Ponzi Finance Revisited

The issue that both Washington Mutual and Countrywide have large portions of their retained loan portfolios in Option ARM loans is starting to get some circulation on the internet although I have not yet seen it discussed much in the mainstream media. The reason that it has been getting so much discussion on internet message boards and the blogging community is the expectation that the interest on these options ARMs is funny money. For example, for WAMU's Q1 2007, they accrued $361 million or $0.40 EPS of interest to the option ARM loan increasing the principal balances by that amount and reporting those accruals as current income. No "cash" was actually received. Many of us see this as ponzi finance because cash earnings were closer to $0.46 EPS and the company is paying out a dividend of $0.55 eps per quarter (again in the case of WAMU as an example).

So to appease the longs and play devil's advocate a bit lets look at how this analysis could be overly bearish / negative. There is no actual problem with accruing that interest currently and adding it to the loan principal amounts IF those amounts are actually collectible. In other words - if I am the bank and can originate an Option ARM for $100,000 principal amount at market interest rates and I can also sell it for $100,000 at the same time I am totally in compliance in my reporting. Furthermore if over a 3 year period I accrue $15,000 in negative amortization interest so that the loan principal amount is $115,000, SO LONG as I can resell that loan again for $115,000 in a liquid market three years later, there is little to no difference from actually receiving that cash at the time I am instead reporting and receiving the accruals.

Again focusing on WAMU as I have more experience looking at the balance sheet and their financial statements - about 55% of the retained loan portfolio is either in 1) option ARMS or 2) home equity lines of credit. This means coincidentally that 55% of WAMU's ASSET SIDE OF THE BALANCE SHEET is in these loans - we are talking billions of dollars here - in the case of the Option ARMs - around $50 billion. Now on the flip side of this WAMU's book value is around $26 billion (asset - liabilities). This equates to around $25 per share for the company. Value investors love to point out the book value which acts as a floor for the stock price as well as the high dividend yield (north of 5%) as providing another floor.

Through this piece I want to call attention to another method to analyze the asset side of their balance sheet and then from that information - their book value and SOLVENCY. So long as the "current market value" for the Option ARMs and Home equity lines of credit stays around that $100 billion market and is resellable in a liquid market for the same amount it is reported at on the balance sheet - the company is not going to have any problems and I am blowing smoke. This is because as soon as WAMU needs cash they can just sell off $10 billion of their Option ARMs and reinvest the proceeds in an even more liquid market (e.g. treasury bills, etc.) . However, if as I suspect the Option ARMs are not really "worth" what they are being reported as - WAMU has a problem as it is essentially operating a failing ponzi scheme. It is paying out more cash than it is bringing in and the value of the assets side of its balance sheet is quickly deteriorating. Furthermore, any attempts to begin liquidation would result in current hits to earnings as it becomes mainstream knowledge that WAMU is taking losses on the Option ARM sales - information that is already "suggested" by the quarterly $100 million losses in the mortgage business that continue to mount.

How can we test this theory? Here is where I need help. All we need to do is finding the pricing for Option ARM Mortgage back securities issued by WAMU and Countrywide in the market that approximate the same characteristics (re: origination date, and credit score / rating agency tranche) as the two have actually retained. If we find out that the equivalent MBS have declined in value by 10% then we would want to make a corresponding adjustment to our updated WAMU financials. If instead the the value of the equivalent MBS has increased in value or is level then I am full of it for now and perhaps it is a buy on all the negative news and in fact a "value play."

I hope this introduced a few ideas that people had not previously considered.

Best regards,

BG