WaMu won't escape subprime turmoil

During the housing boom of the past several years, Washington Mutual was among the nation's top lenders in the high-risk sector of subprime mortgages.

Now subprime loans industrywide are failing at an alarming rate.

Although the Seattle-based thrift has cut back its subprime lending, it still has a lot of the loans on its books.

Exactly how vulnerable it remains will become clearer today when WaMu holds its annual shareholders meeting and releases first-quarter financial results.

The high-credit-risk market known as "subprime" represented 9 percent of WaMu's overall loan portfolio at the end of 2006. Analysts who follow the company predict first-quarter profit will suffer as a result.

"Some of what they did is going to come back to haunt them," said Stuart Plesser, an equity analyst with Standard & Poor's, which last month downgraded WaMu shares to "sell" from "hold."

For its part, WaMu has been tightening its subprime-lending standards and selling off its riskiest loans to investors, while talking up the strength of its other businesses.

"WaMu is primarily a retail and small-business bank," David Schneider, president of WaMu's home-loan group, wrote in an e-mail. "Our retail banking, card services and commercial businesses are highly profitable and growing."

Some analysts see it differently.

"While they have a lot of interesting things going on in retail banking, their balance sheet is still predominantly mortgage loans," said Fred Cannon, an analyst with Keefe, Bruyette & Woods in San Francisco.

Shares of WaMu rose $1.31 Monday to $40.73. They were trading in the $45 range at the start of this year.

WaMu, which employs more than 5,000 in downtown Seattle, had $21 billion in subprime mortgages at the end of last year.

The volume of its subprime loans made in the fourth quarter dropped 41 percent from a year earlier, but the company still ranked among the 10 most active subprime lenders, according to National Mortgage News.

Loans skyrocket

The subprime-mortgage industry took off in 2003, fueled by low interest rates and rapid house-price appreciation. The volume of subprime loans made annually more than tripled to $625 billion from 2002 until the peak in 2005, according to Inside Mortgage Finance Publications of Bethesda, Md.

But many of those mortgages came with adjustable interest rates that began climbing in 2005 and 2006 after the Federal Reserve began raising rates.

At the same time, house-price appreciation slowed, forcing borrowers to pay more for homes suddenly worth less. Borrowers increasingly dropped behind on payments, defaulted on loans and saw their homes fall into foreclosure.

"Conditions deteriorated faster than the industry expected," Schneider said.

WaMu last year determined it would not be able to collect on $140 million worth of subprime loans, up from $50 million in 2005. An increase in these charge-offs ultimately translates to a reduction in profit.

Industry in turmoil

More than two dozen subprime lenders have gone out of business, halted operations or put themselves up for sale in the past year.

New Century Financial of Irvine, Calif., the nation's second-most-active subprime lender, this month filed for bankruptcy protection.

WaMu will avoid anything that drastic because it has other businesses to fall back on, said Erin Swanson, an equity analyst with Morningstar.

"They've done a good job of diversifying their revenue stream," she said, citing WaMu's purchase of credit-card issuer Providian Financial in 2005.

The company reported a profit of $1.06 billion in the fourth quarter, partly due to the sale of its WM Advisors mutual-fund subsidiary.

However, its home-loan group lost $122 million.

"The subprime business already is hurting their profits and will continue to do so for the next two or three quarters," Cannon said.

WaMu and other lenders often packaged subprime loans into mortgage-backed bonds sold to investors.

Among 20 issues in the closely watched ABX-HE 06-2 index of subprime loan bonds, a WaMu bond had the worst delinquency rate, said Matthew Howlett, a mortgage analyst at Fox-Pitt Kelton in New York.

About 23 percent of subprime loans supporting the bond issue were delinquent for 60 days or more in March.

"Their reputation is not the best in the business," Howlett said of WaMu. "They're a little aggressive."

But that appears to be changing.

Cannon said WaMu no longer offers subprime mortgages with no money down.

It also has indicated it's reviewing its policy of qualifying subprime borrowers based on their ability to pay the lower "start" rates of so-called 2-28 loans — 30-year mortgages that often adjust rates upward after the first two years.

Cannon said Schneider told him last month that an estimated one-fifth of borrowers who took out 2-28 loans in 2005 will not be able to refinance and will face payment shock this year.

WaMu sold to investors most of the riskiest subprime loans it made in 2004, 2005 and 2006, but it is less able to do so this year, Cannon said.

That means it's making less money from the sale of the loans and carrying more risk.

"They certainly appear to have their arms around the challenges," Cannon said. "But the challenges are significant."

Plesser, with Standard & Poor's, said trouble for WaMu also could come from another type of loan in which the thrift has been active — adjustable-rate mortgages (ARMs) that give borrowers the option to make limited monthly payments, sometimes for less than the interest due.

Lenders typically recalculate payment-option ARMs every five years, or when the amount owed grows beyond a certain threshold — for example, 120 percent of the original mortgage amount.

When that happens, borrowers must begin paying back the principal and interest.

"It's going to start hitting in the second half of '07," Plesser said.

Losses, opportunities

WaMu had $326 million set aside last year to cover losses from subprime loans, down slightly from $374 million in 2005.

Plesser said he believes WaMu will have to set aside more money as losses mount.

"I think this is a bit of a reprieve," he said. "When first-quarter earnings come out, people will focus on delinquencies and might be alarmed at how high they are."

Others take a more long-term view. With fewer lenders to compete against, WaMu eventually could emerge as an even bigger subprime player.

"Subprime mortgages aren't going to disappear completely," said Swanson, with Morningstar. "And someone's going to have to write them."

Amy Martinez: 206-464-2923 or amartinez@seattletimes.com