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WaMu's Gone, but Trouble Spots Remain

The financial sector isn't out of the woods yet, even though one of the primary companies that had investors fretting is sold to JPMorgan Chase.

You can find more stories like this in our On the Brink series.

Washington Mutual's

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extraordinary demise late Thursday hasn't exactly been the watershed moment Wall Street was hoping might kickstart the financial sector's recovery.

Market observers and analysts say unless a bailout package is passed soon by Congress, more banks could disappear.

While most analysts were reluctant to name which bank could be next to follow in

Washington Mutual

's footsteps, investors on Friday were clearly delineating they firms they believed could be in greatest need of aid.

"The market perception is clearly that all the bad players have not been dealt with," says Nancy Bush, an independent analyst in Annandale, N.J. "I would say that's not true, but we're in an environment where perception is not reality. The market is already telling us where the perceptions of weakness are."

Bank stocks took a tumble on Friday following the news of WaMu's failure. The Keefe Bruyette & Woods bank index of the top 110 banking companies fell 3.6% to 69.39.

Among the largest losers, shares of


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plummeted 34%, while National City's stock price lost as much as half its value at one point. Other midcap banks that also had steep declines included

Sovereign Bancorp


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, down 9%, and

First Horizon

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off 15%.

Tom Hepner, an investment adviser with Ruggie Wealth Management, which has some investments in bank stocks, is concerned about Wachovia, unless the government passes a package.

"Smaller banks will not have any where near the impact

of WaMu ... but a Wachovia would," if something doesn't happen to ease credit and provide some relief.

The Charlotte-based bank has substantial liquidity, but it has been engulfed by mortgage problems this year following its 2006 acquisition of California residential real estate lender Golden West, as loans once thought to be relatively good quality have soured. Golden West was known for its option adjustable-rate mortgage product, but as home prices plummeted, Wachovia has been hamstrung by its $122 billion option ARM portfolio.

Hepner is less concerned about one other firm that has had a rocky few months --


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"Citi plans get back to basics that will be long-term income streams for them and really divest themselves of less attractive assets," he says. "I think they have got good management at the top now. They will survive whether there is a package or not." Ruggie own shares of

Wells Fargo

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, among other firms, but not Wachovia or Citi.

(Late Friday,

The New York Times

reported that Citi and Wachovia are in preliminary talks about a merger.)

Late Thursday,

Washington Mutual

's banking operations were sold to

JPMorgan Chase

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after federal regulators seized the nation's largest thrift.

JPMorgan Chase agreed to pay the Federal Deposit Insurance Corp. $1.9 billion for WaMu's deposits, assets and other liabilities.

In addition, the New York-based banking titan, which also bought Bear Stearns in June, will take writedowns of $31 billion against WaMu's $242 billion average loan portfolio. The writedown "primarily represents our estimate of remaining credit losses related to the impaired loans," the bank said.

Credit deterioration in WaMu's residential mortgage portfolio has been significant as housing prices fell sharply, forcing the thrift to raise $7.2 billion in capital from a group of institutional investors led by TPG, as well as a restructuring of the company away from mortgage broker-originated home loans. WaMu had large exposures to subprime mortgages and option ARMs -- two of the more troubling loan types causing pain to the banks that originated them.

Since Sept. 15, WaMu had deposit outflows of $16.7 billion, according to the Office of Thrift Supervision, its primary regulator.

The failure of WaMu is not a turning point because "we still have significant troubled assets spread throughout the industry," says Jaime Peters, an analyst at Morningstar, who covers large-cap banks. "We have several banks with tight capital and problem assets loading their books."

"While most of the problem banks are incredibly small where the FDIC had to step in, there are still some out there that are large enough to cause significant problems in the market," she says.

The number of financial institutions on the FDIC's "problem list" this year is up to 117, according to a report issued last month. Thirteen banks have so far failed this year, including another once large mortgage lender

IndyMac Bancorp


Since the beginning of September alone, the government has rescued

Fannie Mae



Freddie Mac




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Lehman Brothers

has filed for bankruptcy,

Merrill Lynch

agreed to be sold to

Bank of America

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Goldman Sachs

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Morgan Stanley

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have become bank holding companies.

Some observers say that for all the political wrangling going on in and outside of Congress regarding the proposed $700 billion bailout package, it won't be the cure all for a recovery in the financial sector.

"I don't think there is going to be a watershed moment," Bush says. It will "simply be a moment where we pick up our heads and housing inventories have fallen or home price declines have stopped or foreclosures have peaked. There will just be a moment where everybody says 'OK.' But between now and then there is going to be a lot of damage."

Fox-Pitt, Kelton Cochran Caronia Waller analysts cited Wachovia,


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Marshall & Ilsley


among the 14 large-cap and Midwest regional banks covered by the firm as those most at risk given their exposure to problematic assets, according to a report issued Thursday.

The analysts looked at residential mortgages, home equity and residential construction loans, as well as certain capital-markets related investments.

"The bottom line is that we believe banks have not marked down these 'key concern' assets to reflect remaining loss content," the note said. "Unfortunately we estimate banks have realized only 46% of ultimate losses across these assets. Capital markets-related assets have generally been marked-to-market each quarter."

At least two analysts upgraded National City to buy-equivalent ratings on Friday given the bank's strong capital position.

This spring, National City underwent a $7 billion capital injection led by Corsair Capital and other investors. The company has had similar troubles as WaMu due to its foray into subprime mortgages through its former First Franklin subsidiary and home equity loans brokered by third parties. The Cleveland-based bank has since retooled its mortgage business away from third-party originated loans as the housing and credit markets deteriorated.

"While National City has outsized problem loans on its balance sheet (its liquidating portfolio is 17% of loans), its capital level is far greater than peers," Fox-Pitt analyst Andrew Marquardt wrote in a research note. In addition, it "had been more aggressive than peers in writing down" troubled assets. The bank's Tier-1 ratio was 11% at the end of the second quarter.

Friedman Billings Ramsey also upgraded the firm to a buy-equivalent rating for similar reasons.

After hosting several investor events with National City's management, Marquardt says "the message was clear that it raised more than enough capital to deal with problem credits (and should have excess capital coming out of this cycle), it is prudently maintaining excess liquidity given the uncertain environment, is focus on improving credit quality and focused on its core businesses."

In contrast, Wachovia doesn't "have the capital cushion that Nat City does and they were behind the curve in terms of taking markdowns," he said in an interview.

"This bailout plan will come through in one way or another and it will be a net beneficiary" to those banks that "have been most aggressive at marking down

assets and ones that have excess capital that would enable them to take accelerated losses," he says. "The two names that really jump out in that context

are Bank of America and National City. The one that stands out as not is Wachovia."