Thursday, June 26, 2008

Wachovia Takeover Speculation Heats Up

The rumors concerning potential suitors for Wachovia continue circulate.  Wells Fargo?  JPMorgan?  Anyone?  The speculation has intensified since Wachovia disclosed on Tuesday that it had hired Goldman Sachs to evaluate its loan portfolio, leading many to speculate that it had hired the investment bank to find a merger partner.  Wachovia would be an ideal takeover candidate, if it weren't for one big stinky problem: the "pick-a-pay" mortgages sitting on its books.  Wachovia paid $25 billion for Golden West in 2006, roughly $15 billion more than book value at the time.  Wachovia is left with $120 billion in option arm loans which includes $3.5 billion in deferred interest as of the quarter ended 3/31/2008.  Deferred interest is interest that the borrower has yet to pay because he has opted to pay the minimum amount required by the lender, thus the catchy name "pick-a-pay".  The borrower is not off the hook, he is merely deferring his liabilities.  Under GAAP accounting rules, Wachovia can book this amount as interest income, although it shows up on the cash flow statement because the company has yet to collect the cash.  How much of this deferred interest will Wachovia actually ever collect?  That is highly dependent on the delinquency and default rates of the loans, which are growing significantly due to falling housing prices across the country. 
According to Wachovia's 10-K, 59% of the "pick-a-pay" loans were based in California, 10% in Florida, and the remainder in various other parts of the country.  To summarize, nearly 70% of Wachovia's option arm portfolio is concentrated in two states where home prices have plummeted in the past year.  So Wachovia has $90 billion in exposure to borrowers in California and Florida who are making minimum payments more than likely because they could never afford a fully amortizing mortgage, and are probably now underwater on their mortgages.  According to Housing Wire, performance on Alt-A mortgages significantly deteriorated in May.  The 2006 vintage of Alt-A loans saw 60+ day borrower delinquencies among first liens reach 21.22 percent in May, up 10% in a single month.  The 2007 vintage saw 60 day delinquencies up 22% to 18.55%.  My guess is that Wachovia has seen its own delinquencies surge since the last quarter ended and realized it finally needed to take significant action.  This is why Ken Thompson, the ex-CEO who was a staunch defender of the Golden West acquisition, was given the boot in early June.  The company, which STILL has not written down the $15 billion in Goodwill from the Golden West acquisition, finally realizes that the loans are impaired, the acquisition was a big mistake, and Wachovia has not taken enough in reserves against potential losses.  What will Goldman conclude after its analysis?  Does any investor was to buy these assets?  My guess is that Wachovia will be forced to take an enormous, eye-popping loss if it sells the "pick-a-pays".  Furthermore, I don't think any bank will buy Wachovia until it can rid itself of the risky loans.  Wachovia is already trading at a significant discount to book value, so it is clear that investors are bracing for some very bad news.  But have they prepared for the worst? 

1 comment:

Anonymous said...

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