Why WaMu Got Walloped

In addition to the deteriorating housing market, the lender was hit by news of an investigation by the New York AG. S&P rates the shares sell

Conditions in the thrift and mortgage industry, for which Standard & Poor's Equity Research has a negative fundamental outlook, took a turn for the worse on Nov. 7.

First, at an investor conference, Washington Mutual (WM) announced it believes industrywide mortgage originations will fall to $1.5 trillion in 2008, 25% below the consensus forecast of $2 trillion for 2008, and 37.5% below projections for 2007. The stock weakened on the news.

Allegations of Phony Appraisals

But there was more to come. Later in the day, New York State Attorney General Andrew Cuomo announced he has extended his investigation of inflated appraisals of home loans. He had already accused WaMu of pressuring a subsidiary of First American Financial (FAF) to supply erroneous appraisal information for homes for which WaMu was to write loans. Cuomo is now investigating the government-sponsored enterprises, or GSEs, Fannie Mae (FNM) and Freddie Mac (FRE) about their role in the process.

By the end of the trading day on Nov. 7, WaMu shares were down 17%, Fannie 10%, and Freddie 8.6%.

Cuomo directed Fannie and Freddie to appoint examiners to look particularly at mortgages acquired from WaMu. The companies also were subpoenaed for information on mortgage loans they had purchased from banks. Finally, Fannie and Freddie are not allowed to continue buying WaMu's mortgages unless the GSEs are sure these loans are based on reliable and independent appraisals.

All these facts taken together, combined with more-stringent lending standards and capital restraints within the mortgage industry, point to a further industrywide slowdown in mortgage originations.

GSEs Will Survive the Blow

As for the companies involved in the investigation, we continue to look negatively on the prospects for WaMu. Besides the likely need for additional provisions owing to deteriorating home prices, we think WaMu's origination volume could come under serious pressure if the company is unable to sell to the GSEs.

Also, if WaMu is implicated in any wrongdoing, holders of erroneously appraised mortgage-backed securities may be able to put them back to WaMu. As a result, WaMu would need to build an additional reserve. As for the GSEs, although we look at investigation of them as a negative, we do not view it as damaging. We first point to the credit quality for the GSE's guaranty business, which despite trending downward remains strong compared to historical levels.

We think the negative impact of an erroneously appraised book of business would have already been reflected in these delinquency rates. We also note that, although WaMu is a large mortgage originator, it comprises less than 5% of GSE mortgage-backed security volume. Even under a worst-case scenario, in which WaMu is implicated for wrongdoing, we don't believe that all of the loans it originated were overinflated.

Finally, we see the GSE's credit business gaining ground with or without WaMu. That's important because GSE-backed loans are virtually the only loans that can be sold into the secondary market with any consistency.

WaMu carries a 2 STARS (sell) recommendation from S&P Equity Research, while Freddie and Fannie are each ranked 4 STARS (buy).

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