It doesn't take a George Soros backache to predict that Washington Mutual (NYSE:WM) would struggle in the third quarter, given its exposure to low-quality mortgages. However, it appears Mr. Market feels the light at the end of the tunnel is too far away and has stopped holding his breath.

If banks like Income Investor selection JPMorgan (NYSE:JPM), US Bancorp (NYSE:USB), and Wells Fargo (NYSE:WFC) get Bs for their recent results, then banks like Citigroup (NYSE:C) and Washington Mutual get Ds. As a result of sharp losses in mortgage loans, WaMu's third quarter stank. The loan loss provision increased to $967 million versus $372 million just one quarter ago. Net income plummeted to $210 million from $748 million a year ago.

At this point, hope is a four-letter word, at least for now, because all roads lead downward. Illiquidity in the secondary markets has dried up available credit. Many borrowers couldn't get mortgages even if they wanted to buy homes. Homebuilders are cutting prices dramatically to offload a glut of inventory, and they're competing with foreclosures.

According to Washington Mutual's CFO, Thomas Casey, "I have never seen housing credit conditions change so significantly over such a short period of time." In other words, at this point, all bets are off.

Luckily, Washington Mutual has a strong deposit base, thanks to its network of branches. Deposits provide a pretty stable funding source and give WaMu the liquidity it desperately needs in this desert of illiquidity.

For example, in the quarter, WaMu took $17 billion of mortgage loans it was trying to sell and decided to hold them on its own balance sheet, taking a $147 million charge in the process. If WaMu, due to illiquidity problems, was forced to sell those loans, it would have taken much more severe losses.

Nevertheless, WaMu's credit trends do raise some concerns. For example, its loss reserve trend is troubling:

Q3 07

Q2 07

Q1 07

Q4 06

Q3 06

Nonperforming assets to total assets






Allowance as a percentage of loans






Coverage of allowance to nonperforming assets






There are some reasonable explanations for part of the divergence. WaMu currently holds $500 million in restructured assets, which although not performing, should outperform the typical non-performing assets (NPA). In addition, some lower loan-to-value loans have gone into the NPA category, where ultimate losses should be lower as well.

I give WaMu management credit that, after realizing its mistakes, it moved to de-leverage the balance sheet and shore up liquidity. But the damage has been done, and given the housing backdrop and the threat of recession, WaMu will probably spend a bit of time digging itself out of a hole. Investors with strong stomachs could do well to catch this falling knife, but only those who aren't afraid of a little blood.

Related Foolishness:

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  • This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.