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Wednesday, 08/13/2008 1:33:02 AM

Wednesday, August 13, 2008 1:33:02 AM

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Wachovia's commercial loans stir worries

Bank may have cut corners In bid to join industry giants, analyst says

By Alistair Barr, MarketWatch

Last update: 6:59 p.m. EDT Aug. 12, 2008 Comments: 58

SAN FRANCISCO (MarketWatch) -- In September 2006, Wachovia arranged a $285 million loan for Latrobe, Penn.-based drinks maker Le-Nature's Inc.

The bank then sold the debt on to investors including Philip Falcone's $20 billion Harbinger Capital hedge-fund firm and the Missouri State Employees' Retirement System.

Roughly 60 days after the loan, Le-Nature's was bankrupt. The company was later found to have fraudulently inflated revenue by about 10 times, according to federal prosecutors.
Harbinger, Missouri and other investors sued Wachovia (WB 16.00, -2.21, -12.1%) , claiming the bank knew about Le-Nature's problems, but went ahead with the financing anyway. The fee of more than $7 million was alluring and the deal helped Wachovia in its goal of becoming a major player in the junk-bond market, the suit alleges.

Wachovia said earlier this year that it didn't know about Le Nature's problems and is itself a victim of the fraud.

However, the suit was an red flag to at least one analyst who is concerned that Wachovia may have let underwriting standards slip in recent years, looking to grow quickly to join Bank of America Corp. (BAC 31.13, -2.25, -6.7%) , J.P. Morgan Chase & Co. (JPM 37.92, -3.97, -9.5%) and Citigroup Inc. (C 18.54, -1.28, -6.5%) as one of the giants of the U.S. banking industry.

"This company's mantra was grow, grow, grow," Gerard Cassidy, an analyst at RBC Capital Markets, said in an interview. "They were so focused on wanting to be in the trillion-dollar asset club for banks that they cut corners."

Until now, most analysts and investors have focused on Wachovia's $122 billion portfolio of so-called pick-a-pay mortgages, inherited from the infamous acquisition of lender Golden West at the height of the housing boom in 2006. These kinds of negative-amortization mortgages allowed borrowers to pay less than the required monthly amount, increasing the size of the loan. As house prices slump, more of these home loans are souring.

But Wachovia also has more than $200 billion in commercial loans that could trigger even more losses if the U.S. economy slides into recession, according to Cassidy.

"This is more frightening to me because it's bigger," he said.
If Wachovia did cut corners underwriting commercial loans, then higher losses on these assets could force the bank to raise more capital or sell lucrative business to get through the downturn, the analyst added.

Robert Steel, Wachovia's new chief executive, brings a welcome, objective view to the company's problems, "but the heavy lifting has not begun," Cassidy warned.

MarketWatch contacted Wachovia spokeswoman Christy Phillips-Brown on Tuesday seeking comment. She said that the bank wasn't able to comment immediately. Shares of Wachovia ended down 12% at $16 in Tuesday trading.

Commercial-loan boom
In the past 15 years, commercial and industrial loans have more than doubled to $1.4 trillion, according to data from RiskMetrics Group and the Federal Deposit Insurance Corporation. Wachovia had $206 billion of commercial loans on its balance sheet at the end of June, up 25% from a year earlier and more than double from five years ago.

Such types of loans are made to companies to help them pay for acquisitions and for other reasons, such as financing inventories and receivables. They are sometimes unsecured, so when loans go bad there's no collateral to sell to recover any money, leaving a 100% loss, analysts say.

In contrast, real-estate loans are backed by property, so when defaults happen there are assets to sell. That has limited losses during previous downturns in the credit cycle.

Net charge-offs on real-estate loans have been lower than losses on commercial and industrial loans every year since 1991, according to RiskMetrics. That's partly because of the unsecured nature of some commercial loans.

But due to the current housing slump, there were higher losses on real-estate loans than commercial loans during the first quarter of this year, RiskMetrics data show.

As real-estate loans go bad, several banks have been trumpeting their business in commercial and industrial loans, which has been near record levels in recent quarter, RiskMetrics noted.

"However, as signs of a weakening economy continue to emerge, we are likely to see credit quality in C&I lending deteriorate in tandem with the general economy," wrote Kevin Mixon, an analyst at RiskMetrics, in a June report to investors.
This type of lending "is currently a less-appreciated component of risk in bank portfolios," he added. "A continued economic downturn may lead to increased events of default in this inherently higher loss-rate lending category in upcoming quarters."

Net charge-offs on commercial and industrial loans fell as low as 0.18% of total loans in the first quarter of 2006. Since then, the rate of losses has climbed to 0.68%, RiskMetrics indicated.

At the height of the dot-com bust, the rate of net charge-offs on these types of loans reached 1.71% in 2002. In 1991, during an earlier recession, net charge-offs climbed as high as 1.79%, RiskMetrics data show.

In the second quarter of 2007, before the credit crunch hit, Wachovia reported that net charge-offs on these types of loans were 0.07% of average commercial loans. That jumped to 0.88% in the second quarter of 2008.

In the second quarter of 2002, during the dot-com bust, Wachovia reported the rate of net charge-offs on commercial loans was 1.24%.

Worrying signs
The lawsuits surrounding the collapse of Le Nature's made RBC's Cassidy concerned about Wachovia's loan-underwriting procedures. But there have been other worrying signs, the analyst said.

In its latest annual report, Wachovia said provisions to cover bad debt would remain under 0.75% of average net loans, on an annualized basis, during the first half of 2008. However, soon after the bank disclosed in a regulatory filing that provisions would probably exceed that level.

"That was a red flag to me," Cassidy said. "Where were the controls?"

In April, The Wall Street Journal said that Wachovia was being investigated by federal prosecutors as part of a probe into alleged drug-money laundering by Mexican and Colombian money-transfer companies. An official at the bank told the newspaper that it was cooperating with authorities. Wachovia cut ties to the money-transfer firms when the probe started in December and January, the paper reported.

In the same month, Wachovia agreed to pay an estimated $144 million to settle charges that it took advantage of older customers through questionable relationships with telemarketers. The bank didn't admit or deny wrongdoing.

Also in April, the company reported a first-quarter net loss of $393 million, or 20 cents per common stock. Three weeks later, Wachovia almost doubled that loss to $708 million after reviewing agreements related to its bank-owned life insurance portfolio.

Mervyn's, SemGroup, WCI
Wachovia also has ties to some recent high-profile bankruptcies.

SemGroup LP filed for bankruptcy protection in late July after losing billions of dollars in oil-trading losses. The company changed a credit agreement in February, allowing it to borrow as much as $600 million, up from $250 million. Wachovia Bank was the administrative agent and issued the letter of credit.

At the end of July, Mervyn's LLC went bust. Wachovia Capital Finance, a unit of the bank, was administrative and collateral agent on a loan facility of up to $600 million that was extended to the retailer.

WCI Communities Inc. (WCIMQ:WCI Communities, Inc 0.28-0.05-15.15% went bankrupt on Aug. 4. The Florida home-builder had a revolving credit construction-loan agreement with Wachovia Bank.

"There's a history of evidence that this company cut corners.

They didn't have the systems in place to control risks," Cassidy commented. "Wachovia was in such a rush to get into the big guys' club, that our biggest fear, aside from pick-a pay, is that they didn't underwrite commercial loans properly."




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