No Stock Offering for Wachovia…Yet

CEO Steel says he has no plans to issue shares, but analysts say Wachovia may be forced to raise capital as its loan portfolio deteriorates

Wachovia (WB) dodged a bullet on July 22 after the bank's new chief executive said there was no plan to issue common stock to raise capital. But analysts believe the accelerating pace of credit deterioration may make such moves unavoidable.

The fourth-largest U.S. bank by asset size reported a staggering $8.9 billion loss for the second quarter, mostly due to impairment charges on the declining value of its loan portfolios, confirming that the bloodletting by U.S. mortgage banks has yet to show signs of slowing.

No plans for an offering

The second-quarter loss, which translates to $4.20 a share, included a $6.1 billion noncash, "goodwill impairment" charge reflecting lower market valuations and asset values. The bank also increased its reserves to cover potential losses by $5.6 billion, leaving the reserves at $10.9 billion after $1.3 billion in net charge-offs. A year ago, the Charlotte (N.C.)-based company earned $2.34 billion, or $1.22 a share.

Even excluding the $6.1 billion impairment charge and net merger-related and restructuring costs of $128 million, the operating loss of $1.27 a share was significantly larger than analysts' average estimate of a 78¢ loss for the June quarter. The operating loss fell within the $1.23 to $1.33 range the company pre-announced in early July.

The market initially hammered Wachovia's shares, which dropped as much as 11.6% before rebounding, to close 27.4% higher, at 16.79. The reversal in sentiment came after CEO Robert Steel said during a conference call that the company had no plans for a common stock offering and had other ways to preserve and free up cash.

Many of the short positions [on Wachovia's stock] were based on expectations that we were going to hear an announcement about having to raise equity capital, which would have been dilutive to existing shareholders," says Gerard Cassidy, an analyst at RBC Capital Markets in Portland, Me.

Fortification needed

"Among the cost-cutting measures, Wachovia said it expects to save roughly $700 million each quarter by slashing its dividend by nearly 87%, to 5¢ a quarter. The dividend had already been reduced by more than 41% in April. The company also plans to cut 6,350 jobs.

To further reduce its risk exposure, Wachovia said it is exiting the wholesale mortgage origination business. Last month, Wachovia stopped offering the negative amortization option for the Pick-a-Pay mortgages it inherited from its $24 billion acquisition of California thrift Golden West Financial in 2006.

These actions are expected to generate or preserve more than $5 billion of capital over the next 18 months. Wachovia said it had $50 billion of regulatory capital and a Tier 1 ratio of 8% at the end of June. In addition, the company said it will consider selling some noncore assets if it needs to raise capital.

The company would likely dispose of some assets before undertaking a common stock offering, says Tom Kersting, an analyst at Edward Jones in St. Louis. He said he was encouraged by the plans CEO Steel laid out to bolster the bank's finances, given how tough a decision it is to cut the dividend and potentially shrink its asset base.

Pivotal role of commercial loans

However, Kersting thinks any efforts to fortify the various business portfolios will take some time—more than just one or two quarters. Preserving $5 billion in capital over the next year and a half will depend on the extent of the credit deterioration, not just in the mortgage market but in Wachovia's commercial loan portfolio as well, says Cassidy at RBC Capital, who has a sector perform rating on the stock. "If their nonperforming assets double or triple from existing levels, combined with a doubling or tripling of net charge-offs, then preservation of $5 billion is not going to be sufficient" to avoid having to raise capital through other means such as a common stock offering, he says.

In a July 22 research note, Goldman Sachs (GS) analyst Brian Foran noted that the bank's portfolio of nonperforming assets grew 42% from the first quarter, higher than the 35% growth rate for its peers, and that its current 2.4% nonperforming asset (NPA) ratio is one of the highest in the sector. The NPA ratio is the percentage of loans in the overall portfolio that have become delinquent. (Goldman Sachs has received compensation from Wachovia for investment banking services in the past 12 months, expects to receive compensation for these services in the next three months, and makes a market in Wachovia's securities.)

However, if Wachovia's nonperforming assets peak at 50% higher levels—not exceeding 3.6% of the total portfolio—and net charge-offs peak at current levels, then it might not have to raise additional cash, says Cassidy.

The Achilles' heel for Wachovia and all the other commercial banks is how severely their commercial loan portfolios will be hit, he says. Commercial loans, which companies use to fund everything from leveraged buyouts to working capital expenses for apparel manufacturing and retailers, typically go bad in a recession, but that hasn't happened so far, Cassidy says. If commercial loan portfolios explode as they have in previous recessions, he says, "Wachovia is going to have to come back for more capital."

Like other money-center banks, Wachovia's core net interest margin expansion and capital markets results, excluding writedowns, were better than expected, but this was more than overshadowed by rapid deterioration in its credit book, Goldman Sachs' Foran said in his research note .

Trying to be proactive

Wachovia's key business, its Southeastern U.S. banking franchise, is performing well, but its exposure to the hard-hit real estate markets in California and Florida are dominating its results, says Kersting at Edward Jones, who has a hold rating on Wachovia's shares.

The bank just boosted its projected cumulative loss rate on its option-adjustable-rate mortgage portfolio, to 12%, from a prior estimate of 7% to 8%. That's probably the bank's best assumption now, but Kersting expects that number to move around as the market continues to work through the housing crisis.

On the conference call, CEO Steel tried to drive home the point that Wachovia is being proactive in its efforts to preserve the value of its mortgage portfolio, such as by reassigning about 1,000 employees from the mortgage origination business to helping customers refinance or restructure their Pick-a-Pay mortgages.

But Kersting doesn't think Wachovia has much control over the value of its mortgage portfolio, which depends mostly on how far housing prices fall. "The things they can control are their overall expense base and asset size and the businesses they want to focus on in the longer term," he says.

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