WaMu Says "Whoops!"

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Financial-services giant Washington Mutual (NYSE: WM) presented a 143-page presentation Wednesday that can be summed up in one word: "Whoops."

As in "Whoops, we shouldn't have made all those subprime loans." The heart of Washington Mutual's credit problems lies in the accursed subprime business. Try to spot the red flag in the following data:

Loan Type	Oustanding*	Nonperforming*	NPL %
Single-Family Residence	105.9	1.5	1.4%
Commercial	41.0	0.2	0.5%
Credit Card	26.2	0.7	2.7%
Home Equity	59.1	0.5	0.8%
Subprime	20.0	2.4	12.0%

*In billions.

Clearly, subprime's problems have had a disproportionate effect on credit quality, with much of the problems stemming from some bad decisions to originate second-lien (less secure) loans.

When home prices are increasing, even homeowners who are experiencing difficulties can either refinance or sell their homes. When home prices decrease, though, it wreaks havoc on overleveraged borrowers. Now these homeowners can no longer sell or refinance their homes. In some cases, they may have to declare bankruptcy. The bank often has no choice but to foreclose, rapidly depreciating the home's value, and leaving the second-lien loan with little or no value, either.

WaMu has taken steps to fix the problem, cutting subprime loan originations from $9.4 billion in the third quarter of 2006 to $0.5 billion in the third quarter of 2007. Nevertheless, as home prices continue to depreciate, the remaining subprime loans on WaMu's books will continue to bleed red ink for 2008. As a result, the company sharply hiked its 2008 credit loss estimates, to $2.7 billion - $2.9 billion. That's double the estimates it made last July.

To add insult to injury, WaMu also learned that New York Attorney General Andrew Cuomo was probing Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) about allegations that the bank colluded with Fannie and Freddie to inflate home appraisals. Last week, Cuomo sued First American (NYSE: FAF) based on similar allegations.

It seems like everything but the kitchen sink has been thrown WaMu's way, plunging shares to 10-year lows. It'll take awhile for WaMu to work out the poison from the toxic loans originated in 2006 and 2007, and a dark cloud hangs over the company from the attorney general's investigations. Buyer beware -- only those with extreme conviction should proceed.

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• The Buying Opportunity You Won't Want to Miss
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• WaMu's Subprime Past