Wachovia's "Problems", A Warning Sign?

Wachovia's new chief executive is slashing his way through that bank's problems, but some argue he's not being aggressive enough.

The Charlotte, N.C., bank's second-quarter loss of $8.9 billion far eclipsed its gloomy forecast earlier this month when it announced it had hired Treasury Undersecretary and ex-Goldman Sachs investment banker Robert Steel to take over as its chief executive.

Steel has an ugly task ahead of him, and an unexpected $6 billion goodwill impairment charge in the second quarter--related to commercial banking, corporate lending and investment banking--could be one sign he is trying to make a break with Wachovia's recent troubles.

"We're serious about getting on top of these issues quickly," he said on a conference call Tuesday.

But many were surprised that Steel has focused on preserving capital rather than on raising more. He didn't eliminate Wachovia's dividend entirely, cutting it to a nickel a share, which saves $2.8 billion a year.

Wachovia is closing down its wholesale mortgage origination business, firing more than 6,000 workers and leaving another 4,400 open jobs unfilled, as well as selling loans and other non-core assets. It is also cutting off commercial borrowers who only look to the bank for loans.

Still, the results don't assuage concerns about the company's ability to survive as an independent entity, though Wachovia says it intends to do so even with mounting pressures from its large exposure to real estate. Wachovia set aside another $4.2 billion for future loan losses--an amount more than twice that of its competitors--as it faces far worse conditions in Florida and California.

"The market was expecting an update of a direct capital raising plan rather than capital conservation," says Richard Ramsden of Goldman Sachs.

Some think Wachovia could raise a substantial amount of capital by selling its retail brokerage operation, now with 14,000 financial advisers and $1.1 trillion in customer assets. Last year, Wachovia bought St. Louis-based AG Edwards for $6.8 billion and merged it into Wachovia Securities. That division is valued around $22 billion, though Prudential Financial owns one-quarter of it.

Then there's the possibility that Wachovia itself could be taken over, something that has been speculated for several months. But Steel would have to do a lot of window dressing to attract potential buyers. Wachovia has the among the highest non-performing asset ratios in the industry (2.4%), and it is bound to go higher.

Without the impairment charge in the quarter, the loss would have been $2.6 billion, approximately what Wachovia had pre-announced.

Moody's Investors Service and Standard & Poor's Corp. downgraded Wachovia, citing much higher-than-expected losses in its adjustable rate mortgage portfolio, which makes up 25% of Wachovia's assets. Moody's said losses are expected to be $16 billion for the $122 billion portfolio, twice as much as previously expected. There is a possibility, Moody's said, "that Wachovia could report losses into 2009."

The view is not much better for Washington Mutual, which is not expected to return to profitability until late next year as well. Analysts at Lehman Brothers project losses of $26 billion for the largest U.S. thrift, $21 billion of that tied to mortgages.

Wamu lived up to fears. It had a second-quarter loss of $3.3 billion after taking a $5.9 billion provision for loan losses, including $2.2 billion of charge-offs. "The company now expects the remaining cumulative losses in its residential mortgage portfolios to be toward the upper end of the range it disclosed in April," the bank said. The loss was $3.34 a share, much higher than the $1.05 a share expected loss.

The Wachovia numbers tossed water on hopes that the worst was behind the bank sector. Last week, big banks like JPMorgan Chase and Citigroup had better than expected results, which is to say they didn't do as terribly as feared.

But it's going to get a lot worse.

Loan losses and delinquencies are mounting and aren't expected to crest until later this year. That'll force banks to set aside billions of more dollars in extra reserves. Meanwhile, companies like Citigroup and JPMorgan are still writing down asset values, and many other banks will be forced to raise more capital by cutting or eliminating dividends, selling new shares or reducing their leverage.

Oppenheimer analyst Meredith Whitney, one of the most bearish of bank analysts, sees Wachovia as having the "greatest reckoning" of all banks in the coming quarters. "We are hard-pressed to find examples of financial companies that have successfully shrunk their businesses," Whitney said last week.

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