WaMu Option Arm Capitalized Interest - And Why Its DANGEROUS
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2007-04-18 22:14 by Karl Denninger , 2 references Ignore this thread
WaMu Option Arm Capitalized Interest - And Why Its DANGEROUS *
I keep getting people asking me why I am so against companies like Washington Mutual (WM) booking back capitalized interest as income - basically, the deficiency on "Pay Option" ARM mortgages.

Rather than keep explaining on message boards, I'll post it here - then I can just link it back.

Let's use WaMu as an example, because they make a particularly good - or ugly, depending on your perspective - example of this.

In March of 2006, Washington Mutual recorded net income of $985 million dollars. 4Q06 they booked $1,058 mln. This last quarter, they booked $784mln.

But in those three quarters they booked $194mln, $333mln and $361 million, respectively, in PayOption ARM "Capitalized Interest." This was booked and recognized as EARNINGS.

Now here's the problem: In 1Q 06, 194 million out of $985 is 19.7%. In December, it was 31%. But this last quarter, it was FORTY SIX PERCENT, more than a DOUBLE over the year ago levels.

And what's worse, not one dime of that "income" can be spent! It is entirely phantom.

This is the same sort of crap that sunk Lucent and Enron - booking "income" that is not in fact spendable, as it has an impairment associated with it (the LTV is INCREASED by this negative amortization) AND it is not CASH!

There is a legitimate argument to be made for booking this as a net increase in the bank's assets, offset with a loss reserve due to the increase in LTV on the property (this is the most likely part of the principle to be unrecoverable in the event of a default.) In effect this is a capital asset that is drawn down in value over some period of time - up to 30 years for most mortgages.

But now the bank has elected to pay 55 cents of dividend, yet the single largest contributor to their "86 cents of net income" this last quarter was in fact capitalized interest that cannot be spent!

So if you take that out you find that the bank actually made 46 cents - less than the dividend! (Oh, and let's not forget the preferred either)

WaMu had better hope that the housing market markedly improves out there in Californicated. I doubt it will though. And as more and more people get squeezed and have to pay those minimum payments, that "back cap" will grow - up until all those loans hit hard recast.

Then the shit hits the fan as the payments will double and, if market values have in fact declined, the "owners" won't be able to refinance.

Guess what happens next to those "earnings" that weren't real in the first place?

As I mentioned, Lucent did the same thing with their "capital leases" during the tech bubble. It made for great earnings and drove the stock price to the sky during the salad years of the bubble.

When the tech bubble came apart it also nearly bankrupted the company.

All you had to do to know that all this "income" Lucent was posting during that time was bogus was to read the footnotes. Wasn't it nice of them - just like WaMu - to put that little ditty in the footnotes instead of featuring it "front and center" in the earnings report?

I wonder why WaMu didn't proudly trumpet that 46% of their "earnings" were in fact capitalized interest in their latest release - and not spendable money?

Ref: http://edgar.sec.gov/Archives/edgar/data/933136/000115752307003679/a5377269ex991.htm