Why Wachovia Needs That $7 Billion

Yesterday, I asked why Wachovia needed another $7 billion in fresh equity, and suggested it might be because it overpaid for Golden West Financial and was considering writing down part of the $25.5 billion acquisition cost. There's a big problem with that theory, however: goodwill is not included in capital-adequacy calculations, which means that even a large write-down wouldn't harm Wachovia's capital base.

Wachovia's real problem with Golden West, it turns out, is not the headline acquisition cost, so much as the inherited Golden West loan portfolio, which includes a staggering $121 billion - no, that's not a misprint - in "pick-a-pay" mortgages.

These loans behave just like you think they do: borrowers get to decide how much money they're going to pay back each month. Predictably enough, that isn't working out too well.

On Monday, Wachovia conceded total losses from Pick-A-Pay loans could eventually amount to a staggering 7% to 8% of the loans' combined value, a range of $8.5 billion to $9.7 billion.

There's your $7 billion right there.

What's more, there's good reason why the 8% figure might turn out to be conservative: Wachovia has already said that 41% of its pick-a-pay customers have made the minimum payment in each of the past 12 months. The loans are structured so that making the minimum payment makes no sense for someone who could afford to pay more, which means that a huge number of these borrowers are clearly in pretty dire straits already. If and when house prices continue to deteriorate in value, to a level well below the principal amount on the mortgage, Wachovia might end up having to write off an enormous chunk of these loans, and accept extremely low recovery values to boot.

Oh and one other thing: 60% of the pick-a-pay mortgages were written in bubblicious California. That $7 billion, far from being excessive, could end up being insufficient to cover the losses on these things.