Credit analyst sees too much downside to recommend Washington Mutual

By Ronda Fears

Nashville, Tenn., Aug. 28 - Kathy Shanley, senior bond analyst at Gimme Credit, said that while Washington Mutual is a strong credit itself there are too many downside risks to be a buyer of its paper.

Washington Mutual (A3/BBB+) is buying what's left of HomeSide Lending (A2/BBB) from National Australia Bank in a cash deal valued at $1.3 billion, plus the assumption of $735 million in medium-term notes and other liabilities.

Washington Mutual, which bought HomeSide's operating assets and became the portfolio subservicer in March, is now also acquiring a $131 billion mortgage servicing portfolio.

"So far, Washington Mutual and other U.S. mortgage lenders have proved more adept at hedging interest rate exposure," Shanley said, noting the "HomeSide story is a cautionary tale of the potential risks in managing a large portfolio of mortgage servicing rights."

A year ago, HomeSide was the sixth largest U.S. mortgage servicer and tenth largest originator.

Bulk purchases, including portfolios acquired from Bank One and First Chicago NBD in the late 1990s, fueled its growth.

Unfortunately, because of incorrect interest rate and other assumptions, the mortgage servicing rights on the books were overvalued and had to be unexpectedly marked down to the tune of $1.75 billion, one of the largest charges ever recorded by an Australian firm, the analyst said.

"The acquisitive Washington Mutual, which was also in the midst of acquiring Dime Bancorp and the mortgage operations of FleetBoston and PNC Financial, agreed last December to buy Homeside's operations, but not its mortgage servicing rights," Shanley said.

The transaction closed in the first quarter, she said, with Washington Mutual paying $1.2 billion in cash for certain assets, including about $1 billion in loans held for sale and a servicing technology platform valued at $52 million.

"Considering the recent boom in refinancings, we're not enthusiastic about Washington Mutual's plans to acquire $1.3 billion in mortgage servicing rights." Shanley said.

"It already had $6.5 billion in mortgage servicing rights on the books at the end of June."

Impairments of existing mortgage servicing rights totaled $1.1 billion in the second quarter, even before the latest wave of activity this summer, though writedowns were offset by hedging gains on other securities, she noted.

"We're not surprised by the HomeSide deal, however, as Washington Mutual previously disclosed it had the right to make the first offer on the mortgage servicing rights if HomeSide decided to sell out," Shanley said.

The actual purchase price will be adjusted to reflect prevailing interest rates at the time of the closing, she noted.

Washington Mutual plans to mitigate its risk exposure by selling off "excess" servicing rights, defined as the excess over the standard 25 basis point fee on conforming fixed-rate loans, she added, noting that in second quarter sales of such "excess" mortgage servicing rights reduced the balance outstanding by $711 million.

"Although Washington Mutual has taken pains to explain its hedging strategies to investors, and has maintained a good track record to date in hedging its mortgage assets, there is always a possibility the company's strategy for managing its derivatives exposure could go awry if interest rates move sharply and/or unexpectedly," Shanley said..

She noted that the ratings of HomeSide were already cut last year to a level comparable to Washington Mutual debt.

"It was clear the U.S. mortgage market was not a business NAB [National Australia Bank] intended to remain in for long," Shanley said.

"The sale to Washington Mutual rules out the possible risk of a divestiture to a lower-rated or unrated buyer."

Nonperforming loans at Washington Mutual dipped to $2.6 billion at the end of second quarter from $2.8 billion at the end of March, she said, but reserve coverage remains weak compared to commercial bank peers with 63% coverage at the end of June.

"Margin compression is also a risk factor, since there isn't much more room to cut interest rates on deposits," Shanley said.

"We view Washington Mutual as strong BBB, but considering the downside risks, we would not be a buyer of this paper."

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