Editor's note: The credit markets have been the epicenter of volatility on Wall Street throughout the second half of 2007. Falling home prices and subsequent defaults on mortgage-backed securities led to a liquidity crisis that's expected to get messier in 2008. The outlook for companies in the financial sector and beyond is dim as corporate profits weaken amid a weakening economy and rising inflationary pressures. This is the second installment in an ongoing series about how the tumult in the credit markets will affect the economy and the markets in 2008.Washington Mutual ( WM) built itself from an obscure Seattle-based savings and loan into a national retail banking powerhouse with a heavy emphasis in mortgage lending.
Regulators typically call a bank "well-capitalized" if the Tier 1, or core capital ratio, is at least 5% of assets, and its so-called total risk-based capital -- essentially its core capital plus reserves -- is at least 10% of assets. At the end of September, WaMu's Tier 1 capital for the holding company (as opposed to a separate ratio for its bank subsidiary) was 5.86%, a low level compared with other large banks. WaMu announced plans to shore up its capital and restructure its home lending business by cutting more than 3,000 jobs and closing its subprime mortgage business earlier this month. The bank is also ramping up reserves for loan losses to cushion against greater delinquencies on subprime mortgages and home-equity loans. It expects to set aside up to $1.6 billion in the fourth quarter for bad loans -- approximately twice the level of expected fourth-quarter net charge-offs. The provision is likely to range between $1.8 billion and $2 billion in the first quarter of 2008, approximately double what it set aside in the third quarter. Analysts agree that WaMu's capital plans won't be enough to withstand the level of loan losses expected throughout next year. WaMu's nonperforming loans comprised 1.72% of some $230 billion in loans, up from 1.40% just the previous quarter. On the other hand, its loan-loss reserves as a percentage of nonperforming loans dropped to 39.37% from 43.43% in the second quarter, according to an analysis of data through the end of the third quarter, TheStreet.com Ratings found.
In addition, its ratio of nonperforming assets to core capital and reserves was second highest behind National City ( NCC) at 25.29%, up from 19.11% in the previous quarter, TheStreet.com Ratings found. Most banks and thrifts surveyed showed a ratio below 10%. Friedman Billings' Miller is concerned about WaMu's exposure to $58 billion of pay-option adjustable-rate mortgages -- in which borrowers can choose one of several payment options depending on how fast they want to pay off the loan -- $62 billion of home-equity lines of credit, $20 billion of subprime mortgages and $40 billion of credit card receivables. "We believe the current capital raise will be insufficient to get through the next few quarters and we expect further capital raises in the coming months," he writes. But David Hendler, an analyst at CreditSights, estimates the company's capital ratios should remain above well-capitalized levels as long as WaMu's net losses remain below $4 billion at least through the end of 2008.
It was forced to draw down an $11.5 billion line of credit this summer after the secondary market seized up. Soon after Bank of America ( BAC) invested $2 billion into the Calabasas, Calif.-based company through the purchase of preferred stock. And Countrywide said in September that it secured an additional $12 billion in borrowing through new or existing facilities. Still, despite posting a third-quarter loss of $1.2 billion, or $2.85 a share, Countrywide declared a quarterly dividend of 15 cents. Mark Batty, a financial services analyst at PNC Capital Advisors, says Countrywide is "still committed to their dividend
but if 2008 remains a challenge where they're not able to earn their dividend, certainly they would have to address that." Other investors say Countrywide should get more credit for its capital position. The company's bank subsidiary, based in Alexandria, Va., has a Tier 1 capital ratio of 7.31%. "In some ways it's a bit overdone," says Chris Fortune, an equity analyst covering banks and mortgage lenders at T. Rowe Price. "People aren't giving Countrywide credit for the huge provision they took in the third quarter and still have excess capital." Erin Swanson, an analyst at Morningstar, said Countrywide's $3 billion of writedowns and charge-offs was manageable, given its capital position. She estimated that the firm is operating with $6 billion in excess capital, "meaning it's able to withstand at least another couple of quarters like the third quarter," she wrote.
"Assuming Countrywide reserves 2.5% of its loans for losses -- up from 1.86% at Sept. 30 -- and writes off $304 million of foreclosed assets in its bank and $1 billion of subprime and prime home-equity residual interests ... its excess capital falls to $3.8 billion," she continued.
Najarian blames the "rapidly deteriorating non-conforming mortgage exposure" Wachovia has in California, as well as "much higher home equity and subprime auto loan losses." Nonperforming loans at World Savings Bank were 1.19%, up sharply from 0.84% in the second quarter. World Savings' ratio of nonperforming assets to core capital and reserves was 18.06% -- the third highest of the 20 banks, according to the analysis. (Wachovia Bank's NPA to core capital and reserves was 4.27%.) With a difficult earnings year expected for 2008, thin capital positions at many banks means difficult decisions -- like WaMu's -- could be ahead for others. T. Rowe Price's Fortune raised the specter of recession and said banks could really be pressured to raise more capital. "If we're going into a recession ... more people are going to default on their loans, and the banks are going to get less of their money back in a foreclosure," Fortune says. "That would really put pressure on
banks' building provisions and that could lead to having to raise more capital."