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Is WaMu the Next Countrywide?

The lender could find itself in a liquidity crunch, an analysis by Ratings shows.

Countrywide Financial


isn't the only big bank threatened by the deepening real estate crisis.

An analysis of the largest 20 banks and thrifts by Ratings shows that four institutions are under-reserved for possible credit losses, a red flag as the economy slows and mortgage defaults rise.

Perhaps more troubling, the numbers show that one of those institutions --

Washington Mutual

(WM) - Get Free Report

-- could join Countrywide in facing serious liquidity problems as worries about the housing and mortgage markets multiply. Meanwhile, another big lender,

National City


, could see its earnings and dividend come under pressure as a result of its low reserve levels.

Neither Washington Mutual nor National City immediately returned calls seeking comment. But the findings come as investors confront a rising tide of bad news in the U.S. credit markets. Foreclosures nearly doubled last month from a year ago, RealtyTrac reported Tuesday. Shares in bank and brokerage stocks have dropped sharply this summer. Countrywide alone has shed $13 billion in market value this year.

With the financial sector under increasing stress, Ratings checked two key ratios to measure the strength of big banks' balance sheets: loan-loss reserves as a percentage of nonperforming loans, and nonperforming assets as a proportion of core capital and reserves.

Banks and thrifts walk a fine line in setting their quarterly loan-loss provisions, which add to their reserves against future losses. If they reserve too little, they can be seen as taking on more risk in the event of a decline in credit quality and padding their earnings for the current quarter (since the loan-loss provision lowers net income). If they reserve too much, investors, analysts and regulators may see the institution as over-reserving -- so it can manage earnings by under-reserving at a future point when earnings would otherwise weaken.

A good benchmark for loan-loss reserve coverage is 100% of nonperforming loans, which are loans past due 90 days or more. If a bank is forced to charge off loans totaling more than its loan-loss reserves, the losses eat into capital. That can hurt earnings if loan quality continues to deteriorate.

Another thing to consider is headline risk. As we have seen with Countrywide, any bad news in this environment can cause depositors to flee -- every bank's worst nightmare.

Looking at the largest 20 banks and thrifts, it is clear that four are under-reserved and two have an alarming level of capital exposure to nonperforming loans. Here's a look at the four cases.

WaMu Could Get Wobbly

At Washington Mutual, as at the other institutions, credit quality is in decline, and reserves appear somewhat skimpy. Given those trends, in a worsening economic environment liquidity -- as well as the bank's dividend -- could come under pressure.

The bank reported nonperforming assets comprising 1.40% of total assets as of June 30, double the level from a year ago. The thrift's net income rose 9% from a year ago in the second quarter, but its ratio of reserves to nonperforming loans dropped to 43.4% -- its lowest level in more than five years.

Meanwhile, Washington Mutual's ratio of nonperforming assets to core capital and loan-loss reserves was 19.17% -- a very high level for a large bank. Most banks and thrifts we surveyed showed a number well below 10%.

If we assume that when disposing of a repossessed home a bank is likely to recover 70% of the remaining loan balance, the institution would still be comfortably well-capitalized, with a risk-based capital ratio of 11.76% (it needs to be 10% to be considered well-capitalized).

OK so far, but what if a significant portion of the loans past due only 30-90 days are eventually foreclosed? Loans past due 30-89 days totaled $2.9 billion. Addressing the expectation of a continued decline in credit quality, CFO Thomas Casey revised the holding company's guidance for reserves for the second half, saying the company would set aside $900 million to $1.1 billion for reserves during the second half of 2007. This will have a major impact on earnings.

If banking industry conditions deteriorate, Washington Mutual's divdend could come under pressure. The company paid out 60% of its second-quarter earnings to shareholders. This payout ratio is high, considering that the thrift is under under-reserved -- so it is conceivable that the dividend may have to be reduced in coming quarters, if asset quality continues its dramatic decline.

Liquidity is also a major concern. A high percentage of Washington Mutual's deposits are in non-retirement accounts with balances exceeding $100,000. We call these large, partially insured deposits "hot money." Washington Mutual's hot-money ratio was 37.6% as of June 30. As we saw last week with Countrywide Bank, these deposits can fly quickly in a time of uncertainty.

Nat City Regroups

National City faces similar issues to Washington Mutual. National City Bank tops the list in terms of capital exposure, with a ratio of nonperforming assets to core capital and loan-loss reserves of 19.72%. Its ratio of nonperforming assets has tripled over the past year, to 1.40% as of June 30.

National City Bank's level of capital is relatively lower than Washington Mutual's, with a risk-based capital ratio of 10.64% as of June 30. If we again look at where the capital level would be if the bank were to charge off all of its nonperformers with a recovery rate of 70%, the institution would remain well-capitalized with a risk-based capital ratio of 10.32%.

However, loans past due 30-89 days totaled $2.1 billion, compared with $376.3 million in June 2006. This represents significant additional risk to capital if a good portion of these move to nonperforming status in coming quarters.

Looking at capital levels, holding company stock buybacks and dividends paid out over the past year, it is clear that National City Bank is trying to manage its capital as efficiently as possible. If a bank holds a high level of capital, it is in a stronger position if credit quality declines, but will have a lower return on equity. Over the past year, the institution has paid out dividends exceeding its earnings, and it has maintained a risk-based capital ratio below 11%. For the first half of 2007, dividends kicked up to the holding company totaled $950 million, on net income of $670 million.

It's quite reasonable to see a threat to the holding company's 5.8% dividend on common stock, if the bank is forced to significantly increase its reserves. That being said, on the holding company's second-quarter conference call, CFO Jeffrey D. Kelly said that the buybacks would likely be suspended during the third quarter as the acquisition of MAF Bancorp is completed, "allowing the tangible equity ratio to move up."

National City's strategy has been to reduce capital, as it restructures to "a business model oriented largely to direct businesses with a smaller, more efficient balance sheet."

Countrywide on the Downside

Countrywide can't stay out of the headlines. It recently announced that it was speeding up its plans to move most of its mortgage lending to the thrift, away from its mortgage company. This was expected to build confidence in Countrywide's liquidity, since the thrift would fund new loans primarily with deposits, rather than bank credit lines.

The problem with relying on the thrift to fund new lending is that Countrywide does not have a strong track record of gathering retail deposits. That's why last week's announcement -- along with Countrywide's decision to tap an $11 billion bank line -- led to a mini-run on deposits last Friday. There were reports of large depositors moving their uninsured deposits to other banks.

Most of Countrywide Bank's deposits are in nonretirement accounts with balances exceeding $100,000. Countrywide's hot-money ratio was a whopping 89.1% as of June 30. With the majority of these balances uninsured, continued deposit outflow seems likely.

If that funding problem isn't enough, the institution's wholesale borrowings are maxed out. Countrywide had $28.8 billion in Federal Home Loan Bank advances as of June 30, or 31% of its total liabilities. It's hard to imagine the institution's wholesale borrowings increasing much from here.

Considering the problems selling loans in the secondary market, along with all of its funding concerns, it would seem that Countrywide's bread-and-butter mortgage lending activity will be scaled back for some time.

As far as asset quality is concerned, Countrywide has followed the pattern of other large mortgage lenders, with nonperforming assets at 1.0% of total assets, increasing from 0.27% in June 2006. Loans past due 30-89 days totaled $1.7 billion, potentially doubling the institution's level of problem loans.

Wachovia's Wide World

World Savings Bank is held by


(WB) - Get Free Report

, which acquired the bank in October 2006. Unlike the other three institutions highlighted here, the holding company has deep pockets and a varied revenue stream.

As of June 30, World Savings reported that nonperforming assets were 0.84%, up from 0.37% a year earlier. The institution's ratio of loan-loss reserves to nonperforming loans was 24.11%, the lowest level of coverage for any of the largest 20 banks and thrifts.

However, the institution's low level of reserves does not tell the whole story. World Savings is known for conservative underwriting. Most of its mortgage portfolio consists of adjustable-rate mortgages, and it does not sell any mortgage loans.

Mortgage loan approvals are mainly based on the value of the collateral, and the average loan-to-value ratio for its mortgages is around 70%. This means that when it charges off nonperforming loans, it recovers nearly all of its losses. The institution's ratio of net charge-offs to average assets has been below 0.01% for over six years.

As always, it remains to be seen just how bad the asset quality problems will get. World Savings reported loans past due 30-89 days of $2.3 billion as of June 30. This is more than double the nonperforming loans, so even this conservative lender may experience a darkening scenario for earnings in the quarters ahead.

Philip van Doorn joined TSC Ratings as a banking analyst in February 2007. He has a varied background, with a B.S. degree in business administration from Long Island University. He previously worked as a loan operations officer with Riverside National Bank in Fort Pierce, Fla. Before that he was a credit analyst, monitoring banks and thrifts at the Federal Home Loan Bank of New York.