WM Will Remain Under Pressure

Updated from 9:10 a.m. EST on Jan. 17.

Washington Mutual (WM - commentary - Cramer's Take) reported a loss of $2.19 per share vs. the negative average of $1.20 that was expected. The biggest reason for the shortfall was the write-off of goodwill in the home loan business of $1.6 billion, meaning that ongoing EPS was a negative 81 cents. Analysts very seldom think about when goodwill might be written off, but I am sure this surprised nobody, and this was not an incremental negative for the stock.

The other big factor was the $1.5 billion provision for loan losses, up from $967 million in the third quarter and $344 million last year. This is the first time in a while that provisions have met management's projections; on the other hand, these projections are only one month old.

The performance of the banking operations was generally in line with expectations. Net interest income was up 2.5% from last year and 1.6% from the third quarter, and the net interest margin came in at 2.85% on an 8% decrease in interest-earning assets vs. 2.58% margin last year.

New account growth is still OK as is fee revenue in the banking side. Non-interest income at $1.365 billion vs. $1.592 billion last year was affected by a $528-million market valuation loss on the trading and available-for-sale portfolios, a problem that will probably lessen but may not go away soon.

Management rightly pointed out that the pay option ARM portfolio does not have much of its rate resets until 2009, with bigger resets in 2010 and 2011. With only about 3% negative amortization and interest rates falling as the Fed fights a recession, this portfolio would seem to be a relatively small problem at this point in time.

That said, the current 694 average FICO score looks low to me. Original loan-to-valuation ratios of 72%, however, were conservative. Management estimates that 3% are now over a 90% loan-to-valuation and 25% are over an 80% loan-to-valuation, which came from declining home values.

Management did not give a satisfactory answer to a question about credit card projected losses of 8.5% to 9.0% for 2008 being extreme. Instead, management commented that the company expects an increase in unemployment from the 5% level. Well, a 5.5% or even a 6% unemployment rate is not really consistent with 8.5% to 9% losses, in my opinion.

What happens if we get to a 7% rate in a recession? And losses are still coming back up to normal for the industry after the bankruptcy change induced low level. I note that after a 5.83% loss rate in 2006 for managed card receivables, the loss rates were in the sixth percentile during 2007, ending at 6.9% for the fourth quarter.

This is while balances were trending up from supposedly getting higher-quality accounts from marketing to WaMu's depositors vs. the old Providian customers. Management did say that the 19% of outstanding credit card balances in California showed no different credit experience than the rest of the portfolio.

Looking at the company's subprime portfolio statistics, the current FICO of 607 seems relatively low to me. Looking at first liens, the estimated current loan-to-valuation ratio greater than 90% is 7% and the first greater than 80% is 28%, while the estimated current loan-to-valuation is 70%.

This looks like a very wide dispersion that can only be caused by the California portfolio. My guess is that losses from California get much worse, raising the overall 4% charge-off rate markedly from here.

Subprime home equity loans are only $2.5 billion vs. the $16.1 billion subprime first lien portfolio, but the company's current combined loan-to-valuation ratios of over 80% and 90%, respectively, are 67% and 89%. This makes me think that investors should mentally write off the whole portfolio, which is now showing about a 17% charge-off rate. (Did the company make any real calculations about the incremental losses or equity needed for these things as it invaded what had been mortgage insurer industry territory?)

I believe that the $1.8 billion to $2.0 billion provision expense run rate projected for the first quarter and possibly for the remainder of 2008 will be adjusted upward. As long as that provision goes up beyond management's guidance, the stock will be under pressure, absent a buyout. With the capital raising and dividend cut, I am not questioning the company's viability at this point.

WM Preview: Not the Time to Speculate

When I last covered Washington Mutual's (WM - commentary - Cramer's Take) earnings in the second quarter, I wrote the following:

I have followed financial stocks for a long time, but I do not know how to make any reasonable estimates of ultimate losses on the layering of teaser rates on top of high loan-to-value ratios, on top of general subprime credits, on top of a housing price decline that may end up being the biggest since the depression. And I do not believe that anybody else can make reasonable loss predictions on this either. Finally, on top of all of this, given WaMu's history of past operational screw-ups, I worry that the underwriting standards that were supposed to have been applied may not have been made properly as to documentation, etc.

I stand by that statement more than ever.

I concluded with:

A good feel for the ultimate in subprime losses to be experienced at WM may not come until the fourth-quarter results, especially because of the importance of the interplay of the risk factors mentioned above.

So, for now, I think that the quarterly results will make interesting reading, possibly giving the shorts part what they want but not providing a situation that deep value on which investors could be comfortable buying.

On this, I was too optimistic. Standard & Poor's just raised its 2006 subprime loss estimate for the industry to 19% vs. the sell-side 10% to 15%. And I am pretty sure that everybody on the sell-side with that 10% to 15% ratio was already scared of WaMu's future results.

While Washington Mutual has reloaded its equity with a dividend cut and $3 billion of preferred equity, bringing tangible equity to 6.42% of assets, and the subprime portfolio is down to $20 billion, the $58 billion home equity portfolio is now becoming a big credit problem. These are late-cycle loans 2006 and 2007, and Standard & Poor's loss estimates for these are likely to be exceeded by WaMu given that the company has almost half of its portfolio in California and considerable exposure to piggybacks.

I will leave option ARMs alone for now as there is more equity content there, which has seemingly been the only thing that investors can hang their hat on lately.

I am concerned about the credit card portfolio given Washington Mutual's late-cycle aggressive lending. This portfolio is at the subprime end of the scale, and with investor worry migrating out of subprime mortgages into auto and credit card lending, WaMu's portfolio is the absolute front of the line of credit card suspects. Analysts are talking about possible 9% credit card loss rates in 2008. On that I would say that losses could then go higher in 2009 in a continuing recession.

Though I was up to my ears in credit card-related stocks in the 1990s, I was scared of any loss ratios in the eight percentile. I do not know if it is true, but a gaming analyst once told me in the 1990s that losses on casino credit averaged about 8%. As an investor, you have to stop somewhere, but at some relatively high loss ratio, you cannot have confidence that the losses will not rise uncontrollably. So 8% is my limit.

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At the time of publication, Thomas had no positions in the stocks mentioned.