Wachovia CEO's Optimism Cost Him Job

Acquiring option-adjustable rate mortgage lender Golden West was the biggest factor in Ken Thompson's demise.
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Updated from 3:37 p.m. EDT

To some extent, you want your CEO to be a fighter, willing to defend the company at all costs. But the ouster of

Wachovia

(WB) - Get Report

CEO Ken Thompson suggests the bank's board of directors could no longer keep a blissfully ignorant cheerleader around.

The biggest criticism investors can levy at Thompson is that he continually failed to issue adequate warnings about the company's ticking time bomb: the $120 billion adjustable-rate mortgage portfolio it inherited from its 2006 purchase of Golden West.

Investors who put their faith in Thompson's optimistic analysis of the loan portfolio got severely burned. Wachovia's stock has now fallen about 40% this year. Shares closed down 1.7% to $23.40.

On Monday, Thompson

retired

at the request of the board of directors. Although Wachovia didn't say so, it is likely the ouster was largely related (or should have been related) to Thompson's endless cheerleading for the Golden West portfolio.

Cramer: I've Been Too Upbeat On Wachovia, AIG

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"No single precipitating event caused the board to reach this decision, but a series of previously disclosed disappointments and setbacks cumulatively have negatively impacted the company and its performance," Chairman Larry Smith, who was appointed interim CEO, said in a statement.

As recently as late January, Thompson was being way too optimistic about the fate of Golden West's "pick-a-payment" mortgages. These option ARMs allow borrowers to pay less than the fully-amortized amount of interest and principal. About 60% of these loans are in California, where housing prices are tumbling and more borrowers are facing negative equity, which raises their probability of defaulting.

At a Citigroup investor conference in January, Thompson defended the loans, while also saying he was "very confident" with Wachovia's liquidity and capital position. Then in April, Wachovia raised $7 billion and slashed its dividend, mostly to reserve capital to cover much larger expected losses in the future from the Golden West loans. Rival banks

Washington Mutual

(WM) - Get Report

and

National City

(NCC)

also raised money and preserved capital amid deep losses at that time.

TheStreet.com

warned in February

about the looming risks of the Golden West portfolio

Since the Golden West "pick-a-payment" product allowed borrowers to pay less than the fully amortized rate in markets such as California, where housing prices were falling, some homeowners' leverage ratios were ballooning. More borrowers found themselves facing negative equity, and thus became more likely to mail the house keys back to Wachovia, rather than sink more money into a losing investment.

At the Citigroup conference, one audience member asked Thompson about rising delinquency trends at a fellow option ARM lender exposed to California. The Golden West loans were "totally different than other option ARMs in the market, and we've gone over this time and time again," Thompson.

When analysts and investors raised concerns about Golden West loans over the past year, Thompson's answers focused mostly on the strength of the loans' original underwriting standards and the low historical default rates in the portfolio. He told investors to take comfort in the fact that Wachovia's delinquency rates in various loan products were better than the industry's rates.

In reality, the problem with the option ARM product had little to do with credit scores or underwriting, and everything to do with falling home prices and the structure of the product itself.

In April, Wachovia surprised investors with a $644 million first quarter loss reported, largely related to loan charge-offs and increased loss reserves tied to the Golden West loan portfolio.

Analysts on the conference call pressed Thompson regarding the about-face on the health of the Golden West portfolio.

Thompson cited the bank's implementation in the first quarter of a new default prediction model for its mortgages. The model incorporated the view that changes in borrowers' equity levels are a greater predictor of future losses than FICO scores.

One of the main reasons for the increased reserves and the capital raise was that Wachovia was finally becoming more realistic about the ultimate fate of the loans.

It's amazing it took this long for Wachovia to build this new model. The writing on the wall about the dangers of option ARMs for California homes had already been apparent to most people -- except Thompson (at least what he said in public) -- since late last year.

Wise investors were paying attention to the likes of Meredith Whitney, the influential banking analyst at Oppenheimer, who raised the broader issue in December 2007 about how loan-to-value ratios (rising from housing prices falling) were becoming a more important predictor of default than FICO scores.

Short sellers late last year looked at Wachovia's exposure to California, where housing prices were falling and negative equity was increasing among borrowers, and concluded the bank was under-reserved for loan losses in the Golden West option ARMs.

In consideration for his bumbled handling of the Golden West situation, Thompson will get a severance payment of $1.45 million and will see the immediate vesting of his approximate $7.25 million of restricted stock, according to an SEC filing on Monday.

Investors, meanwhile, can learn the priceless lesson that when CEOs talk, it is often wise to listen with skepticism.