Washington Mutual Shows Mortgage Mess Isn't Over: Jonathan
By Jonathan Weil
Oct. 31 (Bloomberg) -- If
you think the worst is over for mortgage lenders, a close
look at Washington Mutual Inc.'s balance sheet should
dispel that notion pretty quickly.
The largest U.S. savings
and loan stunned investors on Oct. 17 when it said it
would set aside as much as $1.3 billion this quarter to
cover anticipated loan losses. The news came the same day
Washington Mutual announced a 72 percent drop in third-
quarter net income to $210 million.
Since then, Washington
Mutual's stock has fallen 15 percent. And at $28.11, the
Seattle-based thrift now trades for only slightly more
than its book value, or assets minus liabilities, while
its dividend yield is a whopping 8 percent.
The signal from the
market: Washington Mutual's dividend and book value aren't
sustainable -- and with good reason. Washington Mutual has
paid more than $1.9 billion in cash dividends over the
past year, including $485 million last quarter. Meanwhile,
the real wonder is that Washington Mutual's forecast for
fourth-quarter loan-loss provisions wasn't substantially
First, a brief accounting
primer: Loan-loss allowances are the reserves that lenders
set up on their balance sheets in anticipation of bad
loans. Provisions are the expenses lenders record to boost
their loan-loss allowances. As loans are written off,
lenders record charge-offs, reducing their allowances.
For the third quarter,
Washington Mutual recorded $967 million in loan-loss
provisions and $421 million in net charge- offs. Those and
other actions brought the company's loan-loss allowance to
$1.89 billion at Sept. 30, up from $1.56 billion at June
As for the fourth
quarter, Washington Mutual predicted that provisions would
be $1.1 billion to $1.3 billion and that charge-offs would
increase 20 percent to 40 percent.
To see why even $1.3
billion in provisions looks light, consider Washington
Mutual's $57.86 billion of so-called option- ARM loans,
which make up 24 percent of Washington Mutual's loan
portfolio. These adjustable-rate mortgages were popular
during the housing bubble, because they give customers the
option of postponing interest payments, which the lender
then adds to their principal balances.
As of Sept. 30, the
unpaid principal balance on Washington Mutual's option
ARMs exceeded the loans' original principal amount by $1.5
billion, meaning the customers owed $1.5 billion more in
principal than what they originally borrowed. By
comparison, that figure was $681 million a year earlier,
when Washington Mutual had $67.14 billion, or 16 percent
more, option ARMs on its books.
Look to the end of 2005,
and the trend becomes even starker. Back then, Washington
Mutual had even more option ARMs on its balance sheet, at
$71.2 billion. Yet the unpaid principal balance exceeded
the original principal amount by only $160 million -- and
that was up from a mere $11 million at the end of 2004.
The deferred interest
from option ARMs also boosts Washington Mutual's earnings,
part of a process known as negative amortization, or ``neg-am.''
That's because option-ARM lenders recognize interest
income when customers postpone their interest payments,
even though the lenders got no cash.
For the nine months ended
Sept. 30, Washington Mutual recognized $1.05 billion in
earnings as a result of neg-am within its option-ARM
portfolio. That represented 7.2 percent of Washington
Mutual's $14.61 billion of total interest income
year-to-date. By comparison, neg-am contributed 1.8
percent of Washington Mutual's interest income for all of
2005 and just 0.2 percent for 2004.
What's going on here?
Either the borrowers postponing their interest payments
are doing so as a matter of choice, by and large, or they
can't afford to pay them. Common sense suggests it's the
latter -- and that there's serious doubt Washington Mutual
ever will collect the $1.5 billion of postponed interest
that its option-ARM customers have added to their original
Yet the $1.1 billion to
$1.3 billion of fourth-quarter provisions that Washington
Mutual predicted -- for the company as a whole -- wouldn't
even cover the $1.5 billion of tacked-on principal. The
trend among Washington Mutual's option ARMs shows no sign
of slowing, either.
Through a spokeswoman,
Libby Hutchinson, Washington Mutual officials declined to
comment. She said the company's executives aren't fielding
questions until their next meeting with investors on Nov.
Then there's the bigger
picture. While Washington Mutual's loan-loss allowance
rose 22 percent to $1.89 billion during the 12 months
ended Sept. 30, nonperforming assets rose 128 percent to
$5.45 billion. So even if Washington Mutual adds $1.3
billion in provisions next quarter, its loan-loss
allowance still won't be anywhere close to catching up.
To be sure, Washington
Mutual executives have some latitude over the timing of
the company's loan-loss provisions. Yet they also may have
a monetary incentive to push losses into 2008.
Under the formula
Washington Mutual's compensation committee will use to
determine executive bonuses this year, 40 percent is
weighted toward 2007 earnings-per-share targets, according
to the company's latest proxy. Goals related to non-
interest expense and non-interest income each count for 25
percent, while ``customer loyalty'' goals count for 10
The proxy didn't disclose
the specific goals for those performance measures. Still,
it stands to reason that Washington Mutual executives
would come closer to hitting the EPS goal if they minimize
loan losses this year.
On its Web site,
Washington Mutual says the reason it no longer provides
EPS forecasts to the public is that ``many believe EPS
guidance tends to focus management on near-term rather
than long-term performance.''
The same, of course, is
true for executive bonuses that are tied heavily to yearly
EPS targets. If Washington Mutual's management is more
focused on near-term performance now, as the numbers
suggest, this might help explain it.
To contact the writer of
this column: Jonathan Weil in Boulder, Colorado, at
Last Updated: October
31, 2007 00:14 EDT