WaMu earnings report may end speculation about its capital needs

Three months ago, Washington Mutual raised $7.2 billion in new capital — bolstering its balance sheet at the cost of severely diluting the stakes of its existing shareholders. WaMu needed the money to help cover the cost of billions of dollars in mortgage loans that have gone bad or are expected to do so in the future.

Now, as the troubled thrift prepares to release its second-quarter financial report on Tuesday, some observers will be watching closely to gauge if WaMu's condition has deteriorated to the point it might have to go back to investors for even more cash.

Paul Miller, a banking analyst at Friedman, Billings, Ramsey in suburban Virginia, wrote in a recent report that WaMu was among the banks most at risk of needing more capital, based on how many delinquent loans, foreclosed homes and other nonperforming assets it has relative to its capital base.

Earlier this week, WaMu sought to reassure investors that it has enough spare cash to handle its rising pile of bad loans. The Seattle-based company said that in the earnings report it would "provide a more detailed report on its capital position and liquidity, as well as the steps it is taking to work through the current environment."

Wall Street expects WaMu to report a loss of $1.05 a share, according to Thomson One Analytics. However, several financial institutions have pleasantly surprised investors this past week by reporting smaller-than-expected losses.

While the main impact of any new capital raise would fall on shareholders, it could also (depending on the terms) feed concerns about the company's overall health. In addition, the lower WaMu's stock falls, the more attractive it might become to a potential acquirer.

WaMu's share price has declined so much in such a short time that any significant capital raise would require issuing huge quantities of new stock at a discount to the current market price. That would make the stakes of WaMu's current shareholders — including the consortium led by private-equity firm TPG that made the April investment — worth far less.

The TPG-led group bought its stake — potentially equal to more than half the company, depending on exercise of warrants — for $8.75 a share. On Friday, the shares closed at $5.92.

In addition, the deal with the TPG group contains its own dose of fiscal castor oil: If WaMu sells more than $500 million of stock at a price below what the TPG investors paid, WaMu will have to pay those investors hundreds of millions of dollars — either in cash or yet more new stock — to make them whole.

Based on the terms of the deal as disclosed in federal securities filings, The Seattle Times estimates that a sale of new stock at $5.25 a share would require an $800 million payment to TPG itself, which invested $2 billion in April.

Most of the other institutional investors in the April infusion would get equivalent payments corresponding to their stakes. The practical effect of that provision, said Jamie Peters, of Morningstar in Chicago, is that if WaMu needs more capital, it likely will approach the TPG consortium first.

"They're going to go back to the syndicate and say, 'Do you want to put in more money, or get diluted?' " she said.

But Peters and most other analysts said WaMu probably has enough capital to get by — so long as the U.S. economy, and particularly the housing and mortgage markets, don't deteriorate even more than they're now expected to.

"It's a touch-and-go situation," said Richard X. Bove, a prominent banking analyst now with Ladenburg Thalmann. "They seem to have enough funding to take care of the losses we're looking at."

But if the economy sinks much deeper, Bove said, "there's a very high risk that won't be enough money."

For safety reasons, regulators require banks to set aside funds to cover bad loans — existing ones and, especially, ones expected to go sour in the future. When too many loans go bad and banks don't have the reserves to cover them, they can fail or be shut down by regulators.

WaMu continues to be considered "well-capitalized" under one key regulatory test: core, or "Tier 1" capital, of greater than 6 percent of total risk-weighted assets. Core capital consists mainly of retained earnings and shareholder's equity.

But FBR's Miller, in his analysis, noted that regulators can and do look at many different ratios to gauge whether a bank has enough capital given how risky its loan portfolio is.

Even with the $7.2 billion infusion in April, Miller calculated, WaMu's nonperforming assets relative to its capital base are among the highest in the industry. That, he wrote, increases the chances regulators might deem WaMu undercapitalized and order it to raise more capital, cut back on certain kinds of lending, or take any of a range of other enforcement actions.

Bove, though, thinks WaMu can avoid having to sell more stock at the current very low price — despite predicting that the bank will record $38 billion to $40 billion in soured loans over the next three years.

Offsetting that, he said, should be the $7 billion raised in April, $17 billion in existing reserves, and roughly $6 billion a year in cash flow — for a total of $42 billion.

The wild card in that scenario, clearly, is cash flow — another reason why analysts and investors will be examining WaMu's second-quarter report very closely, to see if it's generating sufficient cash from its relatively healthy retail-banking operations.

The other key figures in Tuesday's report will be nonperforming assets (NPAs) and the amount set aside for them.

Moshe Orenbuch, who follows WaMu and the mortgage industry for Credit Suisse, projects WaMu will set aside $3.5 billion in loan-loss reserves for the quarter, about as much as it reserved in the first quarter. Higher reserves mean less money falls to the bottom line.

For the full year, Orenbuch pegs WaMu's loan-loss provisioning at a staggering $12.5 billion. Over the next several quarters, he wrote last week, "a key question is how much reserve-building WaMu will engage [in] while the NPAs build."

Drew DeSilver: 206-464-3145 or ddesilver@seattletimes.com