Minyan Mailbag: An Approach Towards Banks
Even if WM sells off all its loans, what happens if loan growth slows?
I noticed you had called Washington Mutual (WM) into question along with several other lenders. Washington Mutual should be fine -- barring a market crash and/or severe number of job losses, I suppose.
WM does originate Option ARMS. They have sold most of their production for the last two years, almost all of it for the last year. The negative amortization totaled only 7/10 of 1% of the Option ARM mortgage value.
Further, of loans on their balance sheet, only 1% have loan-to-value ratios of over 80%. Assuming the math says most Option ARMs have been outstanding at least a couple of years, and that the initial LTV was 80%, two years of rising home values (and some positive amortization) should have built a strong cushion to support some negative amortization this year.
Thank you for your time and consideration.
Your views reflect the sanguine approach that most investors take toward banks in general and risky banks like WM in particular. Before addressing your specific comments, let's look at the key top-tine points.
Banks are extremely levered companies. They take very thin margins and lever them up dramatically to attain an acceptable return on capital. The Fed has lowered and lowered margin requirements and that is only half of the story. When banks classify loans as "loans to sell" they get even better margin treatment. Whether they actually sell them off or not is something else.
So banks need recurring revenue to lever up in order to produce income. A very small decline in revenue/income is very bad. WM makes its money primarily through home loans: $290 million out of a total of $350 million in assets are home loans. If loan growth slows just a little bit (forget defaults or anything else), it will severely hurt WM's income while WM's stock is valued at a premium where more diversified banks like JP Morgan (JPM) (don't get me started), but more appropriately Citigroup (C), are valued. This is the main point. Even if WM sells off all its loans, what happens if loan growth slows is the main and very bad point. As of 2Q, WM had 20% of income produced by negative amortization loans (as indicated by income produced by deferred interest shown below). If this source just gets cut in half, which it is, that will certainly hit the stock price.
Now to talk about the secondary points you bring up. I don't know where you obtained your information about balance sheet risk, but I will say that you may want to discount some of the information you obtain: A bank, just like a broker (there really is little difference) is a very fluid construct where the balance sheet consists of financial assets whose nature can change overnight and whose nature is described merely by classification. As I mentioned, a bank receives even better margin treatment from its regulator (Fed) if they classify loans as "loans to sell" and WM takes real advantage of this. WM, as of their last 10Q has $266 million (out of $350 million total assets) classified as "loans to sell." Do you really believe they have sold this many or can?
Some main points to summarize:
1) My firm cares primarily about the amount that negative amortization contributes to the income statement, not on the balance sheet. That's the best indicator of the importance of the loans to WM.
2) There has been tremendous grade inflation in the "value" portion of loan-to-value when the loans were put on, so we put very little credence in that LTV ratio.
3) The whole concept of LTV assumes that people didn't borrow the other 20% (or more!) in the first place, which we know they did.
4) Continuing Revenue Risk: at least 20% of WM's revenues are related to servicing or origination of home loans. In an environment of rising interest rates, decreasing home sales and ultimately declining mortgage origination, a high dependency on mortgage earnings leaves a bank more vulnerable to earnings disappointments.
5) Restatement Risk: To some extent, any bank with a high concentration of deferred interest income on their books, is front-loading profits. Per GAAP rules, these loans are generally recognized before they have been paid, which means you need to look at the non-cash income generated from these loans.
Interest payments are recorded in full even if the borrower did not pay the full amount. If the loan is later charged-off, this non-cash income would have to be reversed. These reversals ultimately have to be recognized on both the income statement and the balance sheet. As such, any lender with a high-concentration of deferred interest income on their income statement is at risk.
Exacerbating the problem in that disclosure is spotty. One way to approach it is to get as close to the amount of deferred interest associated with pay-option ARMs booked in a given quarter. WaMu reports the deferred interest amount in a footnote. Then tax effect the number (using the firmwide tax rate) and compare to firmwide earnings. The following exercise was done for us by Credisights, an excellent third-party research provider:
|Washington Mutual||2Q '06||1Q '06||2Q '05|
|After Tax Deferred Interest||149||129||46|
|% of Net Income||19.4%||13.1%||5.4%|
These banks have many moving parts and it is difficult to ascertain their real condition. But we look hard. Be very careful on this one.
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