Wachovia (WB) expects to be inundated by problems in the housing market. So, the fourth-largest U.S. bank took some drastic steps on Apr. 14. It set aside $2.8 billion to handle rising losses on loans, most of them home mortgages. To prepare for even more losses, the bank said it will seek $7 billion to $8 billion in new capital, new stock that is certain to dilute current shareholders' stakes. Also, the bank's dividend will be slashed 41%, a move that will save the bank $2.1 billion over the next year.
Wall Street had been expecting Wachovia to post a profit of 44¢ per share on Apr. 18. Instead, on Apr. 14, Wachovia posted a loss of 20¢ per share as it pushed ahead the release of its quarterly results by four days. The disruption in the credit markets caused about $2 billion in losses.
The shares tumbled 10% in afternoon trading Apr. 14.
Wachovia Chief Executive Ken Thompson said the company's moves should fortify the bank even in a "worst-case scenario." The extra capital and lower dividend will "provide the flexibility to deal with almost any conceivable circumstances that might develop in the future," he told analysts.
Harsh but Realistic View
Bank executives are obviously alarmed by the eroding housing market, particularly in California where Wachovia is a major mortgage lender. Wachovia sold more than 800 foreclosed houses last quarter, and still had 900 left over at the quarter's end. The concern is that home prices will continue to tumble lower, with a huge supply of homes on the market and many more facing foreclosure as the economy weakens. Falling home prices could cause more and more homeowners to default on their mortgages.
So, Wachovia is now taking a far more pessimistic view of the housing market. Home prices have already fallen 6.1% from their peak nationwide, and Wachovia now expects prices will fall another 6.8%, not hitting bottom until the middle of 2009. It was this change in Wachovia's outlook that sparked its drive to raise capital and cut its dividend. "We [tried] to take a view of the market going forward that was harsh enough that we could be prepared for whatever came along," Thompson said.
Morningstar (MORN) analyst Jaime Peters says Wachovia's assumptions may be harsh but are realistic. "They could happen, especially in this environment," she says.
The Worst Behind Them?
Earnings reports are expected in the next few days from dozens of other financial players large and small—including banking giants Citigroup (C) and JPMorgan Chase (JPM). Some analysts and investors are urging banks to report the maximum losses this quarter, in an effort to put the worst of the housing and credit crisis behind them.
Wachovia's pessimism could force other banks to also prepare for mortgage losses by shoring up their capital. Banks large and small are "going to be building those reserves," Peters says.
But some worry Wachovia's "worst-case scenario" isn't bad enough. "We don't think this reflects a 'kitchen sink' as we expect housing values to continue to sharply deteriorate," Morgan Stanley (MS) analyst Betsy Graseck says of Wachovia's Apr. 14 news.
A Core Business
A key question is whether banks can make up for losses on mortgages with revenue from other businesses.
Thompson tried to reassure analysts. "Beneath a complicated and disappointing quarter is a core set of businesses which are performing quite well," he said. A recent merger with A.G. Edwards is going well, he said, and the bank expects wider profit margins now that the Federal Reserve has sharply cut interest rates.
Financial reports from banks in the next couple of weeks will show how much the slowing economy is hurting other banks' core businesses. The answer matters not just to bank shareholders but also to the economy at large.
Morningstar's Peters sees evidence that Wachovia has tightened its lending standards. The worry is that, despite low interest rates, suffering banks could cut off credit to consumers and businesses. That could choke off economic activity just as the U.S. is trying to avoid a serious recession.