Short WM (Washington Mutual)

This comes from Barron's. Lon Witter wrote that there has not been a housing bubble but a lending bubble.

• 32.6% of new mortgages and home-equity loans in 2005 were interest only, up from 0.6% in 2000;
• 43% of first-time home buyers in 2005 put no money down;
• 15.2% of 2005 buyers owe at least 10% more than their home is worth (negative equity);
• 10% of all home owners with mortgages have no equity in their homes (zero equity);
• $2.7 trillion dollars in loans will adjust to higher rates in 2006 and 2007.

I actually believe that this understates the nature of the problem. I believe that all homeowners who bought 2004-2006 will find that they owe more than their home is worth. I base this on the fact that year-over-year prices will be negative. That is, 2006 prices will be lower than 2005 prices....which means that they are at 2004 prices. And dropping.

Many folks say - this is not a problem. It's paper money until they have to sell.
Those folks are incredibly wrong. Because the mortgage payments are not flat but rising. Almsot everyone who bought in the last 3 years is financially overextended - they used ARMs to get the most house they could afford. Now those mortgages are racing up. If they sell, they sell at a loss.

I look at WAMU and I see major problems. WAMU is at the heart of the home financing game. Also, WAMU has some major accounting exposure. The issue is an accounting method called accrual accounting. In accrual accounting, a bank can book profits based on contracted payments and not actual cash.

That is, if a homeowner borrows money and agrees to pay an amount of money but actually pays less, the bank books the full amount owed and NOT what was paid. They book the payment plus the IOU. In other businesses, an IOU is not booked - it's an IOU. banks book it as payments.

It has two impacts. It pushes up profits in the near term. If the payment doesn't happen, it pushes profits down even deeper. That larger swing is what concerns me.

How widespread is this issue? Consider Interest Only Loans and Option ARMs. In both loans, the Bank books the contracted amount an dnot what is actually paid. Option ARM borrowers, for example, can pay a minimum amount that is less than the full amount and that difference gets added to the total loan amount. About 80% of Option ARM borrowers pay only the minimum.

Interest Only loans also offer low payments today in return for an ever increasing loan value. What you don't pay today gets added to the total payment at a compounded rate. A great idea for borrowers when the housing market was surging and the asset price was growing fsater than the loan amount.

WAMU can book as profit today the difference between the original loan amount and the growing loan amount.

You don't have to analyze this too much. Borrowers can pay more, default, or re-finance at high costs ($10K refinancing penalty and a mortgage about 40%+ higher than original). These are all just versions of bad, worse, and terrible for WAMU. Because no matter what, WAMU's profits will drop.

It doesn't matter how much of their loans WAMU has sold on. Simply ending the high profit from these loans is a problem for WAMU.
WAMU has $12.5B of these loans on its books today, up from $2.5B in 2005. In 2005, these loans accounted for $31M in WAMU profit (I'm looking for the source of that figure). That would be $160M for this year. If these loans stop being written, that's a 5% drop in earnings.

Another area of weakness is the drop in mortgage activity. Home sales are down 30%+ year over year. That's thousands of dollars in fees per home sale that they are losing. I would say about $100M in lost revenue - which is about 100% margin. Another 3%~5% drop in earnings.

Next, if home prices drop, so does the value of the mortgages and therefore the value of WAMU's income.

It's easy to see a minimum earnings fall of 10%.

Meanwhile, notice that I haven't mentioned defaults at all. I am not discussing the future state of housing. I am merely talking about key revenue earners for WAMU that will be rapidly disappearing.

Now throw in defaulting loans, and WAMU is not sitting pretty. They have $351B in assets of which $306B is home mortgages. Coincidentally, that is also their debt. Some percentage of their loans will go bad. If even 1% default, that's a $3B loss. Spread that out over 3 years, and that's 30% drop in earnings.