say "no thank you" to the buyout offer from Bank of America (NYSE:BAC), we ponder the tremendous job which Washington Mutual (NYSE:WM) has done so far avoiding the harsh media spotlight reserved for other members of the mortgage specialization peer group.

Why did the Big Media decide to savage the relatively quiet CFC and yet ignore WM, which closed at 0.89x book on Friday? WM reported charge-offs of $1.6 billion in 2007, 3x 2006 levels or roughly 4x peer vs. about $800 million for CFC. CFC's lead bank unit reported all of $460 million in loan charge-offs in 2007, albeit a 14-fold increase from 2006. Both banks are only partially core funded and heavily dependent upon the money markets and Federal Home Loan Banks for liquidity.

The loan default experience disparity between WM and the mortgage peer group comes in part because of the Q4 2005 acquisition of Providian, the sub-prime credit card operation which WM bought after a partial regulatory clean-up. It may be no coincidence that, since the close of that transaction, the LGD of WM's lead bank unit has been > 90% and charge-offs have climbed dramatically, closing over 70bp (annualized) at the end of Q3 2007.

Indeed, as subscribers to the IRA Bank Monitor can see for themselves, the default rate for WM's lead bank has been a rising ski slope, trending upward since Q3 2005 when the bank reported just 8bp of charge offs. Could that be because WM's credit card business, which represent just 4% of total loans, was throwing off 1,000bp of defaults in Q3 2007? Or how about C&I loans at 315bp of default vs. just 34bp for real estate loans?

So the question to all of you holding WB or WM risk: Do you feel lucky?