Golden State Mortgages May Tarnish Wachovia

As housing prices plummet in California, homeowners are increasingly finding that their mortgage debt is higher than the value of their homes. Faced with such a situation, some borrowers have simply stopped paying their loans.

This crisis of confidence is already hurting Wachovia(WB Quote), which has a massive portfolio of mortgages in the state. But some analysts say the issues are about to get much worse for the bank as defaults increase.

Through its purchase of California-based savings and loan Golden West in 2006, Wachovia inherited a $120 billion adjustable-rate mortgage portfolio, which now amounts to 15% of the bank's total assets.

Specifically, the Golden West portfolio consisted of "option ARMs," otherwise known as negative amortization loans.

Option ARMs allow borrowers to make payments at less than the fully amortized rate. By not paying the full rate in a market where housing prices are falling, leverage ratios are ballooning for some borrowers.

Roughly 60% of these Golden West loans were written on homes in California, where price declines have outpaced the rest of the country.

The S&P Case-Shiller home price index for November -- the most recent month for which data is available -- shows housing prices fell 13% in San Diego, 12% in Los Angeles and 9% in San Francisco from a year earlier. That compares with an average 8% drop in the 20 national cities the index tracks.

Based on the home-price problems looming in California, Merrill Lynch analyst Edward Najarian downgraded Wachovia to sell earlier this month.

"Our increasingly bearish credit quality outlook is primarily driven by (Wachovia's) exposure to rapidly deteriorating residential real estate values in CA," he wrote, while also nothing that the company is "under-reserved" for future losses. He expects Wachovia's loan-loss provision to more than double this year from last year.

Already, First Federal Bank of California(FED Quote) and Downey Financial(DSL Quote), which offered similar negative amortization loans as Golden West, have reported very large loss provisions in their most recent quarters.

To date, most homeowner defaults and eventual foreclosures across California and the U.S. have come from subprime loans supplied to borrowers with poor credit. However, defaults have been increasing on loans to more creditworthy borrowers.

In some instances, the defaults are being caused by adjustable rate mortgages recasting from low initial teaser rates to higher rates. This process is known as "payment shock."

Wachovia, however, is facing a different issue. A growing number of analysts have been warning about how defaults in California are already rising in situations where borrowers' interest rates have not reset yet.

"You already have significant non-accruals at Wachovia with no payment shock," says Jefferson Harralson, an analyst with Keefe, Bruyette & Woods, who rates the stock market perform. "The market is weak enough where you see significant losses without payment shock. This shows the weakness in the loan category that the non-accruals are showing up before the recasts were being hit."

Non-accruals, or loans where homeowners have stopped paying the contracted rate, stood at 2.23% of Wachovia's option ARM portfolio in the fourth quarter, compared with just 0.55% a year earlier, Harralson says.

Throughout history, mortgage defaults have been primarily driven by three causes: divorce, a job loss or health issues. Now, another important factor is coming into play: the psychological drain that comes from owning a house worth less than the mortgage outstanding.

"When a borrower owes more than he owns, he is much less motivated to remain current on the loan," Oppenheimer analyst Meredith Whitney wrote in an influential December research note about how high loan-to-value ratios, and not credit scores, will be the ultimate driver of mortgage losses.