Monday: A good day for big retail banks to announce $7 billion cash infusions. Last week it was Washington Mutual (WM), today it's Wachovia (WB).

After reports of the capital raise emerged this weekend in The Wall Street Journal, Wachovia pushed its first quarter earnings release forward to make public some rather dismal results:
 

  • Net loss of $350 million, or $0.20 per share, on revenue that fell 4.5% to $7.90 billion. Analysts were expecting earnings of $0.40 per share on revenue of $7.98 billion.

  • Credit loss provisions increased to $2.83 billion from $177 million last year.

  • Nonperforming assets, or loans approaching default, rose to 1.70% from 0.42% a year ago.

  • Quarterly dividend cut to $0.375 per share from $0.64.

  • $7 billion in common and preferred equity sold at $23 to $24 per share, a 15% discount on Friday's closing price of $27.81.


The company's woes stem from a mistimed purchase of one of the housing boom's biggest issuers of Pay Option ARMs in California. Wachovia bought Golden West Financial for $26 billion in October 2006. According to Bloomberg, 60% of Wachovia's $120 billion Option ARM portfolio is located in California.

Option ARMs create negative amortization, which adds to a loan's outstanding balance if the borrower chooses the most affordable payment option. In addition, banks get to report income regardless of the cash flow generated by the loan. Both issues are marginalized when home prices go up and exacerbated when values plummet.

Banks book income on Option ARMs at the fully amortized rate, even if a borrower selects the minimum payment option. For example, an Option ARM carrying a rate of 7% offers the following choices for payment:
 

  • 7% interest plus principal
  • 7% interest only
  • 1% interest only


If the borrower chooses the lowest payment -- which many do -- the bank still gets to report monthly interest income of 7%. Accounting rules assume the income will eventually be realized, since all back interest is collected when the loan is paid off. However, if the loan defaults and isn't repaid, the cash never materializes.

Banking expert Minyan Peter isn't convinced the recent spate of capital infusions spell a bottom. Professor Sedacca is expecting more of the same in coming weeks as banks look for cash alongside mounting losses.

Hope abounds that the worst of the credit crunch is behind us in spite of growing evidence to the contrary.

For more on the Wachovia and its CEO Ken Thompson, check out Hoofy & Boo's always astute report.