Wachovia, WaMu still in big trouble

Bad news for these big banks

All of this is bad news for Wachovia and Washington Mutual. In April, Washington Mutual blew past an expected $1.05-a-share loss in the first quarter and posted a $1.40 loss -- in part because it had to set aside $3.51 billion to cover potential loan losses in the first quarter. Wachovia handed investors a similar surprise. An extra $2.1 billion set aside for loan losses forced Wachovia to post a loss of 20 cents a share. Wall Street was expecting earnings of 40 cents a share.

These ugly surprises are only a taste of what's to come, says Byron MacLeod, an analyst at Gradient Analytics. Banks such as Wachovia and Washington Mutual need to set aside lots more money to cover upcoming loan losses, he says. They are woefully behind.

Let's start with Wachovia. A year ago, everything looked fine. The bank had an adequate amount set aside. Typically, analysts like to see an amount of cash set aside for loan losses that equals two times the total value of "nonperforming" loans at a bank. At Wachovia and Washington Mutual, a loan is deemed nonperforming when the borrower is three months behind on payments.

That ratio is the average at banks for the past five years, Gradient says. And it's the coverage Wachovia had.

A year later, the picture has changed. The total of Wachovia's nonperforming loans has shot up, and the cash hasn't kept up.

A year ago, for example, just 0.5% of the bank's real-estate loan portfolio was considered nonperforming. By the end of the first quarter, that had shot up to 2.2%. Nonperforming residential loans increased 325% to $5.1 billion in the first quarter of this year, compared with $1.2 billion a year ago. Loan charge-offs -- or delinquencies of 180 days -- are also climbing. They advanced 385% to $771 million in the first quarter, compared with a year ago.

Wachovia hasn't set aside enough cash to cover those nonperforming loans. The amount of cash set aside is up just 94% to $6.6 billion in the same time frame. This means that the ratio of allowances for bad loans to nonperforming loans has dropped to around 1 from the safer level of 2.1 a year ago. "They are not being aggressive in getting in front of these nonperforming loans," Gradient Analytics' MacLeod says.

The key takeaway: The bank will have to set aside much more, which will hit earnings hard again at some point.

Goldman Sachs (GS, news, msgs) analyst Brian Foran last week predicted continuing losses and capital constraints -- in part caused by the need to set aside more money for bad loans -- will mean Wachovia will soon cut its 38-cent-a-share dividend in half.

Wachovia declined to comment.

WaMu started off behind

There's a slightly different picture at Washington Mutual, but it's no more encouraging. Nonperforming loans jumped 193% to $7.8 billion in the first quarter, compared with a year ago. Loan charge-offs were up 647% to $1.4 billion.

Allowances for loan losses have grown, too. They advanced 206% to $4.7 billion. But WaMu started from a weaker position than Wachovia. A year ago, its ratio of cash set aside for bad loans to nonperforming loans was already at a weak level of 0.58. While charges-offs and nonperforming loans are way up, that key ratio has advanced just 4.5%, to 0.6.

"The allowance for loan loss is unlikely to be sufficient to absorb the charge-offs experienced over the next 12 months," Gradient's analysis says.

In other words, like Wachovia, Washington Mutual will have to set aside more for loan losses this year as the subprime situation worsens. That will likely lead to more and bigger losses.

WaMu also declined to comment for this column.

Why did Washington Mutual face the subprime mess last year with a much lower amount set aside to cover bad loans than its competitors -- a mistake that may have cost shareholders big time?

Blame it on executive greed, says Richard Clayton, the research director at CtW Investment Group, which has ties to a federation of unions called Change to Win.

Setting aside less money means the bank was able to report higher earnings in 2006 and 2007. "There is no question that that led to higher executive pay," Clayton says.

At the time of publication, Michael Brush did not own or control shares of any company mentioned in this column.

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