A Rescue for WaMu?

A much-needed cash infusion could allow the mortgage broker to return to profitability sooner

The grim outlook for mortgage defaults as the housing slump deepens has kept pressure on banks such as Washington Mutual (WM) that continue to have a lot of mortgage-related exposure. But a cash infusion of $7 billion that the bank announced on Apr. 8 could give investors more confidence that WaMu will be able to ride out the mortgage storm.

On Apr. 7, unconfirmed talk of a large cash injection, based on a Wall Street Journal report, was enough to push shares of the Seattle-based bank up 29.3% to $13.15, eclipsing an 11.5% drop on Apr. 4. WaMu is one of the leaders in lending to consumers and small businesses.

WaMu said it had entered into definitive agreements to raise an aggregate $7 billion through the sale of stock to an investment group led by TPG Capital, which includes many of WaMu's top institutional shareholders. TPG's investment vehicle, as anchor investor, will buy $2 billion in newly issued WaMu stock.

The bank will sell about 176 million shares of its common stock at $8.75 per share and will also issue roughly 55,000 shares of contingently convertible preferred stock at a purchase price and liquidation preference of $100,000 per share. After getting certain approvals, including that of WaMu's shareholders, the convertible preferred stock will automatically convert into common stock at an initial price of $8.75 per share, subject to adjustment.

Some investors who agreed to transfer restrictions on their shares will also receive five-year warrants that will become exercisable for common stock, subject to certain approvals, based on a post-closing reference price.

The investment will also secure a seat on WaMu's 14-member board for David Bonderman, a founding partner of TPG. Larry Kellner, chairman and chief executive of Continental Airlines, and a former chief financial officer of American Savings Bank, will become a board observer at TPG's request.

WaMu also said it plans to cut its quarterly dividend to 1¢ from the current 15¢ per share to further bolster its capital position. That is expected to preserve about $490 million of capital a year.

In a preview of its first-quarter financial results, slated for Apr. 15, the bank on Apr. 8 announced a net loss of $1.1 billion, or $1.40 per share, and said it was setting aside $3.5 billion for loan losses for the quarter and expects net charge-offs of roughly $1.4 billion.

Access to ample capital has been a central concern for investors in these financial companies who worry that the banks aren't sufficiently capitalized to weather ongoing losses as more homeowners default on their mortgages and their homes go into foreclosure.

Some analysts were optimistic about the deal. Given the write-offs the company took for mortgage-related losses in the fourth quarter, the cash infusion should make regulators and anyone else concerned about the strength of the balance sheet happy, says Gary Gordon, an analyst at Portales Partners in New York.

"This gives them more flexibility, to take more write-offs today and get more of their losses behind them or to limit their amount of asset shrinkage, or [use capital for growth]," he says. "The odds are this is more to plug a potential hole caused by losses." (Gordon, who has a hold rating on the stock, owns WaMu preferred stock, which he says isn't convertible to common shares.)

If the bank were to use a fairly large portion of the capital to build its reserves to cover potential losses, that could speed its return to profitability once the mortgage cycle has run its course, he adds.

Standard & Poor's Equity Research reaffirmed its hold rating on the stock, but said that despite the dilutive effect it would have, the potential capital injection is positive for the bank, given its fourth-quarter Tier-1 capital ratio of 8.30%, which was below its peers.

However, with WaMu's loss allowance at only 42% of nonperforming loans, S&P said it expects additions to loss provisions in the quarters ahead to be significant. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP).)

"Certainly, along with most other players, [WaMu is] going to have to increase its provisions for future loan losses," says Tom Kersting, an analyst at Edward Jones in St. Louis. "They've been dramatically increasing it over the last couple of quarters and we expect it to remain at even higher levels through 2008." (Edward Jones has received compensation from WaMu for investment banking services within the last 12 months and expects to do so in the next three months.)

How high those provisions go will depend on how bad the housing market gets, particularly in California, where WaMu has originated a lot of loans.

While delinquencies have been accelerating, the key question is how many of those delinquencies will actually turn into loan losses, says Kersting, who has a hold rating on WaMu shares. In many cases, there can be recoveries even on delinquent loans, "but those recoveries become smaller and smaller as home prices drop 20% and 30%," he says.

Near-term dilution that will result from the issuance of $7 billion worth of common and preferred stock won't please current shareholders. But that can be forgiven if the capital injection will help WaMu get through the mortgage turmoil and ends up benefiting shareholders in the long run, Kersting says.

WaMu has already taken some drastic steps to reduce its risk, such as discontinuing all lending at subprime channels, closing more than half of its home loan centers and sales offices and cutting more than 3,000 employees and raising roughly $3 billion in capital by issuing convertible preferred stock. These actions were taken in the fourth quarter.

The fact that a private equity outfit as talented as TPG is interested in putting capital into such a beleaguered industry may be cause for some optimism about the housing market, but it shouldn't be taken as a sign that it's reached a bottom, Kersting notes. "We've seen other players put money to work in this market in recent months" only to get burned by further deterioration, he adds.

Indeed, some analysts, including Gordon at Portales Partners, don't expect WaMu or any of its peers to turn a profit until 2010. Gordon recently cut his earnings estimate for WaMu to a loss of $1 per share from a 50-cent profit, given his view that the company will have to increase its loss provisions.

Rather than gambling that the housing woes will diminish any time soon, TPG and other prospective investors are more likely eyeing the potential returns to be made once WaMu's stock rebounds, even if that's three years away, Gordon says.

If WaMu can survive and get back to earning around $3 per share annually, that would translate to a stock price in the mid-30s if you apply the 12 times multiple the stock has had in the past, says Gordon. TPG could triple its investment, and the bank would arguably be a much better takeover candidate at that point, since by then, prospective buyers would know the extent of the company's losses.

The capital injection also probably takes the possibility of a buyout off the table, at least for the time being, says Kersting. Up until as late as a week ago, JPMorgan Chase (JPM) was reportedly discussing an offer with WaMu.

From WaMu's perspective, if it believes it will have adequate capital to survive the current crisis, it may be better to get a large investment and wait for its stock to recover a few years from now, rather than sell out at around 10 per share, Gordon figures.

In the fourth quarter, WaMu's nonperforming assets increased 30% to $7.1 million, or 2.9% of total loans. In January, the bank had $57 billion of Pay-Option adjustable-rate mortgages, $63 billion of home equity lines of credit, $19 billion of subprime mortgages and $27 billion of managed credit card receivables, supported by $14 billion in tangible common equity, according to a Friedman Billings Ramsey (FBR) research note on Jan. 18. "We believe that most mortgage-related names will trade at a deep discount to book [value] until credit losses can be quantified," the note said.

Kersting says WaMu doesn't get nearly as much credit as it should for having "a surprisingly strong retail banking franchise that continues to be overlooked in this environment," with attractive branch locations throughout California, a robust market for retail banking. He believes that only Bank of America (BAC) surpasses WaMu in opening new checking and savings accounts, which is ultimately what drives the business over the long term.

Given questions about how long it will take for the turmoil in the housing and mortgage markets to play out, Kersting says he doesn't know how anyone can predict that WaMu won't be able to make a profit for all of 2009.

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