Mortgage mess hitting WaMu hard

If you think the worst is over for mortgage lenders, a close look at Washington Mutual's balance sheet should dispel that notion pretty quickly.

The largest U.S. savings and loan stunned investors Oct. 17 when it said it would set aside as much as $1.3 billion this quarter to cover anticipated loan losses. The news came the same day Seattle-based WaMu announced a 72 percent drop in third-quarter profit to $210 million.

Since then, its stock has fallen 28 percent.

But the real wonder is that WaMu's forecast for fourth-quarter loan-loss provisions wasn't substantially higher.

First, a brief accounting primer:

Loan-loss allowances are the reserves lenders set up on their balance sheets in anticipation of bad loans. Provisions are the expenses lenders record to boost their loan-loss allowances. As loans are written off, lenders record charge-offs, reducing their allowances.

For the third quarter, Washington Mutual recorded $967 million in loan-loss provisions and $421 million in net charge-offs. Those and other actions brought the company's loan-loss allowance to $1.89 billion at Sept. 30, up from $1.56 billion at June 30.

As for the fourth quarter, Washington Mutual predicted that provisions would be $1.1 billion to $1.3 billion and that charge-offs would increase 20 to 40 percent.

To see why even $1.3 billion in provisions looks light, consider WaMu's $57.86 billion of so-called option-ARM loans, which make up 24 percent of its loan portfolio.

These adjustable-rate mortgages were popular because people could postpone interest payments, which the lender adds to the principal balances.

As of Sept. 30, the unpaid principal balance on WaMu's option ARMs exceeded the loans' original principal amount by $1.5 billion, meaning customers owed $1.5 billion more in principal than what they originally borrowed.

By comparison, that figure was $681 million a year earlier, when WaMu had $67.14 billion, or 16 percent more, option ARMs on its books.

Look to the end of 2005, and the trend becomes even starker. Back then, WaMu had even more option ARMs on its balance sheet, at $71.2 billion. Yet the unpaid principal balance exceeded the original principal amount by only $160 million — and that was up from a mere $11 million at the end of 2004.

The deferred interest from option ARMs also boosts Washington Mutual's earnings, part of a process known as negative amortization, or "neg-am."

That's because option-ARM lenders recognize interest income when customers postpone interest payments, even though lenders got no cash.

For the nine months ended Sept. 30, WaMu recognized $1.05 billion in earnings as a result of neg-am within its option-ARM portfolio. That represented 7.2 percent of its $14.61 billion of total interest income year-to-date.

By comparison, neg-am contributed 1.8 percent of the interest income for all of 2005 and just 0.2 percent for 2004.

Repayment longshot

What's going on here? Either the borrowers postponing their interest payments are doing so as a matter of choice or they can't afford to pay them.

Common sense suggests it's the latter — and that there's serious doubt WaMu will collect the $1.5 billion of postponed interest that its option-ARM customers have added to their original principal balances.

Yet the $1.1 billion to $1.3 billion of fourth-quarter provisions WaMu predicted — for the company as a whole — wouldn't even cover the $1.5 billion of tacked-on principal. The trend among WaMu's option ARMs shows no sign of slowing, either.

Through a spokeswoman, Libby Hutchinson, Washington Mutual officials declined to comment. She said executives aren't fielding questions until their next meeting with investors Wednesday.

Then there's the bigger picture. While the loan-loss allowance rose 22 percent to $1.89 billion during the 12 months ended Sept. 30, nonperforming assets rose 128 percent to $5.45 billion. So even if WaMu adds $1.3 billion in provisions next quarter, its loan-loss allowance still won't be close to catching up.

Timing counts

To be sure, Washington Mutual executives have some latitude over the timing of the company's loan-loss provisions. Yet they also may have a monetary incentive to push losses into 2008.

Under the formula WaMu's compensation committee will use to determine executive bonuses this year, 40 percent is weighted toward 2007 earnings-per-share (EPS) targets, according to the latest proxy.

Goals related to noninterest expense and noninterest income each count for 25 percent, while "customer loyalty" goals count for 10 percent.

The proxy didn't disclose the specific goals for those performance measures. Still, it stands to reason WaMu executives would come closer to hitting the EPS goal if they minimize loan losses this year.

On its Web site, WaMu says the reason it no longer provides EPS forecasts to the public is that "many believe EPS guidance tends to focus management on near-term rather than long-term performance."

The same, of course, is true for executive bonuses tied heavily to yearly EPS targets. If Washington Mutual's management is more focused on near-term performance now, as the numbers suggest, this might help explain it.