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WaMu Woes Could Crack Countrywide

Investors expect to see big losses across the mortgage sector.

Washington Mutual's

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earnings warning doesn't bode well for rival

Countrywide Financial



Observers are saying that Countrywide, the nation's largest independent lender, is likely to fare even worse than WaMu in the third quarter, as a result of the significant deterioration in the housing market and the seize-up of secondary markets for mortgage-backed securities over the summer.

"Countrywide is going to have some significant losses," says Joe Capone, a managing member of Smart Financial Partners, a hedge fund focused on financial services equities. "There all sort of severance costs, marked-to-market issues, credit losses -- they've got everything."

Early Friday, WaMu warned that third-quarter profit is expected to fall by 75% from a year ago. WaMu attributed the steep decline to a $975 million provision expense for loan losses from subprime mortgages and home equity loans, plus $410 million in other losses tied to mortgages and bond holdings.

"What WaMu is trying to do is shore up its balance sheet that will allow investors to really focus on the credit issues and take the liquidity issues out," says Capone, who is also a contributor to


investing ideas Web site.

Investors, buoyed by Friday morning's solid jobs report, sent WaMu shares up 76 cents to $36.04. But Capone stresses that Countrywide fans won't have it so easy the next time they get an update on the firm's financial performance.

"Countrywide is not in that situation. They're just not," Capone says. "They don't have the retail deposit funding

that WaMu has and they're not going to be able to put as many mortgages in their portfolio as WaMu can."

Banks with big deposit bases can afford to hold more mortgages on their balance sheets. Many lenders such as Countrywide have tended to sell most of their mortgages into the secondary market, but that option has largely been eliminated by the subprime mess that started this spring. A spike in defaults on subprime loans scared investors away from riskier debt of all stripes, leaving many lenders sitting on loans they couldn't sell.

The Calabasas, Calif.-based lender warned of trouble during second-quarter earnings. Countrywide's profit dropped by one-third and revenues fell 15% in the quarter. Chief executive Angelo Mozilo said that he did not expect the housing market to recover until at least 2009.

That was only the beginning, though. Faced with a massive liquidity crisis, the lender was forced in August to tap an $11.5 billion credit line to fund loans. It also agreed to sell $2 billion in preferred stock to

Bank of America

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and to cut 12,000 jobs, or 20% of its workforce.

Paul Miller, an analyst at Friedman, Billings, Ramsey Group, estimates that Countrywide could see a $1 billion to $2.2 billion impairment charge on nonagency loans in its pipeline during the three months ended Sept. 30.

The company will also experience further writedowns of subprime residuals and higher provisioning for credit losses, he wrote in a note Thursday. Miller had slashed his earnings estimates on the lender from break-even to a loss of $3 a share in the note.

"We now believe that the impact on earnings from the disruption in the non-agency mortgage market is higher than we previously anticipated, but still remains difficult to determine," Miller writes in a note. "As the economic bid for non-agency mortgage loans deteriorated in August and September, we believe significant mark-to-market adjustments of loans held in the pipeline and reduced gain-on-sale margins will result in negative earnings during 3Q07."

Countywide "has taken significant impairments to its pipeline of non-agency mortgage loans during 3Q07, as the secondary market for these products froze up," he added. "Deterioration of asset values followed by margin calls and the inability to roll commercial paper lines caused extreme stress to mortgage banking companies during the quarter."



, the second largest independent lender, already warned in early September that it is anticipating a third-quarter loss of as much as 50 cents a share "driven mainly by the spread widening and a continued high level of credit costs."

The earnings warning came on the same day that the Pasadena, Calif.-based company slashed its dividend in half to 25 cents a share and said it plans to eliminate 1,000 jobs.

"A good portion of the losses are going to come from the writedowns on some of the assets they originated earlier

as well as residual writedowns and some other credit-related writedowns," says Jason Arnold, an analyst at Royal Bank of Canada's RBC Capital Markets who covers IndyMac. But "they've rotated into defense mode."

Still, "for any of these guys in general, the third quarter is probably going to be a mess," Arnold says.

The mortgage players aren't the only ones taking huge hits on their loan books.


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Merrill Lynch


this week announced billions of dollars worth of writedowns on subprime mortgages, collateralized debt obligations and leveraged loan commitments.

Shares of Countrywide rose 18 cents to $20.06, while IndyMac's stock fell 34 cents to $22.60.