Washington Mutual has been taking a major hit with the current credit and housing crisis.  Washington Mutual is down 71% on a year to date basis and with the recent announcement of a $3.3 billion quarterly loss, things will continue to be difficult.  Washington Mutual is categorized under a S&L/Savings Bank and even given the current share price, is still ranked amongst the top for market cap in this category.

This is an amazing stat in itself since the institution has lost over 71% of its value in this year alone.  The market has been punishing all financial institutions across the board and this reflects the widespread credit and housing problems:

Washington Mutual currently has over 43,000 employees.  In their recent public quarterly report, we can see in one of the attachments the break down of their loan portfolio and we can see why given the current loan distribution why Washington Mutual will potentially have a difficult time if the housing market does not improve.  Just for perspective, IndyMac the recently taken over S&L/Savings Bank had assets of $32 billion.  WaMu has approximately $320 billion.  In this article we are going to look at the $239 billion loan portfolio of WaMu with a major focus on the Option ARM subsection.  First, let us see the breakdown:

*Source:  Edgar Online

What you’ll first notice is that WaMu holds a large amount in home equity loans.  $60 billion in home equity loans is a lot and given how things are playing out in certain markets like California where WaMu has a large presence, many of these loans have made homeowners go underwater.

You will also notice $16 billion in subprime loans.  With such high default rates for subprime loans this is another section that will have continued losses simply because of the overall declining housing market across the country.  In addition, many subprime loans are made to borrowers who simply do not have the means to stay current and by default, subprime loans are made to those with poor to substandard credit.  People get dings on their credit when they miss payments so the history is already there.  Of course the past is no indicator of future behavior but it is a good indicator.

The major issue we will be seeing in the next few months is with the Option ARMs.  WaMu currently has $52 billion in Option ARMs with approximately half of the loans in California.  California as we recently discussed is now making up nearly 10% of all the nationwide foreclosures.  The trend should continue since the recent numbers for the state show that the median price is now down by 37.7% on a year over year basis.  This will prove to be problematic in the upcoming year.  And just to highlight this, let us first look at the recast dates for the Option ARM portfolio:

As you can see from the chart above, the major recasts won’t start until 2009 and this will remain all the way through 2012.  You can see that for the third and forth quarter of this year only $2.2 billion of the Option ARMs will recast.  The trouble with many of these loans is that you have the option to pay an artificially low rate for 1, 2, 3, or even 5 years and then all of a sudden be hit with a stunning rate increase.  In fact, 80 percent of Option ARM borrowers in the country make only the minimum payment.  This minimum payment sets up a negative amortization scenario where the actual balance of the loan increases.  What this means is the borrower isn’t paying any principal down and is most likely not even covering the interest of the loan so the balance grows.  There are caps for the growth and they are hitting at the worst time possible.

What is more troubling is that many of the Option ARMs are already seeing trouble and the bulk of the recasts are still months away:

As you can see from the chart above, problems with these loans started increasing in the third quarter of 2007 when the NCO rate was 0.26%.  Now, we are already up to 3.91% and as you see from the above recast chart, we haven’t even seen the start of the major recasts occurring.

What this tells us is the quickly deteriorating California market is hurting the Option ARM folder quickly.  Keep in mind that at least statistically in 2007 California was still up on a year over year basis.  To go from a positive to a negative 37.7% is an absolute crash and will put the portfolio in a precarious situation.  Many borrowers who would like to sell their home now find that they are underwater with a market that is tanking.  The assumption from many analysts that buyers would not walk away from homes was based on factors that were largely absent in these loans.  That is, down payments of 10 to 20 percent on fixed rate mortgages.  As the negative equity position increases, there is more incentive for the buyer to walk away and with zero down loans in many cases, that 37.7% decrease provides plenty of incentive.  These loans are sure to increase the REO numbers for WaMu.  Let us now look at the actual region breakdown:

$26.3 billion of the Option ARM loans are in California.  An additional $6.8 billion are in Florida.  These are the hardest hit states in the entire country on a nominal basis and they compose $33.8 billion of WaMu’s Option portfolio.  Given that we are extremely early in the recast period and just given the median price drop the vast majority of these loans are underwater.  Short of a boom in California and Florida housing prices these items will drag WaMu down for the foreseeable future.

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Unless you’ve actually gone through the hardship of losing your home through foreclosure, it may be difficult to understand the intricacies of how one mortgage loan can upset your entire budget. We get anecdotal stories of people having their loans reset or losing their home but we rarely get a glimpse at the loans. For one, individuals would rather not discuss the loan and most of time which is completely understandable, people for the most part want to keep the situation private. So the public normally doesn’t get to see how toxic some of these mortgage products really are.

In addition, the other side of the coin from the lenders perspective is that the details want to be held off as long as possible as to not cause panic amongst investors. Well that is about to change. California Attorney General Edmund G. Brown Jr. amended their lawsuit against Countrywide Financial, the now taken over mortgage lender and some of the evidence presented is simply startling. What we are given is a keen insight into some of the financially irresponsible loans put out by the institution.

The problem with Pay Option ARMs is that they are deceitful to both the borrower and also the lender. They are misleading to borrowers because the artificially low starter payment doesn’t come close to reflecting the real payment should full interest and principal be included as in a conventional 30-year fixed mortgage. It is also misleading to a lender since they are allowed to book deferred interest as income and many of these lenders blindly made these loans in the heyday thinking they would be paid in full at sometime in the future. All of the assumptions rested with the one caveat that home prices would continue to go up. If this one assumption were to ever not hold up, the entire house of cards would come crumbling down.

Well as we all know, prices not only came down but came down hard. Many of the borrowers are still current at the artificially low rate while lenders now painfully sit back as they sit with ticking mortgage time bombs. Recent estimates put the outstanding amount of Pay Option ARMs at $500 billion with $300 billion residing in one of the heaviest hit states, California. So let us recap really quickly before we look at an actual Countrywide loan example:

1. $500 Billion in Pay Option ARMs Outstanding

2. $300 Billion here in California

3. Lenders still look profitable with those that are current and the note hasn’t recast

4. Borrowers are still “okay” until the recast date

5. California median home prices are down 35% on a year over year basis (no option of selling since many were zero down loans)

Now I wanted to pull one loan and summarize it to give you a quick view of how quickly things can go bad with these loans. Look at this Excel sheet I put together from one loan example in the lawsuit:

What you’ll notice here, that for the first year of the payment the borrower is only paying $1,479.54 per month which for a $460,000 mortgage, is not a bad deal. Yet the mortgage quickly starts increasing. For the second year, the mortgage has now gone up to $1,590.51, an increase of 7.5%. The third year payment jumps to $1,709.80. Forth year, $1,838.04. Part of the fifth year is $1,975.89 until it jumps to the stunning $3,747.83 for the remaining 25 years. The payment has more than doubled in this short time frame. All it would take is one recast and a person would be on the verge of losing their home.

That is why Pay Option ARMs are so horrific. Now that prices have crashed in California, people are left with no option. They can’t refinance unless they have equity. The only option would be for a loan modification but this would hurt the lender’s bottom line which many are not in a place to do especially if you are current. You can’t sell unless you come to the table with money. So your option is to walk away or pay over double your original monthly payment knowing that you may not break even for over a decade.

According to the lawsuit, as of December 31, 2006 almost 88% of the Pay Option ARMs in Countrywide’s mortgage portfolio have experienced some sort of negative amortization. This rate jumped to 91% as of December 31, 2007. You can only imagine where the rate stands given the rapidly deteriorating California market. With the negative amortization, even a more toxic situation has arisen. That is, the principal balance has increased at a time when housing prices have decreased. This is simply a recipe for disaster.

There are other absurd practices done by Countrywide in the lawsuit that everyone should read. If anything, it offers a rare glimpse at how financially destructive these loans are and why the current housing problems are not going away anytime soon. We are also given some examples at loans that should have never been approved:

“The CLUES report for the loan therefore raised doubts about the borrower’s ability to repay the loan. Nonetheless, Countrywide approved a 3/27 ARM with a 3-year prepayment penalty, to an 85-year old disabled veteran with a 509 FICO score, a 59.90 DTI and 69.30 CLTV. The loan closed in February 2005, and a Notice of Default issued in July 2005.”

You can download and read the full 46 page amended lawsuit PDF here.

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