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.

WaMu's rapid expansion into higher-risk mortgages, however, including those to less creditworthy borrowers, has now backed it into a corner. Amid the housing and credit markets' continued downward spiral, the bank recently announced steep cuts to its dividend and raised $2.5 billion through a convertible stock sale.

WaMu's desperation speaks to the dire straits many mortgage lenders are in with respect to their capital positions.

"This will not be the first, nor the last, recapitalization for mortgage related stocks," writes Paul Miller, an analyst at Friedman Billings Ramsey, in a recent note on WaMu.

Banks and lenders such as WaMu, Countrywide Financial ( CFC) and Wachovia ( WB) have been squeezed hard in 2007, as home prices fell and the mortgage industry plunged into turmoil. Higher borrower delinquencies on home loans mean that mortgage lenders must set aside more money to cover possible defaults.

Unfortunately, the news is about to get worse. More than $300 billion worth of subprime adjustable-rate mortgages are expected to reset to higher interest rates in 2008, according to Credit Suisse. Many borrowers are expected to be unable to afford the higher payments.

And delinquencies and defaults are increasing beyond just subprime loans into home equity, Alt-A loans and even some prime loans.

WaMu's Capital-Raise 'Insufficient'?

Banks need capital to have some basis of borrowing -- or leverage -- for their businesses and to expand their balance sheets by making loans or purchasing securities. The catch is that as a bank grows its business, its capital ratios fall. Therefore, banks must work through the tricky task of growing earnings while paying dividends and maintaining capital levels.

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.

Countrywide Clings to Dividend

Now that WaMu severely curtailed the dividend that shareholders will receive, some expect Countrywide to cut its dividend to add to its capital levels.

Countrywide, the nation's largest independent mortgage lender, has had a challenging 2007 to say the least. Among other problems, the lender -- mainly reliant on selling the mortgages it originates into the secondary market -- faced a liquidity crisis so large this summer that some investors feared the company would fail.

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.

All's Not Golden at Wachovia

Another company that could run into trouble with its capital levels is Wachovia, due to its acquisition of California mortgage lender Golden West, the holding company of World Savings Bank. The lender, acquired in 2006, is best known for originating Option ARMs.

Wachovia's Tier 1 capital was 7.5% at the end of the third quarter, but the Charlotte, N.C., lender acknowledged at an investor conference hosted by Goldman Sachs last week that its $7 billion capital cushion was falling. Chairman and CEO Ken Thompson said Wachovia "will not hesitate" to raise capital should the need arise.

The company says it has "ample" earnings to continue to support growth and build credit reserves at the same time, despite the market deterioration. Management remains confident of its dividend "even under stress scenarios," according to a presentation at the conference.

Wachovia also has boosted its fourth-quarter provision to a range of $500 million to $600 million, up from the $408 million it set aside for the third quarter.

Ed Najarian, an analyst at Merrill Lynch, earlier this month downgraded Wachovia to sell, partly over concerns that the company's credit losses will rise "significantly" next year.

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."