Shorting WaMu

[powayseller]

In Q2 06, WaMu’s deferred interest income, the unpaid but earned interest on option ARMs, was 20% of their net income.
source

WaMu is my best short contender as of right now. The market, clueless as usual, does not price in the risk of loss.

Look at Toll Bros: Toll climbed and climbed until the media started reporting about the housing bust in 2006. The same will happen with WaMu. Although Barron alterted me first to this problem, everyone seems to think that the borrowers will keep making their payments. Once it turns out they are not, sometime in 07, WaMu will get punished just like H&R Block’s Option One.

This is a bet I’m willing to trade on.

Schahrzad Berkland / Analysis

[technovelist]

Sounds reasonable to me. Are there put options on WaMu? If so, buying some that expire next year is probably the safest/best way to play it.

[powayseller]

I’ve been told that about 75% or more of options expire worthless, so the people making the money are the option writers. In a CME study, over 82% of options expired worthless, because making money on options requires being right on timing, direction, and magnitude, a triple whammy. So no options for me.

I should really get a book on shorting, as I know very little, and am probably just dangerous to myself at this point.

[sdappraiser]

From my experience, WAMU has been the most vigilant client I’ve had over the last several years as far as qualifying their clients. In addition, very strict appraisal guidelines with an internal appraisal staff department and very selective contract fee appraiser list.

I’m sure there are bad loans on the books, possibly from the many bank purchases they have made, but their main wholesale and retail division, which probably accounts for the majority of their volumn (anyone care to verify this), is probably the most sound loan portfolio in the industry.

From the thousands of REO and NOD properties I’ve noted in the last year, I only recall several from WAMU or Long Beach.

Powayseller, what makes you so sure this is a good short? With a 5% yield I would be consider buying this now.

You DO know that if you short this, you are on the hook and have to pay the person you borrowed the shares from the $2.08/share dividend right?

[davelj]

“The market, clueless as usual, does not price in the risk of loss.”

How delightfully naive you are. The market, in fact, does price in the risk of loss, but perhaps not at the “correct” time or to the same degree that you do. The market is certainly not clueless, although it is fairly impatient. I guarantee you that I can find 100 analysts who are not short WAMU’s stock who have forgotten more about the company’s financials in the last 60 seconds than you will ever know. That is they understand WAMU far better than you ever will and they still choose not to short the stock. Why? Timing is everything to a professional.

I actually agree with you that at some undetermined time in the future WAMU’s stock might decline for reasons that we would agree on. But the timing and extent of that decline are highly uncertain – even for professionals that watch WAMU every day. That you think that you have some analytical insight that these analysts don’t have is incredibly naive. In fact, you’re at a distinct disadvantage. The ONE advantage you do have, though, is patience. Most professionals can’t wait a year or two for the WAMU boat to sink – they have to be right within six months or so. Otherwise, their job is in jeopardy. Furthermore, there are some very smart people who are short WAMU, so you’ve got that going for you. But, stocks can trade anywhere in the short term – they’ll defy the fundamentals. Remember: the stock doesn’t know you own it, and doesn’t care.

I’m going to beat a dead horse, but I’d stay away from shorting individual stocks. It’s a full-time pursuit and I know plenty of savvy professionals who have lost their asses shorting “obvious” shorts. And remember that lots of the people analyzing WAMU’s stock have myriad sources inside the company that tip them on loan trends, etc. You’ll never be able to compete with that. The stock market is like a poker game: If you can’t spot the fool at the table, it’s probably you.

Having said all that, do I think WAMU’s stock will be lower at some point over the next two years than it is today? Yes. But it’s not a bet I’m willing to take. And, more importantly, it’s not a bet I have to take. There are no called strikes in investing – you can pick your spots and swing for the fence when you get lobbed a softball. WAMU – long or short – is no softball.

[Diego Mamani]

You are right davelj. You must be new to the blogosphere… where such gems as “the market is clueless as usual” and “I can time the RE market” are posted all the time. Or someone predicting high inflation and utter chaos in one post, and then predicting deflation and utter chaos in the next thread.

There are some very bright posters here, but because of low barriers to entry, some posters could be 6-year olds pulling our legs. Some posters sound very assertive and authoritative, regardless of whether they know what they are talking about. But we get to used to it, and learn to tell the good from the not so good.

[powayseller]

Definitely, the market is often clueless, therefore I don’t believe in efficient markets theory. For a recent example, just look at H&R Block; the day the Option One news came out, the stock dropped 9%. The market was clueless about the risk that Option One was taking on. If the market was smart, then H&R Block would have been discounted long before the news came out. The same thing happened with Toll Bros; it only started falling at the same time the RE market fell, not before.

I can understand a stock falling on unexpected news, i.e. a new lawsuit, a drug with bad test results. But when a stock falls because of an EXPECTED earnings shortfall, what else can one assume other than the market is clueless? We on piggington certainly expected this type of loss, even if we didn’t put money on it. Certainly none of us are buying bank or lender stocks now.

One thing I do agree on with both of you: I have no chance going against the insiders or the big traders. I’m no trader, and only a half-ass investor, better at knowing when to get out of the way, than figuring out where to jump in.

I appreciate the input on WaMu, but I wonder if they can maintain their income, when 20% of it is unpaid interest. In the mortgage industry, that is considered a sign of a stretched borrower. Since 20% of their net income is unpaid but earned neg-am income, so if even half of that has to be written off, WaMu will certainly take a fall in its stock. Another weakness for WaMu is its credit card acquisition (Providian). I expect to see a lot more credit card defaults in 07 and 08, as consumers file for bankruptcy.

Thanks for your comments, everyone.

[sdduuuude]

“I don’t believe in efficient markets theory.”

This explains alot.

[davelj]

I’ll tell you what I find fascinating. The average man (or woman) on the street wouldn’t dare to try to diagnose a serious illness – he’d go to a doctor; wouldn’t dare to do his own legal work – he’d go to a lawyer; wouldn’t entrust the preparation of his small business’s financial statements to a non-accountant – he’d use a CPA; generally wouldn’t try to sell his own house – he’d use a realtor… but when it comes to putting a substantial amount of money into some stock that he knows little about – no problem!! No professional counsel necessary. No discussions with management, no financial analysis, no discussions with other major holders, no reading of the footnotes. Nothing. Perhaps a reading of the stock’s yahoo message board, a perusal of the last quarter’s earnings release, a discussion with a know-nothing broker (sorry, that’s redundant) and a quick reading of some guy’s opinion in Forbes. No acknowledgement of the asymmetrical information flow between professionals and non-professionals. Nothing of the sort. They just pull the trigger. No problem. I’ve always been amazed at the willingness of the average person to make such financial decisions without any legitimate basis for doing so. But at least it’s a constant source of entertainment…

[Bugs]

A little tidbit to keep in mind about WaMu: They just laid off their entire appraisal staff, including their supervisors and managers. For most of their employees, their final day is 09/12/2006.

WaMu has contracted with 2 appraisal management companies (LSI and E-Appraiseit) to perform all appraisal and review functions. The fee appraisers who were working directly for WaMu were already cut off, and those who have no other options have already started working for the AMCs, at fees that are 35% – 50% less than what they were getting before. Nobody on the appraisal side of this sees this move as having good results.

I’ve had occasion to speak with a couple of the soon-to-be laid off local managment as well as a couple of the already-laid-off fee vendors, and everyone I’ve spoken to is deeply angry and resentful. Since they now have to do a lot more assignments to make the same amount of money, and since the AMCs are notorious for constantly harrasing their appraisers with 5x daily phone calls and lowball fees, there’s a lot of scheming going on right now on how to do the absolute minimum amount of work necessary to collect the reduced fee. Time is money. Unlike before, most of these people are not taking the position that the company’s exposure to bad loans is a high priority.

I’m already hearing real horror stories about how bad some of these AMC appraisals going to WaMu are. The AMCs are notorious for failing in their review functions and meddling with those appraisers who are trying to complete their due diligence. They’re quite candid that their priorities are about getting appraisals back fast and cheap, everything else be damned.

In the appraisal community, most of the AMCs are generally reviled as parasites, and the people who choose to work for them have often been characterized as being the bottom of the barrel. Lots of really inexperienced appraisers and has-beens who can’t find work anywhere else.

Bottom line here is that WaMu’s exposure to fraudulent loans and poorly developed appraisals is skyrocketing at a critical time. They could not have picked a worse time to give up on appraisal quality. They should be tightening up their standards at this juncture, not gutting them.

Another thing I’m hearing is that WaMu is rolling out a new loan program that will more easily enable overencumbrance of properties. This is also a poor decision (on a long term basis) to be making at this time.

It’ll probably take a while before any of these decisions come back to roost, so it may not figure into your decisions to short right now. But sooner or later these decisions are going to cost them – big time.

[Steve Beebo]

Bugs is correct in that from this point forward, WaMu will be getting, on average, poor quality appraisals and also poor quality reviews of appraisals.

They did have very good appraisal reviewers who knew their individual markets very well – but that’s gone now. In the short run, this move will save them some money by paying low fees for less than average quality appraisals, but in the long term, it can only cost them money as the quality of their loan portfolio will suffer.

[sdappraiser]

I agree, going forward they will have serious issues to deal with. I am one of those who will no longer be doing work for WAMU as I refuse to deal with the likes of LSI. I’d rather take the day off than work for sub-standard fees and deal with the phone monkeys.

In my previous post I was speaking directly towards their current loan portfolio which I believe is probably very solid. If standards and quality go down the drain like most believe, I think it will take at least a year or two for that to be reflected as an increase in defaults.

I still don’t think this is a good time to short WM. Countrywide and Wells have been cutting corners on collateral evaluations for years and it shows in the REO and NOD lists.

[powayseller]

davelj, I don’t know at whom you’re directing your comments, and for what purpose. I don’t recall anyone on this thread saying they would buy or short stocks off a Yahoo message board recommendation. I buy stocks only after studying the financial statements and making a list of 3 reasons for buying the stock, and I’ve posted about this before. You can e-mail me at [email protected], or post your name and e-mail address so I can contact you, and we can further discuss what your problems are with me, off this forum. I request that you stay on topic, which in this case, is shorting WaMu.

Bugs, with loan purchases decreasing, it seems WaMu won’t get stuck with too many new loans-gone bad. I would think that the bulk of their problems, if any, were created in 2005 – 2006, when their neg-am income went up five-fold. Do you think that this appraisal change would increase their neg-am income even further, from the current $203 mil/quarter?

[Bugs]

That’s a good question for which I have no answer. I THINK a lender like WaMu is more likely to retain market share, even in a declining market. I know they do a large percentage of the high-dollar mortgages here in SD County and they’re hooked in as the primary mortgage lender on several of the new home subdivisions.

I know that about 50% of the appraisals WaMu was sending out for field reviews were getting cut and those loans were not being made. Many of those would now fly through the AMC reviews because they take so many shortcuts. If it’s bad to take shortcuts in an appraisal, it’s 5 times worse to do it in a review.

To be sure, a bad appraisal and an overencumbered property do not make for an automatic loss, but it does increase the odds when the borrower has little or no skin in the game and the markets are in decline.

[davelj]

PS, my comments were just that – comments. If you re-read my post you’ll see that I was talking about the “average” investor. If you don’t view yourself as the average investor, that’s perfectly o.k. with me. But apparently you thought of yourself when you read my post – “why” is a question for you to ask yourself.

That you “buy stocks only after studying the financial statements and making a list of 3 reasons for buying the stock,” while perhaps more effective than prayer, is not what I personally would consider proper due diligence for an investment. Although I’m sure that Barnes & Noble sells plenty of books that suggest your approach is more than adequate. So, to each his/her own. Personally, I typically spend several weeks doing due diligence on companies I invest in, which are typically private or semi-private businesses. Of course, that’s what I’m paid to do.

While I’d like to maintain my anonymity here, since you apparently feel the need to know, I’ll email you with a link to my firm’s website. I’m sure it will answer all of your questions and you can form your own views regarding the credibility of my opinions, if not the extent to which you agree with them.

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