Monday, November 19, 2007

Washington Mutual: What I have told you was true... From a certain point of view

Long time readers know I have been a holder of Washington Mutual bonds since early in the subprime debacle. I recently sold my position. Those who have followed WaMu bonds know that I've lost on that trade... badly.

When I put the position on, I did a deep dive into WaMu's mortgage and mortgage servicing portfolio. It looked like there could be some big losses there, but after having assumed that 25% of their subprime portfolio was foreclosed upon and still finding their capital was adequate, I was a buyer.

In the interim, WaMu has made even more disclosures about their mortgage portfolio, none of which altered my view that their capital would wind up being adequate. Of course, WaMu wasn't making those disclosures for their health. They were making them because management believed more communication with investors would improve the market's outlook for the company. If you are a company being unfairly punished by contagion, increasing disclosure is the right play. The market is afraid of the unknown, so you're better off leaving as little unknown as possible.

However, there were some key things that WaMu did not disclosure, chief among them is what percentage of their held-for-investment (HFI) portfolio was stated documentation loans. In fact, I personally asked CEO Kerry Killinger to disclose this statistic at WaMu's Investor Day on November 7, and he refused.

So what we have is a company making many disclosures, and yet holding something important back. One has to assume that what they've held back would reflect badly on the company.

And then there is the matter of New York Attorney General Andrew Cuomo's allegations. In short, he alleges that WaMu pressured eAppraiseIT to inflate home appraisals. If New York prevails, its possible that investors in WaMu originated MBS could "put back" their securities. In essence, force WaMu to buy back their MBS at par. Given that non-Agency MBS issued since 2006 are pretty much universally under water, that would be quite expensive for WaMu. However, I think there is a long way to go between what's been alleged and proving fraud at the securitization level. Not the least of which is WaMu's attempt to put all legal risk on the appraiser for accurate home appraisals. Plus it would appear that WaMu has enough capital to handle repurchasing the bonds, and therefore almost any result wouldn't cause bankruptcy.

But regardless, I have a deeper problem with what New York's allegations say about WaMu's practices. Even if it were to be found that WaMu management never encouraged any kind of favoritism among appraisers, at least not in any overt way that could be proven legally, my concerns run deeper.

As an investor, I rely on companies to report their financial condition accurately and honestly. Sure, I know they are going to spin things and may at times be overly optimistic about their prospects. But the hard numbers need to be reported accurately and honestly. If not, then all bets are off. Once a company starts down the dark path of cheating on their financials, forever will that dominate their destiny.

Was WaMu's overly aggressive appraisal practices an isolated instance? Were their lending practices otherwise completely forthright? Or are inflated appraisals just one example of pervasive dishonest practices?

And you can see where the dark path leads. If WaMu was willing to look the other way on appraisals, what about stated income loans? Obviously that is an area where dishonest lenders have room to maneuver.

Now you might argue that WaMu had no motivation to poorly underwrite loans they are holding for their own portfolio. Perhaps, but during the 2nd and 3rd quarter, WaMu wound up moving a large number of loans from "for sale" to "held for investment." This means that there were a bunch of loans they wanted to sell, but couldn't. Besides, when the housing market was hot, a little fudging here and there to get loans approved didn't look like it would ever hurt anyone.

Unfortunately, once you build a culture without integrity, you might wind up hiring loan officers willing to make all kinds of misrepresentations to close loans. So even if one figures that WaMu management would have intended to underwrite good loans for their own investment, that might not be what they wound up getting.

There are plenty of other areas where there is room to misrepresent reality to investors. Might WaMu be making loan mods to borrowers bound to default? Loan mods are fine and good for borrowers who have a good chance of remaining current after the mod. Borrowers who have no hope need to be foreclosed upon. But maybe WaMu wants to make their loan performance stats look better than they really are.

Now you might think I'm extrapolating a lot of dishonesty from one accusation. But of course, once I'm sure a culture without integrity has infected a company, its too late. See Enron or Refco or Arthur Andersen.

Ethically, I can't invest in a credit unless I can estimate both the risks and rewards of the investment. If I'm going to suffer a default, I need to be able to look my clients in the eye and say I did all the analysis I could, and I was just wrong. Once there is evidence of fraud, all ability to estimate risks is gone. And if I ignored evidence of fraud, and subsequently there was a default, how could I look my clients in the eye and say I did all I could?

17 comments:

Anonymous said...

Kudos on your well-thought post on WaMu. I've been a long-time reader of your blog, and incidentally I'm a WaMu employee too. I'm a small fish, in the lowest rung of the financial ladder.

The morale in the company is low and everyone feels cheated by the top management.

What do you think is a prudent step for someone like me, who has been with the company for a couple of years and is in his late 20s? I am tempted to throw in the towel and look for a better job. Part of me wants to ride out the storm.

I'm amazed that a seemingly big Fortune 500 bank with 2500 retail branches can overnight become a pariah of the street.

Do you think WaMu has a big chance of entering bankruptcy? Will it be taken over by a big European bank? can the US government afford to allow a big bank like WaMu to go under without undermining the banking and financial system?

Too many questions...

I've read everything from Netherland's Tulip mania to Charles Kindleberger's Manias, Panics and Crashes. Didn't imagine I will be in the middle of a panic myself.

Anyway, your honest opinion and thoughts about WaMu will be yet another data point on which I would like to base my decision.

Accrued Interest said...

I think the odds of a sale to some other company are very high. Despite all I said in the post, BK is probably not how this goes down. WaMu does have a valuable franchise that someone would probably want. That's assuming that things are generally on the up and up over there.

I don't think WaMu is too big to fail. I wouldn't expect an overt bailout.

Now, I don't want you to say anything on this blog that could ever be construed as insider information. I know you say you are a small fish, but be careful anyway.

That being said, if you think there really is a culture of dishonesty, you should quit and get out. Get out before you are infected as well. I'm dead serious.

If that's not how it is, and you think WaMu is headed in the right direction, then I'd go forward as you were. There are lots of pariah's one day and then fine the next. Remember when anything dot.com was gold, and then it was shit? Now it turns out some of it was gold and some was shit. Maybe WaMu is actually gold.

I have concluded that I can't be sure.

Deborah said...

To your anonymous poster, look for another job, but do not quit until you find one.

In a down turning market the goal isn't to find a better job, but to have a job. I suspect many jobs in your sector are at risk.

I admire the frank discussion of an investment that went bad.

Anonymous said...

Dear Accrued Interest:

How are the more esoteric loan products securitized? The various pay option loans have highly irregular income streams. From your previous posts on how bonds can go bad quickly it seems these would be impossible to sell. Is this why such a large percentage of them seem to be held by the originators?

Anonymous said...

Accrued Interest,

Kudos to you for your full disclosure description of how that WaMu credit went south. I, like others here, appreciate your insights and your candor.

energyecon

Accrued Interest said...

About 60% of WaMu's "prime" portfolio is option arms. So I'm gathering these weren't sellable.

I've linked to WaMu's portfolio disclosures within my post in the part about WaMu making additional portfolio disclosures.

Accrued Interest said...

Also, thanks to for all the kind words. Look, every one makes bad trades. I think if I pretended that I didn't, I'd never learn anything. The idea is to get better at this gig, not to stand still and stoke my ego.

the cds trader said...

agree with the other commentators, good on you for the honesty on a horrible trade. it's actually one i'd meant to bring up in the comments earlier this year, as i completely disagreed with getting long this credit (i bought cds earlier this year when it was in the 30's and plan to ride it all the way into bankruptcy, although will probably get tempted to cover it when its trading at some seriously big points up-front).

as a fellow blogger, and a reader of Calculated Risk, i am very surprised you wanted any exposure to the US banking sector, the downside seemed pretty clear even from late last year...although I do remember after one of your posts earlier this year that it did tighten a fair bit afterwards.

oh and just to say i also see your good calls...back in august you were mentioning Annaly very positively, stock up 20% since then in a horrible market, but I didn't pull the trigger dammit!

anyway, good luck on the next trade!

Anonymous said...

Please post on Fannie and Freddy.

I was not aware that they carry $50 billion to support $2.8 trillion in MBS.

Apparently they are allowed this 70 times leverage *because* they are a GSE.

Yet, we know that they are crooked. It's not like WaMu where there is doubt.

Please comment on Fannie and Freddie, and please keep blogging.

Anonymous said...

I am a former employee, and I never had any reason to doubt integrity of senior management. Not being expert in securities I can't comment on specifics, but as far as culture goes, it has very collegial decision making, is fairly transparent, focused on retail customer, with risk management in the center of strategy, not taking risky financial bets. I'd say it looked more like gold rather than shit.

Anonymous said...

Talk about "misrepresenting reality",this authors' profound conjecture is baffling. As a former employee of WaMu, we lost so many mortgage deals to low appraisals that I could have paid a year of college tuition with the money I lost. His insinuations that all the loan officers were falfsifying low doc loans is just incredibly naive...this guy has no concept of how the mortgage industry runs, and is regulated, yet he devotes a lengthy article to a subject he obviously knows nothing about...yet thinks he's an expert...typical wall street myopia...

Darth Toll said...

anon 4:22,

What about the other issues like HFI stated doc percentages? Killinger's refusal to state the number tells you a lot about the mindset of the senior management. They'd just prefer not to talk about the ugly stuff but this isn't full disclosure, far from it.

I'm not sure about WM, but I can tell you from my numerous dealings with CFC that they definitely had A-list appraisers that they would go to again and again because they would "hit the number" and the deal would get done. Appraisers that didn't hit the number wouldn't get much work. It's all about originations, dude. That is, as long as you could move the crap OFF the books, LOL!

Your statement about Wall St. myopia is misplaced. Typically, Wall St. myopia consists of overly-rosy economic forecasts by "sell-side" brokerage economists, pump-n-dump shilling by the likes of CNBC, and the quarterly earnings sandbagging by beat-the-number analysts. This honest analysis is neither and is very refreshing.

Accrued Interest said...

I'm getting to Freddie. I think they'll be fine, but their need to raise capital in a bad market will hurt shareholders. They'll wind up issuing a very expensive pref, which they'll be stuck with for a long time.

On WM, I think there is a good chance this ends either with a low price merger or an infusion of capital. That makes CDS a dangerous bet, as it might end badly, but not actually BK.

Anonymous said...

Did you happen to see this post:
http://blogs.marketwatch.com/greenberg/2007/11/drilling-deeper-into-the-freddie-fiasco/#commentslanding

What are you thoughts about what Freddie Mac is doing vs the big banks?

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