Banks Face Capital Punishment

Editor's note: The credit markets have been the epicenter of volatility on Wall Street throughout the second half of 2007. Falling home prices and subsequent defaults on mortgage-backed securities led to a liquidity crisis that's expected to get messier in 2008. The outlook for companies in the financial sector and beyond is dim as corporate profits weaken amid a weakening economy and rising inflationary pressures. This is the second installment in an ongoing series about how the tumult in the credit markets will affect the economy and the markets in 2008.

Washington Mutual(WM Quote) built itself from an obscure Seattle-based savings and loan into a national retail banking powerhouse with a heavy emphasis in mortgage lending.

WaMu's rapid expansion into higher-risk mortgages, however, including those to less creditworthy borrowers, has now backed it into a corner. Amid the housing and credit markets' continued downward spiral, the bank recently announced steep cuts to its dividend and raised $2.5 billion through a convertible stock sale.

WaMu's desperation speaks to the dire straits many mortgage lenders are in with respect to their capital positions.

"This will not be the first, nor the last, recapitalization for mortgage related stocks," writes Paul Miller, an analyst at Friedman Billings Ramsey, in a recent note on WaMu.

Banks and lenders such as WaMu, Countrywide Financial(CFC Quote) and Wachovia(WB Quote) have been squeezed hard in 2007, as home prices fell and the mortgage industry plunged into turmoil. Higher borrower delinquencies on home loans mean that mortgage lenders must set aside more money to cover possible defaults.

Unfortunately, the news is about to get worse. More than $300 billion worth of subprime adjustable-rate mortgages are expected to reset to higher interest rates in 2008, according to Credit Suisse. Many borrowers are expected to be unable to afford the higher payments.

And delinquencies and defaults are increasing beyond just subprime loans into home equity, Alt-A loans and even some prime loans.

WaMu's Capital-Raise 'Insufficient'?

Banks need capital to have some basis of borrowing -- or leverage -- for their businesses and to expand their balance sheets by making loans or purchasing securities. The catch is that as a bank grows its business, its capital ratios fall. Therefore, banks must work through the tricky task of growing earnings while paying dividends and maintaining capital levels.