Can WaMu Go It Alone?

Wall Street is speculating that the bank will go the way of Countrywide Financial and be acquired by a larger player, perhaps JPMorgan Chase

by Christopher Palmeri and Mara Der Hovanesian

Marianna Day Massey/ZUMA/Corbis

Washington Mutual's (WM) long-running TV ad campaign features a smiling, young banker poking fun at his stuffy, suit-wearing rivals. But despite the hip image, Washington Mutual is looking a lot more like other big players in financial services these days, posting huge loan losses, scrambling for fresh capital, and answering to investigators in several states.

The pressing issue for WaMu is whether it will remain independent. With Bank of America (BAC) scooping up troubled mortgage lender Countrywide Financial (CFC) for $4.1 billion, Wall Street speculation is now focused on WaMu, whose shares have fallen nearly as far as Countrywide, from 45 a year ago to 13 on Jan. 16. Last week, CNBC (GE) reported that WaMu had held "very preliminary" merger talks with JPMorgan Chase (JPM). Both firms declined to comment. WaMu's stock price fell 93 cents, or 7%, to 12.46 on Jan. 17. After markets closed, the company reported a larger-than-expected $1.9 billion loss for the fourth quarter. It was WaMu's first quarterly loss since 1997.

A buyout would be an astonishing reversal of fortune for WaMu's hard-charging chief, Kerry Killinger. After rising to the top job in 1990, Killinger built the small Seattle thrift into a $330 billion-in-assets juggernaut, with a string of more than 30 acquisitions, including Home Savings Mortgage in California and Dime Bancorp (DIMEZ) in New York. With those successes, Killinger became a guru for new management practices in banking. He overhauled the typical bank branch, adding coffee bars, play areas for kids, and tellers in khaki pants, while pitching customer-friendly products such as free checking accounts.

WaMu's Big Exposure in California and Florida

Killinger, who earned spare cash rehabbing homes while attending graduate school at the University of Iowa, also strived to be a top player in mortgages. He acquired subprime lender Long Beach Mortgage in 1999 and made many of the aggressive loans that have now come back to haunt the industry.

On Jan. 17, WaMu has indicated it will post loan loss reserves of $1.6 billion for the fourth quarter, four times the amount of a year prior. Nonperforming loans were 1.65% of WaMu's assets in last year's third quarter, twice the level in 2006. That compares with 0.88% of assets at Wells Fargo (WFC), 0.63% at Wachovia (WB), and 0.43% at Bank of America—all of which have focused less on home lending.

Some 70% of WaMu's loans are in California and Florida, two states with sinking property values and an abundance of risky loans. WaMu still has about $20 billion in subprime loans, $5.8 billion of which could reset at higher rates over the next three years.

Dealing with Legal Hassles

With the bank's finances weakening, Killinger moved into crisis mode. In December he announced a major restructuring of the mortgage operation, getting out of subprime loans entirely, closing half of WaMu's 336 loan centers, and laying off 2,600 people, about 22% of the mortgage staff. He slashed the dividend and raised $2.9 billion in a preferred stock offering.

The nation's second-largest mortgage lender in 2003, WaMu dropped to sixth place last year. "They've really just given up in terms of being a top lender," says Guy Cecala, publisher of Inside Mortgage Finance, an industry newsletter.

With WaMu's default rates climbing, government investigators are taking a closer look. In November a lawsuit by New York Attorney General Andrew Cuomo accused WaMu of colluding with First American (FAF). The AG contends First American inflated the value of mortgage appraisals so WaMu could increase loan values. First American said the allegations in the complaint had "no foundation in fact or law." After the lawsuit, WaMu severed its relationship with the firm, saying it was "surprised and disappointed by the allegations in the complaint."

It's not WaMu's only legal headache. In January it was one of 20 lenders cited in a lawsuit by the city of Cleveland. The suit says lenders created a "public nuisance" by making loans to borrowers who couldn't afford them. Killinger has now focused his strategy on WaMu's 2,200 retail branches. WaMu is selling more credit cards, checking accounts, and services for small businesses. In short, if it survives, WaMu may look a lot more like those stodgy bankers in the suits.

Palmeri is a senior correspondent in BusinessWeek's Los Angeles bureau . Der Hovanesian is Banking editor for BusinessWeek in New York .