Mortgage Mess Gets Messier

News from Washington Mutual, H&R Block and IndyMac show the troubles keep piling up

Sometimes bad news comes in threes.

While the Federal Reserve cut interest rates Dec. 11 to ease the financial and housing crises, the market was confronted with yet more evidence of the damage these crises are inflicting on the mortgage industry. Washington Mutual (WM), H&R Block (HRB) and IndyMac Bancorp (IMB) all took hits as more and more borrowers seem unable to pay their mortgages.

Washington Mutual kicked off the latest round after the market close on Dec. 10 by announcing that given the losses on loans, it needs to cut costs, including 3,150 jobs, raise an extra $2.5 billion in capital, and cut its generous dividend to shareholders.

WaMu shares plunged 12.4% to $17.42 on Dec. 11 on the news. The shares had been hit so hard that at one point it was — at least on paper — offering a dividend of above 13%.

Many took that as a sign to expect a dividend cut, and they were right. WaMu's quarterly dividend will fall from 56 cents to 15 cents per share, bringing its annual yield down to 3.4%. The extra $2.5 billion in new capital will come from new convertible preferred stock offering a yield of 8% to 8.5%.

"While the actions appear necessary, we still do not have the confidence that the company is on the cusp of returning to consistent profitability or stability," wrote D.A. Davidson analyst Jim Bradshaw.

The big questions for WaMu and other mortgage players is when will the loan losses slow and mortgage businesses start to pick up again. One sign of trouble: home prices are expected to keep falling in 2008. Another concern is a drop in mortgage originations; WaMu expects originations for the entire industry to fall from $2.4 trillion in 2007 to $1.5 trillion next year.

Finally, losses from bad loans continue to rise. WaMu expects loan losses of $1.5 billion to $1.6 billion in the fourth quarter, about twice expectations, and losses of $1.8 billion to $2 billion in the first quarter of 2008.

Given these conditions, Friedman Billings Ramsey (FBR) analyst Paul Miller says that raising an extra $2.5 billion is "not enough." Companies that originate and/or hold residential loans will continue to come under tremendous pressure until credit trends stabilize," Miller wrote. "This will not be the first nor last recapitalization for mortgage related stocks."

Then H&R Block chimed in by reporting a loss in its second quarter of $1.55 per share, vs. a 49-cents loss a year ago. Most of that loss was due to H&R Block's closed-down subprime mortgage business. It tried to sell its Option One Mortgage Corporation to Cerberus Capital Management in April, but that deal fell through earlier this month.

"We continue to move resolutely to end our participation in the subprime mortgage business," H&R Block chairman Richard Breeden said in a statement. It has sold $3 billion in loans since August. "While we incurred a painful loss in exiting these positions, we determined to take our lumps and move forward," he added.

H&R Block shares opened lower, moved into positive territory after noon, but then fell again after the Fed decision, as many were disappointed in a mere 25-basis point rate cut. H&R Block shares ended the day down 3.2% to $19.31.

The third loser of the day was IndyMac, the nation's ninth largest originator of mortgages that has been hurt both by the housing market slowdown and rising losses on riskier mortgages. On Dec. 11, Standard & Poor's Ratings Service lowered its ratings on IndyMac's debt to junk status, from BBB-/A-3 to BB+/B. (S&P, like BusinessWeek, is a unit of the McGraw-Hill Cos. (MHP).)

The move was made because of "concerns about IndyMac's exposure to deteriorating housing markets and the effect credit losses will have on capital levels," S&P credit analyst Robert B. Hoban Jr. said in a statement.

IndyMac responded by saying the lower ratings "should have no practical impact" on its business because it doesn't need to borrow money in the credit markets. The bank increased its available liquidity from $4.1 billion to $6.3 billion in the third quarter, partly through the sale of stock. "We remain confident that we have the liquidity, capital and reserves to weather the current storm in our industry," the company said in a statement.

S&P said capital at IndyMac is "adequate, but further losses could make capital a primary concern." It noted IndyMac is seeing "higher than normal" deterioration on its core "Alt-A" loans, which are mortgages issued with little or no documentation. IndyMac shares fell 9.7% to $7.61.

If Friedman Billings Ramsey’s Miller is right, expect more fallout for the mortgage industry, with the gloomy headlines stretching into 2008 and even 2009.

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