SevenToTen - Blogging About Everything

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Citi and Merrill are expected to announce another series of writedowns due to eroding values of mortgage-backed securities and leveraged loan portfolios. Other areas, like home equity loans, have shown increasing signs of deterioration too.

The question now is how bad do losses get? The numbers, in some cases, are really disastrous. To make matters worse, consumer spending has slowed and unemployment has increased - driving bigger losses in banks’ consumer-related businesses such as credit card, small business and even their commercial real estate portfolios. As a result, banks are having to set aside more money for potential loan losses.

Washington Mutual revealed on Tuesday that it had to set aside $3.5 billion in loan loss provisions and could be staring at a loss of $14 billion by year end.

The bad news isn’t limited to loan portfolios, either. When the Federal Reserve aggressively cut interest rates earlier this year, the expectation was the cuts would boost banks’ net interest margins, a key measure of the profit banks make from taking in deposits and lending them back out.

But competition for customers has been so tough that banks have been unable to cut their deposit rates as much as they would have in the past. At the same time, companies with sizeable investment banking divisions like Citigroup, JP Morgan and Merrill Lynch are expected to be hit by a slowdown in merger and initial public offering activity. Merger advisory and equity underwriting are two key sources of lucrative fees for investment banks.

Bank investors are hoping that Washington Mutual, Wamu, has come up with an ingenious method to escape the mortgage meltdown.

Wamu received a $7 billion capital infusion from private equity shop TPG. The thrift had profited mightily in the first half of this decade due to the housing boom but shares have been in free fall since the mortgage market collapsed last summer.

With TPG’s entry, a highly dilutive deal looms but a bruising selloff was avoided and it illustrates the faith investors have in TPG founder David Bonderman. His experience in the industry dates back to the savings-and-loan crisis of the late 1980s.

Along with partner Jim Coulter, Bonderman was behind Texas billionaire Robert Bass’ 1988 rescue of failed American Savings Bank. Bonderman and Coulter made $750 million in selling the thrift to Washington Mutual in a 1996 deal that put Bonderman on WaMu’s board. He resigned in 2002.

Investors are hopeful that after Wamu, smart money is at last ready to brave the financial sector. There are plenty of financial firms with hefty mortgage exposure, especially in speculator states like California, Florida, Arizona and Nevada, which need help. These hard-hit firms are waiting to be rescued by buyout shops, which have raised billions of dollars but had little opportunity in recent months to deploy the money.

If Washington Mutual proves to be a model for future dealmaking, investors are likely to pay a steep price. New stocks will be issued at $8.75 a share - a price well below recent trading levels. Still, WaMu investors welcomed the deal as they believe the strong new ownership will undoubtedly find a way to make the most of Wamu’s huge retail deposit base and nationwide branch network.

I think we should not be too optimistic yet as Wamu’s actual losses for two consecutive quarters were well above projections (suspected cover-ups) and further deterioration in housing industry fundamentals could leave TPG’s investment under water.