Apparently Washington Mutual is not as well capitalized as we were lead to believe. As recently as November 7, Washington Mutual management was intimating that they thought their capital was adequate. Now they are saying they need to raise $2.5 billion in new capital through a convertible preferred and will cut their dividend by 75%. The combination of dividend cut and preferred offering will increase capital by $3.9 billion.
Let's put that into perspective. WaMu had $20.4 billion in Tier 1 capital, according to data supplied at their Investor Day on November 7. Increasing capital by $3.9 billion would be 19% of their total Tier 1 capital. Again, as of November 7, WaMu claimed (coincidence?) to be about $3.9 billion over the "Well Capitalized Minimum" dictated by banking regulations. I think we must assume that WaMu is concerned that they will fall below this minimum without additional capital.
Why do I make this assumption? Well, maaaaaaaaaybe WaMu is just being proactive. Maybe they don't expect losses large enough to push their Tier 1 capital below regulatory levels, but they just want to be safe. Maybe. But I doubt it. If that's all it was, why such drastic measures? Why raise $2.5 billion in convertible preferreds? Why cut the dividend 75%? Wouldn't you think if they just wanted to be safe, they'd just do a simple $500 million preferred and keep the dividend as is?
And what kind of losses would it take for WaMu to lose $3.9 billion in capital? Well, I estimated that in a scenario where mortgage defaults tripled their previous highs (which meant 27% for subprime and 4.5% for prime) and loss severity was consistent with a 20% decline in home prices, that WaMu would suffer about $4.8 billion in losses. Given that they had $1.3 billion in loss reserve, that left WaMu with only $3.5 billion in losses. Since they had a $3.9 billion cushion, they'd still be over their "Well Capitalized Minimum." And of course, if you assume all those losses would occur over a multi-year period, the hit on capital would be even easier to withstand.
I think they expect losses beyond their current capital cushion, and want to raise enough capital to survive.
Here's a scary thought. When I estimated $4.8 billion in losses, I assumed a very extreme scenario. WaMu is acting like the extreme scenario is coming to fruition right now. But in thinking about it, does WaMu management actually expect 27% default rate on subprime in 2008? Probably not. I suspect, although I have no hard basis for my suspicion, that WaMu management is expecting losses in other channels than just subprime.
Likely suspects include:
- WaMu's $26 billion credit card portfolio. Perhaps many of the same borrowers have WaMu credit cards and WaMu home loans. Diversification?
- Stated income loans. WaMu has been coy about how much of their "prime" portfolio is stated income. I contend that stated income loans made to borrowers with high FICOs are often investment properties in disguise. There just aren't many people in the world who have a legitimate need for a stated income loan. Most of the people who got these kinds of loans, regardless of their FICO, did so because they wanted to hide something.
- Option-ARMs. These loans make up 53% of WaMu's "prime" loan portfolio. And granted, all these borrowers supposedly had high FICOs, but FICO isn't the whole story. What if these borrowers were largely first-time home buyers? Perhaps former renters looking to get into the high-flying west coast housing market. What if they intended to be a bit house poor, assuming that the home price appreciation would be worth short-term pain?
Obviously these are all "what if's" and I have no particular reason to believe WaMu's portfolio is worse than average. No reason other than this extreme capital raising plan.
WaMu is also likely to test whether a large bank can operate with a below-investment grade bond rating. Many investors, myself included, always assumed that banks were likely to do whatever it took to maintain a high credit rating, because cost of funds is so important to their basic business model. While WaMu does not currently have a junk rating, the cost of any new debt will be at junk-type levels. If WaMu can operate while paying junk-type levels on its debt, that will change many perceptions about banks and the value of a rating.
On the other hand, the onerous cost of debt will clearly be yet another challenge to WaMu's recovery.
Disclosure: No positions in WaMu.