Resolve to keep your portfolio healthy: Help us pick the worst stock for 2008.

I'm usually an optimistic sort of guy, but last year was rough for anyone holding shares in bank stocks, including yours truly. And 2008 looks like it will be Act 2. But how long will the play last?

Washington Mutual (NYSE: WM), a super-regional bank that's expanded from my home state, is smack in the middle of a perfect storm. (OK, I promise I won't use any more of the words and phrases on Lake Superior State University's annual "List of Words Banished from the Queen's English for Mis-Use, Over-Use and General Uselessness.") And 2008 will not be the year the rainbow comes out and everything turns out to have been a bad dream. Let's review what happened to the company in 2007 to see why.

Setting the stage
Everything was fine through the first half of the year, despite a slowing housing market and quickening concern about subprime mortgages. Then in late July, Countrywide Financial (NYSE: CFC) announced that defaults and delinquencies were rising across all classes of mortgages, not just the subprime ones that started the ripple effect.

In August, WaMu announced it was increasing its mortgage standards and cautioned that conditions were deteriorating in the secondary mortgage market, where mortgages are packaged and resold. Ultimately WaMu increased loss reserves by about $500 million in September -- about 30% higher than it had indicated it would in July.

Then October hit
At first, the thrift was a red flag that earnings would be less, mostly due to the increased loss reserves. The actual earnings pointed to some real problems, like:

  • Total provisions for loan and lease losses expense up 480% year over year and 160% sequentially, to $967 million
  • Net charge-offs up 170% year over year and 55% sequentially, to $421 million
  • Nonperforming asset ratio up 96 basis points year over year and 36 basis points sequentially, to 1.65% of total assets
  • Total customer deposits below $200 billion for the first time in more than a year and a half, down 7.9% year over year and 3.5% sequentially.

Since then, WaMu has

  • Announced layoffs of more than 3,000 workers
  • Become embroiled in an SEC probe related to a New York state lawsuit of First American (NYSE: FAF) over an alleged role in fixing home appraisals
  • Cut its dividend by 73%
  • Said it will dilute its shares with a preferred stock offering.

The second half of 2007 was terrible for the company.

Reasons to stay out
The clouds continue to darken. Just last week, the stock took another hit as Countrywide reported another worsening of foreclosures and late payment levels.

There are a lot of questions without any answers, let alone reasonable estimates.

  • How much further will loan loss reserves increase?
  • How much more of its assets will end up as nonperforming?
  • Will total deposits continue to decline?
  • Given the above, will the company be able to remain liquid? If so, how?
  • Is WaMu guilty of encouraging inflated appraisals?
  • Is CEO Kerry Killinger the right man to dig the company out of its problems?

That last comes from recent comments by famed value investor David Dreman, whose investment firm is a significant shareholder. He said that Killinger has been slow to disclose the problems facing the company, and seemed interested only in growing the company and making "quick profits."

At some point, the company's shares will be a good investment again, fulfilling their promise when picked by Income Investor. But that probably won't be in 2008. Until some answers begin to appear, the company's stock price will likely continue to languish.

Yes, the dividend is around 4%, but as argued last fall, a CD will pay you that. Add the risk of further bad housing news coming to light and, depending on liquidity, a possible second cut to the dividend, and I just cannot see putting new money here.

If you agree, head over to Motley Fool CAPS and punch in with an "underperform" rating. If you disagree, go over and vote the other way.

Jim Mueller owns shares of Washington Mutual, but of no other company mentioned. WaMu is a recommendation of the Motley Fool Income Investor newsletter service; help yourself to a free 30-day trial. The Fool is all about investors writing for investors.