April 14, 2008: 1:26 PM EDT
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Wachovia shows credit crunch isn't over

A huge jump in projected credit losses shows more pain is ahead in the banking sector.

By Colin Barr, senior writer


NEW YORK (Fortune) -- Wachovia's dour numbers should end any fantasies that the credit crunch is almost over.

The Charlotte, N.C., bank delivered a big dose of bad news to investors Monday. Wachovia (WB, Fortune 500) swung to a surprise first-quarter loss and set plans to raise $7 billion in capital by selling common and preferred stock. Wachovia also cut its quarterly dividend by more than 40%, just two months after executives made a point of saying the payout was safe.

But most jarring was Wachovia's decision to boost its reserves for future loan losses by billions of dollars. Just as another big mortgage lender, Washington Mutual (WM, Fortune 500), did last week, Wachovia is finally confronting the steep price it will have to pay for the excesses of the housing boom. Expect other big banks to do the same in coming weeks.

"The precipitous decline in housing market conditions and unprecedented changes in consumer behavior prompted us to update our credit reserve modeling and rely less heavily on historical trends to forecast losses," Wachovia CEO Kennedy Thompson said Monday. "As a result, we have substantially increased our reserves."

Wachovia's provision for credit losses jumped to $2.8 billion in the first quarter from $177 million a year earlier. The bank said it expects more losses ahead, too: It said it expects around $6 billion in additional reserves and charge-offs by the end of next year.

The dismal numbers come just three months after executives insisted on a conference call with bondholders that an earlier round of capital raising - Wachovia raised $2.3 billion in December and $3.5 billion in January, though sales of preferred securities - made its dividend safe. "There's been a lot of speculation from folks saying, 'Well, gosh, the reason you added some in January must be your outlook is that there's some tragedy on the horizon, and that's the reason you raised that capital,'" finance chief Tom Wurtz said back on Feb. 8 on the Wachovia Fixed Income Update call. "And I'm here to tell you that simply isn't true."

But even if Wurtz was right that there's no "tragedy" on the horizon, it's clear Wachovia and many of its peers are facing more pain ahead. Washington Mutual came to the same conclusion last week, when it announced a big first-quarter loss that hinged on a sharp increase in its own reserves for future credit losses. WaMu, which just months earlier had forecast a first-quarter credit-loss provision of around $1.9 billion, said last week that the actual provision was $3.5 billion.

The bad news at Wachovia marks the third time in the past week that investors have gotten a bracing look at the problems in the finance sector. Seattle-based Washington Mutual agreed last Tuesday to raise $7 billion by selling shares at a steep discount to a group led by private equity firm TPG. On Friday, General Electric (GE, Fortune 500) - a conglomerate with a formidable finance arm - posted disappointing first-quarter earnings, saying frozen debt markets made it impossible for the firm to meet its asset-sale targets.

The reversals come just two weeks after Wall Street staged an improbable April Fools Day rally on the heels of Lehman Brothers' (LEH, Fortune 500) $4 billion sale of convertible preferred stock. The reaction to that dilutive maneuver, and a sharp rise in UBS (UBS) shares even after the Swiss bank announced its own $15 billion capital-raising plan, had some observers venturing that perhaps the worst of the financial sector meltdown was behind us.

But it's now clear that the pain will continue. With big banks including Citi (C, Fortune 500), Bank of America and JPMorgan Chase due to post their own first-quarter numbers in the next week, multibillion-dollar writedowns of subprime-related securities holdings will grab lots of headlines. But investors will be keeping a closer eye on credit provisions, because they offer the first glimpse of how many more capital-raising efforts may be necessary. BofA and JPMorgan will come under particular scrutiny, because they - unlike Citi - have been seen up to this point as having managed their mortgage exposure fairly well.

The sharply rising credit provisions at WaMu and Wachovia show that big mortgage companies are belatedly taking a much more realistic view of the problems in many U.S. housing markets. Prices are falling sharply in once-hot areas such as Florida and California, and the declines are spurring rises in mortgage defaults and delinquencies. Those trends are saddling big lenders with hefty losses.

Just a year ago, CEO Ken Thompson sounded certain that Wachovia would avoid that fate. Asked his views of possible regulation of so-called exotic mortgages - ones that, like Wachovia's Pick-a-Pay product, give borrowers the option to pay less than the full amount of interest that accrues in a given month - Thompson made comments on an April 17, 2007, earnings call that now sound a bit naive. "It does not affect us," Thompson said. "And I think that goes to the very conservative underwriting standards and servicing standards ... at Golden West," the California thrift Wachovia acquired in 2006. "And we are changing none of that. So, if anything, we think that any changes might, in fact, benefit us relative to our competition."

On Monday, though, Wachovia announced a $1.1 billion addition to reserves for losses on Pick-a-Pay loans. The company cited "credit modeling with greater emphasis on forecasted future changes in customer behaviors assuming continued house price depreciation, particularly in stressed markets."  To top of page

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