Thoughts on WAMU and Bull / Bear Markets

I had an interesting interchange with another follower of the WAMU stock earlier today. I thought people might find it interesting. Here was the basic exchange:

I posted:

Wikipedia defines insolvency as follows: "Insolvency is a financial condition experienced by a person or business entity when their assets no longer exceed their liabilities, commonly referred to as 'balance-sheet' insolvency, or when the person or entity can no longer meet its debt obligations when they come due, commonly referred to as 'cash-flow' insolvency."

WAMU is certainly not "cash-flow" insolvent as they have proven time and again their ability to raise capital in the market via debt issuance, regardless of their actual cash operating performance. The important question then is whether or not WAMU is "balance sheet" insolvent.The recent issues in the Bear Stearns hedge funds concerning their "mark to model" accounting raise some important issues for WAMU. Although WAMU does not own CDOs in its investment portfolio (it is instead usually selling its own loans to Wallstreet so they can make the CDOs or MBS or also sometimes instead retaining the loans for its own portfolio).......the question arises of how does WAMU come up with the value of the loans that it does retain and hold on its balance sheet.

Based on the Q1 2007 financial disclosure table and balance sheet information that WAMU provided back in April 2007. They currently hold over $58 Billion Option ARMs in their portfolio as well as $56 Billion Home Equity loans. In addition to this they own over $20 Billion in Subprime Loans.According to their own balance sheet they have net shareholders equity / book value of $25 billion.

So the next question is how much of WAMU's $134 billion in risky mortgages have to implode in order to wipe out the entire book value. Easy - just $25 billion or a mere 18%.Keep in mind - I am not talking about DEFAULTS of $25 billion - I am talking about a drop in market value of $25 billion in th retained loan portfolio. Considering the http://www.markit.com/ readings that many of these types of mortgages once securitized already trade around $0.50 on the dollar in th secondary market - the correct answer is that WAMU is ALREADY balance sheet insolvent.

The reply to my comment was as follows: "LMAO! That erroneous case can be made for a whole lot of mortgage lenders. Short some more dummy, and I'll guarantee that you'll be insolvent long before WaMu."
Forgetting for a second this person's cunning ability to assess my probable future, :) let's look at my reply to that.

Ben: The fact that "everyone is doing it" does not make it right. If we trace the logic of the Bulls' argument over the past 6 months it started like this:

Fall of 2006: The loans on the balance sheet are worth more than face value - they are in high demand from Wall Street

Spring of 2007: Who cares if there are a few defaults? The underlying value of the collateral (re: the home) is more than enough to offset and cover any principal amount on the loan as well as past due interest.

Now Summer of 2007: Bear Stearns controversy makes it evident that these types of loans are not worth anyhthing close to what WAMU is carrying them at on the balance sheet. We also know that with home prices falling nationwide that the collateral of the loans is quickly disappearing. Bulls are essentially saying: who cares the collateral value is eroding, and that WAMU is misrepresenting on its balance sheet the market value of its loan portfolio - in essence because ALL banks are doing this - this is OK.

Rather than try to wrap my mind around such difficult to grasp concepts as "huge retail footprint" or "large accounts growth" - I would prefer to stick to the statistics that have traditionally mattered during a credit crunch. Namely - liquidity. If the secondary market for securitization of both Option ARMs and Home Equity Loans is drying up or at least offering substantially lower amounts for these types of loans - it suggests that WAMU will have hard times ahead of it.The fact that a Ponzi scheme can go on for a long time and fool many people does not make it a sound business plan. WAMU is no exception.

Follow up thoughts: aside from the obvious bias that I feel towards WAMU, I had some thoughts today about being long the market versus shorting the market. More particularly I thought about the phrase - "There is always a bull market somewhere." Is the obvious corrollary - "There is always a bear market somewhere" - also true?

I have read that in the early days of hedge funds the simplistic model involved going long a certain percentage of stocks say (60% of portfolio) and go short (40% of portfolio) - it is not 50/50 in order to account for the long term upward bias in the market. The idea behind this approach was that by picking the best companies and the worst companies - market risk would be eliminated and the fund could generate "alpha" due to its superior stock picking.

I am not so interested specifically in this idea but an analogous one - mainly - are there entire bear markets going on in certain sectors even during a primary bull market such as we have experienced over the past four years? Im not sure - although it should be easy enough to check.

I am still tracking the real estate sector spreadsheet and currently only ONE sector is in a primary bear market (the homebuilders). Some sub-sectors are still making new 52 week highs (Title Insurance companies) and other sectors are in slight corrections but still bull markets (re: REITs, Mortgage Companies, and Brokers).

The final thought I had is how do I define bear market or bull market? Is the test just a simple - "I know it when I see it." or is there a better quantitative method to apply that actually could hold true. I have seen some people argue that nominal drops in stock prices represent a bear market if the fall is enough, while others argue that regardless of price movement a bear market occurs mainly as a result of falling valuations re: PE multiples as was the case during the 1970s in the US.

More questions than answers but it was nice to get a few ideas off my chest.

-BG