Strap Your Boots On, It's Coming: The Alt-A and Prime Mortgage Collapse

One of my recent favorite blogs (linked on the left hand side) is Mr. Mortgage's Guide to the TRUTH! His recent post on the state of the Alt-A and Pay Option ARM Market is directly in line with my recent post on The Pending Mortgage Default Wave - Alt-A and Prime. Take a moment to read those two posts if you haven't yet.

If you look at bank balance sheets, you will find enormous Option ARM portfolios that have not yet taken significant markdowns. I normally pick on WaMu but will give them a break for the time being. Instead, let's look at Wachovia. This is a bit more fun given that it is the fourth largest depository institution in the United States ($477 billion of net loans and $436 billion of deposits).

If you take a look at Wachovia's Q2 2008 earnings presentation you'll see, on page 12, that of Wachovia's entire $488 billion gross (pre-reserve) loan book, Wachovia provided for $5.6 billion of additional reserves in Q2 of which $4.2 billion related to its $122 billion pick-a-pay book (Option ARMs). [stated another way, WB only reserved an additional $1.4 billion on the other $366 billion loan book]. Of Wachovia's total $11 billion credit loss provisions (2.25% of total loans), $5.2 billion related to the pick-a-pays (which means only 1.6% of the remaining loan book is reserved against, but, again, a story for a different day).

So, $5.2 billion of reserves on a $122 billion pick-a-pay loan book sounds like a lot. But is it?

If you take a typical Option ARM securitization from 2006 or 2007 and aggregate all the tranches such that you recreate the whole loan portfolio, those securitizations are generally trading in sum for about $0.40 to $0.60 on the $1.00. Wachovia's whole loan Option ARM portfolio is marked at $0.96 on the $1.00. A tad generous, perhaps?

Now, I accept that Wachovia's Golden West subsidiary, which originated most of these loans, is a superior underwriter in many ways. But the loans are still overwhelmingly California and Florida (about 85%), they are still high LTV, and they are still building size through negative amortization. In addition to these soft factors, we can see on page 14 the acceleration of pick-a-pay delinquencies (NPAs) and charge-offs. NPAs as a percentage of outstanding pick-a-pay loan balance at 6/30/07 were 1.03%. On 3/31/08, they were 3.82%. As of 6/30/08, they were 5.78%. That is literally exponential growth of NPAs. And resets from the nastiest vintages have yet to start while negative amortization continues apace. Even Wachovia's own estimates, which can be seen on page 16, show that the average current LTV on the entire pick-a-pay book will reach 99% at the house price trough. At that moment, severities will be highest and default rates will be brutal.

So, will Wachovia's Option ARM book be worth fifty cents on the dollar? No, it probably won't be that bad. But will it be seventy five cents on the dollar? Well, perhaps. Today, they have that book at ninety six cents.

A 25% write-off on that portfolio means another $25 billion of losses on just the pick-a-pay book. I'm willing to suppose that at that time, the rest of Wachovia's loan book will also be performing below expectations. Now, Wachovia is generating $4 billion of pre-tax operating income every quarter (excluding writedowns and above normal reserving), so the longer Wachovia can string out taking its hits, the better its odds are of earning its way through the problem. And with a $39 billion market cap (as of today's close at $18.40) it is trading at less than 3x pre-tax operating earnings. So, I'm not saying it's a short, I'm just saying that there is a ton of pain left to come and if Wachovia is forced to take that pain in a condensed period of time, as one of the least well capitalized major banks (based on Tier 1 Capital Ratio), equity holders could have a zero (or, more likely, massive dilution). While Wachovia could sell AG Edwards to raise capital, given the suboptimal environment to sell into today, Wachovia would be stealing from its future to survive which would also impair long-term value if Wachovia gets to the other side.

This problem hits WaMu as well, but worse given that a greater percentage of WaMu's asset base is in residential mortgages.

We all need to be very hopeful on two fronts:
1) these losses either do not come or come over a very long time such that depository institutions can earn their way out of this mess; and
2) that investors continue to have an appetite for investing new capital in existing depository institutions such that if losses come fast, the capital shortfalls can be plugged.

Prediction with regards to #2: we begin to see a wave of denovo banks. Why put your money into a blackbox of assets when you can start a new bank without legacy liabilities and use all these fun federal lending conduits (FHLB, Fed TSLF, etc.) to buy highly rated yet wide-spread securities and build your leverage base? I also suspect you'd be able to attract brokered deposits given the lower risk profile of a fresh bank. Buy 7% yielding assets, fund at LIBOR, lever 10x through the bank structure and have a 35%+ ROE. I can think of worse things to do with my money!