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Tuesday, August 12, 2008 11:34 PM

Can Wachovia Do Anything Right?

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An analyst at RBC Capital Markets suggests Wachovia cut corners to join the trillion dollar asset club. MarketWatch has the story in Wachovia's commercial loans stir worries. My comments follow.

"This company's mantra was grow, grow, grow," Gerard Cassidy, an analyst at RBC Capital Markets, said in an interview. "They were so focused on wanting to be in the trillion-dollar asset club for banks that they cut corners."

Until now, most analysts and investors have focused on Wachovia's (WB) $122 billion portfolio of so-called pick-a-pay mortgages, inherited from the infamous acquisition of lender Golden West at the height of the housing boom in 2006. These kinds of negative-amortization mortgages allowed borrowers to pay less than the required monthly amount, increasing the size of the loan. As house prices slump, more of these home loans are souring.

But Wachovia also has more than $200 billion in commercial loans that could trigger even more losses if the U.S. economy slides into recession, according to Cassidy. "This is more frightening to me because it's bigger," he said.

Wachovia had $206 billion of commercial loans on its balance sheet at the end of June, up 25% from a year earlier and more than double from five years ago.

Such types of loans are made to companies to help them pay for acquisitions and for other reasons, such as financing inventories and receivables. They are sometimes unsecured, so when loans go bad there's no collateral to sell to recover any money, leaving a 100% loss, analysts say.

"As signs of a weakening economy continue to emerge, we are likely to see credit quality in C&I lending deteriorate in tandem with the general economy," wrote Kevin Mixon, an analyst at RiskMetrics, in a June report to investors.

In the second quarter of 2007, before the credit crunch hit, Wachovia reported that net charge-offs on these types of loans were 0.07% of average commercial loans. That jumped to 0.88% in the second quarter of 2008.

In the second quarter of 2002, during the dot-com bust, Wachovia reported the rate of net charge-offs on commercial loans was 1.24%.

In its latest annual report, Wachovia said provisions to cover bad debt would remain under 0.75% of average net loans, on an annualized basis, during the first half of 2008. However, soon after the bank disclosed in a regulatory filing that provisions would probably exceed that level.

In April, The Wall Street Journal said that Wachovia was being investigated by federal prosecutors as part of a probe into alleged drug-money laundering by Mexican and Colombian money-transfer companies.

In the same month, Wachovia agreed to pay an estimated $144 million to settle charges that it took advantage of older customers through questionable relationships with telemarketers. The bank didn't admit or deny wrongdoing.

Also in April, the company reported a first-quarter net loss of $393 million, or 20 cents per common stock. Three weeks later, Wachovia almost doubled that loss to $708 million after reviewing agreements related to its bank-owned life insurance portfolio

"There's a history of evidence that this company cut corners. They didn't have the systems in place to control risks," Cassidy commented. "Wachovia was in such a rush to get into the big guys' club, that our biggest fear, aside from pick-a pay, is that they didn't underwrite commercial loans properly."
Can Wachovia Do Anything Right?

Wachovia (WB) has messed up badly in Alt-A, in taking advantage of older customers, in cutting corners on loans, in having to restate losses, in Pick-A-Pay mortgages, and possibly in a drug-money laundering scheme. Yesterday, New York Attorney General Cuomo said he is expanding his investigation into the collapse of the auction-rate securities market to include JPMorgan (JPM), Morgan Stanley (MS) and Wachovia Corp (WB).

Indeed, Wachovia's list of problems seems to grow every day, just like Pinocchio's nose. Yet, it is very difficult to do anything right when your biggest concern is to grow, grow, grow, with no system in place to control risk (or the length of one's nose).

Wachovia's commercial loans chargeoff rate during the dot-com bust was 1.24%. However, real estate was not a problem in 2002. Real estate is a massive problem now. And making matters worse, Wachovia levered up at exactly the wrong time, doubling its commercial loan portfolio to $206 billion in the last 5 years.

Office vacancies are now rising, lease rates are falling, and unlike 2002, the Shopping Center Economic Model Is Now History.

Here are some recent high profile bankruptcies Wachovia was involved in: Mervyn's, SemGroup, WCI. One might expect a dozen more before this is all over.

And when it comes to expected writeoffs this cycle, it's $500 billion down and $1.5 trillion to go.

Wachovia (WB) Bank Daily Chart

click on chart for sharper image

The key to survival for Wachovia is to raise capital now, before the above chart turns into something that looks like this.

Fannie Mae (FNM) Daily Chart

click on chart for sharper image

Those charts are amazingly similar, aren't they?

My Suggestion For Wachovia

"Raise capital now when you can, for as much as you can, if indeed you even can. Because if you don't you may end up like Washington Mutual, unable to raise capital at all."

See Death Spiral Financing at WaMu, Merrill Lynch, Citigroup for more on WaMu's inability to raise capital.

Here's the deal. The Fed and the Treasury are highly unlikely to go to the same lengths to bail out Wachovia as they did Fannie Mae (FNM) and Freddie Mac (FRE). Alt-A and commercial loan problems at Wachovia are poised to skyrocket. This could be Wachovia's last chance to raise a significant amount of capital in an equity deal and/or by unloading some assets it should never have bought in the first place.

Mike "Mish" Shedlock
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