Disruption to Capital Markets Whacks WB

Updated from 3:59 p.m. EST on Jan. 18.

Wachovia (WB - commentary - Cramer's Take) reported fourth-quarter EPS of 3 cents vs. a 33 cent average estimate and $1.19 last year. But for an income tax benefit, the quarter would have shown a 10-cent per share loss. The chief reason for the shortfall vs. consensus was a more-than-expected disruption in the capital markets, causing more mark-to-market negative valuation adjustments.

Other than credit quality and capital markets operations, results were fine. Average loans were up 9%, 5% linked quarter (8% commercial and 3% consumer). Deposits rose 8%, and checking accounts increased by 935,000. Net interest income rose 2% on a linked-quarter basis, with the net interest margin down 4 basis points, to 2.88%.

The Fed's 75-basis-point decrease in the funds rate means that there is clear sailing here, though management said that not much margin widening will take place in this quarter. Fee and other income was 10% below the third quarter and 37% below last year because of capital market disruption. Wealth management results were OK.

Capital markets sustained $1.7 billion in valuation losses, $600 million of which came from commercial mortgage structured products, where spread widening hit valuations but without the properties' economics being affected, according to management. About $1.0 billion came from subprime residential asset-backed securities collateralized debt obligations. The remaining balance is $3.6 billion, with 10-year duration equivalent exposure at $0.9 billion. Over 50% of exposure is AAA or above. While there can be more hits here, I would think that this problem will be lessening in coming quarters and may reverse itself when the credit markets finally do open.

Management did build the loan-loss reserve by $1.0 billion, as expected, with a $1.5 billion provision, while write-offs were $0.5 billion. Non-performing assets are now 1.1% of loans net of other real estate owned, up from 0.65% in the third quarter. The loan-loss reserve is 1.02%, up from 0.82 %. Net charge-offs increased from 19 basis points in the third quarter to 41 basis points in the fourth quarter. So, the loan-loss reserve as a percentage of non-performing asset restructured loans is now 96%, down from 135% in the third quarter.

When asked about this, management said that the company's lack of an unsecured credit card portfolio somewhat skews this number. Credit cards are written off at 90 days delinquent and do not get into non-performing assets. There are also what management refers to as "straights," in which the borrower files for bankruptcy without ever going delinquent on payments. These are valid arguments, but without looking at an adjustment for these, my belief is that the reserve is somewhat low, though Wachovia's good credit experience might have kept it that way.

Management also said -- and this is the pivotal factor in the credit quality outlook, in my opinion -- that it has seen no significant declines in the quality of the company's home equity portfolio as of yet.

Home equity only has a 1.37% of loans that are 30+ days, and net charge-offs are running at 25 basis points, up from 17 basis points in the third quarter and 10 basis points last year past due. The average loan-to-valuation limit is 74%, and most was placed via the company's own personnel. Sixty day past dues are one-third of the industry average. While this portfolio will obviously have worsened credit quality in 2008, I would still not expect it to become a big new problem.

The Golden West's Pick-a-Pay (somewhat option ARM-like) portfolio did get its rethinking by management. Its 2006 vintage has around 4% 90-day past dues largely because of its California concentration, and $550 million of the $1 billion addition to the provision was for these loans. Current loan-to-valuations over 95% are $8 billion of a $120 billion portfolio. With 20% housing depreciation on California in the 1989 to 1991 period, the portfolio sustained 20 basis points in losses.

Management says that Wachovia is now is reserved for a 56-basis-point loss from this portfolio. For all of the attention it gets, this portfolio is only showing 31 basis points of losses now, up from 4 basis points in the third quarter, much of it from the change in loss recognition methodology by going OCC from OTS.

The non-performing-asset-to-loan ratio is 2.31%, up from 1.47% in the third quarter, which is closer to prime first mortgages than Alt A for instance. Negative amortization is about 2.5%, and with a 71% average current loan-to-valuation and 81% for the loan-to-valuation of the non-performing asset portfolio, there is enough equity there to refinance into different loans, which may not even need to be done because of the effect of today's 75-basis-point rate decline on the ARM index.

Management did say that there was a "dramatic change" in credit quality deterioration, and total non-accruals rose 82% from the third quarter, with an increase in first lien mortgages and a commercial real estate level of 400% of the third-quarter levels, mostly because of homebuilders. Commercial and industrial non-accrual loans rose 70%. Things are getting tougher, no doubt, and I was surprised by the percentage increases in problem loans, though they do come off of low bases. Management said that the company expects to build the reserve by about 75 basis points in the next two quarters. I think that is somewhat below what will be needed.

But, at the end of the day, the stock discounts so much more than that, even without the Fed rate cut, which could be that catalyst for psychology changing and a bottom being made in the financial stocks. Do you really want to fight the Fed after a 75-basis-point rate cut on stocks that you know are extremely cheap?

WB Preview: Light at the End of the Tunnel?

Wachovia's (WB - commentary - Cramer's Take) fourth-quarter sell-side EPS was estimated to be $1.25 in early September, and here we are looking at 33 cents now vs. $1.19 a year ago.

I hope that when these economic problems are over that the accounting regulators will go back to allowing banks to put up decent loan-loss reserves when loans are made, instead of practically taking their loan losses right through the income statement as is being done now and is unnecessarily reducing valuations for financial institutions.

Loan volume in the third quarter was up 8% and interest rates are falling as Wachovia is in a liability-sensitive position, so the focus will be on loan quality and when the capital markets will open up.

I will be looking closely at the conclusions of management's analysis of Golden West's likely loan losses in this cycle vs. past cycles. Management should be done with this exercise, and I would expect some additional reserving from an environment that has to be tougher than the 1990 to 1991 recession period.

Importantly though, I still would not expect that the increases in mortgage-related non-performing assets will result in the huge losses that the stock market is ascribing to the company. As I said in the third-quarter call, Golden West typically shows increases in on-performing assets during recessions that are not accompanied by the same losses that hit others such as Washington Mutual (WM - commentary - Cramer's Take).

The secret to this, and it seems that it has become a secret lately, is underwriting. Golden West's peak losses in the last cycle were 20 basis points, and while a higher ratio is likely this cycle, I do not foresee a disaster. That having been said, the fact that there was a $900 million non-performing asset increase in consumer mortgages in the third quarter did a lot of harm to the stock valuation.

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At the time of publication, Thomas was long Wachovia.