Last Updated: April 14, 2008: 3:46 PM EDT
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Wachovia's California nightmare

The 2006 purchase of Golden West has saddled the bank with a problem of growing proportions.

By Roddy Boyd, writer

Doomsday on Wall Street

NEW YORK (Fortune) -- Wachovia investors are paying through the nose for the bank's ill-advised California gold rush.

Shareholders in Charlotte, N.C.-based Wachovia (WB, Fortune 500) were rocked Monday by a nasty one-two punch: a sudden (and dilutive) sale of common and convertible preferred stock, and the bank's first quarterly loss since 2001. Wachovia swung to a $350 million loss in the first quarter, reversing the year-ago $1.2 billion profit, as the bank posted weak numbers across its businesses. The breadth of the bank's losses stunned Wall Street, sending shares down 10%.

Though Wall Street was rife with whispers in recent weeks of a possible writedown at Wachovia, Monday's investor presentation makes for some sober reading. Among many other things, the bank took a $2 billion charge for "market-disruption" losses in the quarter, including a surprisingly high $729 million for unfunded loans and leveraged finance positions. Wachovia also took a $2.8 billion provision to cover credit-related losses.

The most compelling reading, however, concerns the former Golden West Financial, which Wachovia acquired in 2006 for $24.6 billion. And by "compelling," we mean cringe-inducing.

Golden West was a leading issuer of so-called option adjusted rate mortgages (ARMs) - loans that give borrowers the right to pay less than the full bill - with a portfolio now valued at roughly $120 billion. Wachovia's holdings of those loans are getting painful: Wachovia said its reserve for possible loan losses on Golden West's portfolio of Pick-a-Pay variable rate mortgages surged in the latest quarter to $1.1 billion, while late payments nearly doubled to 3.1% of the portfolio.

While a possible $1.1 billion loss hardly seems newsworthy in this era of multibillion writedowns, the fact that 58% of Wachovia's option ARM portfolio is based in California is problematic. Independent research boutique CreditSights argues that a new computer model put into use for Wachovia's risk management is implying losses of between 7% and 8% for the Pick-a-Pay portfolio. That could mean another $2 billion of potential losses. The bank estimated that 14% of the loans appeared to have negative equity, or loan-to-value percentages of greater than 100.

To be sure, Wachovia has avoided the high-profile meltdowns sustained by Bear Stearns (BSC, Fortune 500), which was sold last month to JPMorgan Chase (JPM, Fortune 500), and Citi (C, Fortune 500) and Merrill Lynch (MER, Fortune 500), both of which ousted their CEOs late last year after disclosing massive losses on mortgage-backed securities. Wachovia's chief executive, G. Kennedy Thompson, appeared contrite, telling investors that he was "deeply disappointed" by the bank's quarterly performance.

But last year, Kennedy was sounding optimistic. "We feel confident about the superior credit quality of our mortgage portfolio, the prospects for cross-selling our product set in Golden West markets, and originating Pick-a-Pay mortgages through traditional Wachovia channels," Kennedy told investors on last April's first-quarter conference call.

The bitter irony here is that, while option ARMs can be problematic for both the consumer and the mortgage holder in a housing collapse, Golden West was almost universally held to be the most conservative and ethical underwriter in that marketplace. CreditSights said calls Wachovia's management "top-flight," but says bank management was caught "off-guard" by the housing market's rapid collapse.

As bank investors are painfully aware by now, Wachovia executives aren't the only ones caught flat-footed in this market.  To top of page

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