Wachovia and marking mortgage loans to market

Wachovia Finds Itself in ARMs' Way

By PETER EAVIS

Here's betting James Dimon isn't very popular with certain other bank chief executives right now. Particularly Wachovia's CEO, Robert Steel.

Mr. Dimon's J.P. Morgan Chase scooped up the remains of Washington Mutual after it was seized by the Feds. Lancing the WaMu boil was a boon for financial markets, but may make life tough for some of Mr. Dimon's peers.

As part of the deal, J.P. Morgan forecast large losses on $176 billion of WaMu's mortgages. Applying J.P. Morgan's projections to other large banks implies higher losses for those with WaMu-like assets.

Associated Press

Wachovia CEO Robert Steel

Wachovia looks pretty ugly under this approach.

This may be one reason why Wachovia's shares plunged Friday.

Take option-adjustable-rate-mortgages. On these, J.P. Morgan foresees additional losses equivalent to around 20% of the total. Adding losses already taken by WaMu leads gives a cumulative loss rate of 25%, according to Morgan Stanley analysts.

By contrast, Wachovia, with $122 billion of Option-ARMs, is forecasting a 12% loss-rate. Ratcheting that up to 25% implies as much as $15 billion in extra losses.

J.P. Morgan's numbers, meanwhile, imply that the loss rate on WaMu's home-equity loans could hit 31%.

Granted, investors should be careful with this approach. First, there is a potential incentive for J.P. Morgan to set loss forecasts at a high level at the time of the deal. Doing so can help make its WaMu acquisition look more profitable over time.

Also, banks might soon be able to drastically lessen their exposure to toxic mortgages by selling them to the government.

Next, investors need to remember that WaMu grew particularly fast during the mortgage boom, so its lending may have been less discriminating, leaving it with worse borrowers and higher losses than peers.

Then again, looking at Wachovia's Option-ARM borrowers, it is hard to make the case that the bank's portfolio is going to perform better. Some 20% of its Option-ARMs were made to deep subprime borrowers with FICO credit scores under 620 and another 21% had scores below 700.

Losses can't be looked at in isolation. Some banks might be able to absorb higher-than-expected credit costs because they raised surplus capital and have strong earnings coming from their healthy businesses.

What's more, banks don't mark down their loans every quarter like brokers. Instead, they build loan-loss reserves, a more incremental approach that, in theory, gives banks time to heal themselves.

But credit markets, where banks do some of their funding, are impatient. Banks that have moved quickly in this crisis have fared better than those that have dawdled. If WaMu had sold itself to J.P. Morgan in the spring, it wouldn't have been seized this week. And Merrill Lynch now looks smart for selling out to Bank of America.

Wachovia is in preliminary deal talks with several suitors. But to deal with Wachovia's balance sheet, a buyer needs to be strong, not just big.