Credit crunch, Act 2

Washington Mutual is reeling from a one-two punch of bad loans and a probe into past appraisals. But it may not be alone.

By Peter Eavis, Fortune senior writer

NEW YORK (Fortune) -- What the heck's happening to our financial system?

That will be a question many people will be asking after Washington Mutual shares plunged 17 percent in a single day. This after all is an industry-leading bank with over $320 billion in assets.

Seattle-based WaMu was whacked by two pieces of bad news on Wednesday.

First, the bank said its bad loans could remain a problem into 2008.

Second, as part of a wider probe of the mortgage industry, the New York Attorney General Andrew Cuomo demanded that Fannie Mae (Charts) and Freddie Mac (Charts, Fortune 500) examine whether mortgages sold to them by Washington Mutual were for homes that had been appraised at an artificially high price.

The fear is that Fannie and Freddie might cut back on purchases and guarantees of loans from WaMu (Charts, Fortune 500). That would be a crippling blow for the bank, because the market for loans that Fannie and Freddie buy is the only part of the mortgage market that has substantial volume.

Washington Mutual's situation is particularly worrisome, but its issues highlight the sort of bad news that could start to come from other banks.

One: Bad loan problems are spreading out of subprime mortgages and into other types of loans.

Two: If Cuomo's allegations are true, WaMu could be holding mortgages on properties that are worth a lot less than its balance sheet says. And investors are fleeing plenty other bank stocks because they don't trust banks' balance sheets.

If those are the two main issues, credit crunch fears won't ease until there is good evidence that bad loans have peaked for all types of credit - from credit card loans to non-junk mortgages to commercial real estate loans. Banks are only beginning to talk about problems in these nonsubprime areas, so it could be several quarters before it's clear how affected they will be.

Investors need to begin to feel that banks have revealed all the losses on their balance sheets. Citigroup (Charts, Fortune 500) has stated that it could report mortgage-related losses of up to $11 billion in the fourth quarter, and Merrill Lynch is expected to report more writedowns, following its $8 billion in the third quarter.

And Morgan Stanley (Charts, Fortune 500) announced a $3.7 billion writedown late Wednesday.

Auditors are breathing down managements' necks, with the backing of regulators, so a bank would have to be very foolish not to take an accurate count of losses in this quarter.

However, it's not quite as simple as gradually working some bad assets out of the financial system. The process of dealing with current losses could be complicated by internal turmoil at the banks and, worst of all, a real slowdown in the economy.

The CEOs of Merrill and Citi have departed their posts, leaving leadership vacuums and more opportunity for infighting at those two banks.

The other common feature of post-boom crack-up is scandals that stem from fraud committed during the go-go period. If true, Cuomo's claims about artificially high real estate appraisals at WaMu would lead to high-level resignations at the bank, for example. And if the Securities and Exchange Commission probe of Merrill's mortgage portfolio comes up with any real dirt, there could be more turmoil and departures there.

The most sobering thought about the credit crunch so far is that it's happened without anything approaching a recession. Difficulties in the financial system could slow the economy and that in turn that would create new losses at the banks.

If it wanted to, the Federal Reserve could just cut interest rates and cheaper borrowing costs would help the banks and spark economic activity. But with the threat of inflation and the weak dollar, the Fed doesn't have much room to maneuver.

Sorry, but we're only just moving into the second act of the credit crunch. Top of page