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WaMu: "Self Inflicted Wounds"
July 6, 2004

Watching the negative press heaped upon Washington Mutual (NYSE:WM) makes us wonder, is it the people or the business model? WM's team was once the toast of Wall Street -- at least until the bad news started to flow. Now they seem to be just toast.

One Sell Side analyst calls the problems "self-inflicted wounds," an amazing description for a bank that was once seen as a source of new ideas in a staid and shrinking industry. The $248 billion asset WM was the new, retail driven bank of the future, an acquisitive, branch-sprouting juggernaut that was going to show the other Mega Banks how it was done. No more.

When WM Chief Executive Kerry Killinger said the effects of interest-rate changes "are likely to outpace the timing of ongoing cost-reduction plans in our mortgage banking business," we almost heaved our Wheaties. Not, mind you, because we were surprised to hear his particular revelations about poor interest rate risk management, but for what this confession implies for the rest of the industry.

We have ranted several times in the past month about the "Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities," a effort by the OCC, OTS, Federal Reserve, FDIC and SEC to improve compliance and oversight over derivatives and other "complex" but notional financial instruments.

Part of the reason for the sudden interest in this subject by regulators, we're told, is the mounting evidence that banks -- even large banks, have not a clue what they are doing when it comes to even the most basic types of risk management. As we asked not long ago and we'll repeat, if giant organizations the likes of WM or Fannie Mae (NYSE:FNM) cannot manage the duration risk of relatively pedestrian mortgage portfolios, what makes the regulators think that the vast majority of smaller institutions can play in the world of customized derivatives contracts?

The other scary aspect of the WM debacle is how the bank's heretofore solid image with the Sell Side barely hinted at the problems now revealed by the change in earnings guidance. Below the surface, however, the key ratios are remarkable -- and have been visible to fundamental analysts for a long time.

The historical loss given default rate for WM's lead bank had largely tracked the mortgage lending specialization peer group defined by the FDIC, but the degree of interest rate sensitivity of its liabilities is well above the peer mean, while the rate sensitivity of its assets is well below that of other mortgage lenders, according to Q1 2004 data from the FDIC. In keeping with its aggressive image, WM's loans as percent of assets is 10 points above the peer mean. On the liability side, WM's deposits to assets ratio is 57% compared to 76% for the mortgage lending peer group. In terms of Op-Risk, WM's Other Liabilities category is a whopping 23% of total assets vs. 10% for the peer group.

As we learn more details regarding WM's internal difficulties, risk managers should consider whether the price-based metrics that Wall Street relies upon for predicting default and restatement risk served their stated purpose in this case. WM's stock price traded above $46 per share in November 2003, then fell back to $40 before year-end. The valuation then rebounded above $45 in Q1 2004, but is now near the 52-week low. Q: Given that the profile in the paragraph above was clearly visible in WM's historical financial statements, why would any investor (as opposed to a momentum driven punter) who favors bank paper ever like this name?

The answer, it seems to us, is that WM has consistently reported asset returns roughly 2X the mortgage lending peer mean, albeit returns built upon a structure that is far more aggressive than the mean. This suggests that in the future, those institutions that evidence above-average performance with a risk profile that is also significantly higher than the peer group should be challenged to verify those results.

Meanwhile in Chicago...

Perhaps its just a coincidence, but the Federal Home Loan Bank of Chicago has just confessed its own internal shortcomings and has been placed under a de facto consent decree by regulators in Washington to improve internal controls and risk management capabilities. Like WM, the FHLB of Chicago once bragged about its superior returns and leading position among its FDR-era peer group.

Last week, Standard and Poor's lowered its long-term counterparty rating on the Federal Home Loan Bank of Chicago to double-A plus from triple-A, ending a review process started in November. The agency also affirmed the Chicago FHLB's A-1+ short-term rating, but said the outlook for the ratings remains "negative."

We hear from the trenches that the asset-liability mismatch inside the Chicago FHLB is an order or magnitude more serious than the problems at FNM, problems that caused Fed Chairman Alan Greenspan such agitation that he made them a central part of his comments to Congress about reforming the GSEs. When the examiners get done excavating the remains at the Chicago FHLB, how much you want to bet the regulators become even more hysterical over the issue of "Complex Structured Finance Activities."

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