Washington Mutual

(WM) - Get Report

may have no choice but to raise more capital down the line, despite its reassurances to investors that it is adequately capitalized for the foreseeable future in the wake of massive second-quarter losses.

The Seattle thrift's shares rallied almost 10% Wednesday, after it reassured investors that it would not have to raise capital after

reporting

a loss of $3.3 billion, or $6.58 a share, Tuesday after the bell. The loss was well in excess of analysts' expectations, as the continuing decline in housing prices surprised the company.

It's been almost a year since we asked if Washington Mutual was the

next Countrywide

, the huge mortgage lender that sold itself to

Bank of America

(BAC) - Get Report

on July 1.

With its large mortgage portfolio, including some of the riskiest mortgage products that were so popular during the housing boom, WaMu has been another bellwether for the crisis. While its capital position is better than it was a year ago and its loan loss reserves significantly increased, the bank may need to raise money if it continues to suffer losses as steep as it reported for the first quarter.

A Big Miss

WaMu's net loss of $3.3 billion in the second quarter compares to a loss of $1.1 billion in the first quarter and net income of $830 million in June 2007. The bank's loss per diluted share was $6.58 -- $3.24 of which resulted from accounting changes related to its stock issuance in April. Excluding these one-time non-cash charges, the loss would have been $3.34 per share. The consensus estimate was a loss of $1.05 per common share.

Investors seemed to shrug off the loss, as WaMu shares rallied 9.8% early Wednesday. The stock turned negative, however, after Standard & Poor's lowered its counterparty credit rating on the company to BBB-/A-3 from BBB/A-2. Recently, shares were down 7.9% to $5.36.

Here's a quick look at earnings, provisions for loan losses and ratios for the past year:

The company explained the $5.9 billion provision for loan loss reserves as a reaction to "changes in the company's provisioning assumptions in response to continued declines in housing prices nationwide." Clearly, even WaMu was surprised by the continuing deterioration of the housing market.

The company stated it expected loan loss provisions to peak during 2008, and pointed out that the provisions have kept ahead of the pace of loan charge-offs over the past three quarters. During the bank's conference call, CEO Kerry Killinger also emphasized efforts to cut expenses, with steps to reduce annual expenses by $1 billion.

Improved Capital Ratios

Despite the large net loss and continuing increase in nonperforming loans and charge-offs, Washington Mutual's capital position and reserve coverage were much stronger as of June 30 than they were last quarter.

The bank was highlighted in Ladenburg Thalmann analyst Richard Bove's July 14 industry comment, titled "Who is Next?," exploring other banks in trouble following the

failure

of

IndyMac Bancorp

. According to this report, the company's ratio of nonperforming assets (including loans past due 90 days or more, nonaccrual loans and repossessed real estate) to loan loss reserves and common equity was 40.6% as of March 31, putting them eleventh on the list of 107 U.S. bank and thrift holding companies with at least $5 billion in total assets.

TheStreet.com

had pointed out just days before federal regulators took over IndyMac that WaMu, while much better capitalized,

faced similar problems

with its loan quality.

WaMu responded the same day as the Bove report, emphasizing it raised $7.2 billion in new capital through sales of common and preferred stock and warrants to TPG Partners and other institutional investors in April. The bank pointed out that it remained well-capitalized per regulatory guidelines as of June 30. Still, the damage was done, with shares dropping 35% on the day.

After it raised the $7.2 billion, Washington Mutual said it expected to remain well capitalized through 2008 and 2009.

It had better, at least until November 2009, since under the April 7 agreement with TPG and other private investors, Washington Mutual must pay "an amount sufficient to compensate them for the dilution suffered" in the event the company raises more capital by selling "more than $500 million of common stock or other equity-linked securities" for less than $8.75 per share, or engages in a change-of-control transaction. Reports earlier this year suggested

JPMorgan Chase

(JPM) - Get Report

was one interested suitor.

With shares closing at $4.65 Wednesday, it's clear how dangerous this agreement was for Washington Mutual and how desperate the company must have been when it agreed to TPG's harsh terms .

So how does Washington Mutual's total exposure look now? The ratio of nonperforming assets, as reported in the earnings release, to total equity capital less preferred stock, was 33.93% as of June 30, down from 38.62% last quarter.

Asset Quality

Nonperforming assets totaled $11.2 billion as of June 30, an increase of 22% from last quarter. While this is a large increase, the pace of the increase in nonperformers has been slowing.

In the earnings release and conference call presentation, the company also pointed out that the pace of growth of "early delinquencies" -- loans past due between 30 and 89 days that are still considered performing -- had slowed considerably. These loans can provide a leading indication of where overall asset quality is headed. They increased by less than 5% in the second quarter, a considerable improvement from growth rates of over 25% in the third and fourth quarters of 2007.

The three areas contributing most to poor loan quality and charge-offs are option-payment adjustable-rate mortgages, home equity loans and lines of credit, and subprime mortgages.

Washington Mutual's portfolio of option-ARMs has been a center of attention over the past year. This portfolio has been shrinking over the past two quarters, and the company has exited this business, along with closing down its entire wholesale mortgage business. Option-ARMs totaled $52.9 billion as of June 30, with $2.05 billion in negative amortization. This represents the amount principal loan balances exceed the original loan balances.

During the conference call, John McMurray, WaMu's chief enterprise risk officer, stated that "in a typical month you may have on the order of three quarters of those negatively amortizing," meaning their loan balances are going up.

When an option-arm hits the negative amortization limit, the loan "recasts," meaning that the payment is amortized like a regular mortgage, including principal and interest. The earnings release presentation included predictions of $2.2 billion in recasts for the second half of 2008 and $7.1 billion in 2009. This paints an ugly picture, since we can assume that many of these borrowers will not be able to afford the fully-amortized payments, since they aren't making those payments now.

Nonaccrual option-ARMs totaled $3.23 billion as of June 30, or 6.11% of the total option-ARM portfolio. The annualized net charge-off rate for this portfolio was 3.91% of average loans.

For its home equity portfolio, Washington Mutual stated that the loss rate on charged-off loans was "drifting to 100%." This is understandable, since most of the loans are second-lien mortgages, secured by homes that have lost value. Prime home equity loan and line of credit nonaccruals totaled $1.5 billion, or 2.5% of total loans of this type. The annualized net charge-off rate for the prime home equity portfolio was 4.65%.

Nonaccrual subprime mortgage loans totaled $3 billion, or 18.68% of total subprime loans as of June 30. The net charge-off rate for the subprime portfolio was 13.44%.

Charge-offs and Capital Erosion

Loan charge-offs will continue to be the focus of attention for investors trying to determine WaMu's capital adequacy. While the second table shows considerable strengthening of reserves and capital ratios, the $2.2 billion in net charge-offs for the second quarter represents a large portion of the $7.2 billion in capital raised.

Washington Mutual's annualized return on common equity for the quarter was a negative 69%, showing that despite the capital raising and efforts to reduce its balance sheet size, several more quarters like this one will lead to another capital shortage.

Philip W. van Doorn joined TheStreet.com Ratings., Inc., in February 2007. He is the senior analyst responsible for assigning financial strength ratings to banks and savings and loan institutions. He also comments on industry and regulatory trends. Mr. van Doorn has fifteen years experience, having served as a loan operations officer at Riverside National Bank in Fort Pierce, Florida, and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a Bachelor of Science in business administration from Long Island University.