Fitch Mulls Downgrade of Wachovia over Option ARMs

The infamous Pick-a-Pay is coming home to roost at Wachovia Corp. (WB: 16.75 +7.86%), with Fitch Ratings warning on Friday of a likely downgrade to the Charlotte, North Carolina-based bank over concern about the company’s mortgage exposure. It’s a warning that some insiders told HW Friday afternoon was long overdue.

Put bluntly, the bank holds a substantial $170 billion residential mortgage portfolio; a whopping $121 billion of that total is in the form of option ARMs, the latest toxic mortgage to come to light in the burgeoning industry crisis. To put that number in perspective, consider that the bank’s market capitalization after market close on Friday stood at $32.3 billion.

Option ARMs were nearly universally put into portfolios by banks, due to the innovation of deferred interest that allowed them to book current-period income when borrowers chose to make only the minimum payment on the loans. Wachovia, for example, has already booked $3.5 billion in deferred interest as income tied to the loans.

The question now, however, is how much of that will peel off of future earnings as its option ARMs continue to explode. Unlike securitized mortgages, portfolioed option ARMs present a double-whammy threat to income: previously recognized deferred interest income disappears, not to mention the more direct cost of the bad asset itself.

“The vast majority of Wachovia’s Pick-A-Pay portfolio (58% or approximately $71 billion) is in the troubled California market, with much of that in the central part of the state that has experienced among the most severe home value devaluation,” Fitch said in a press statement.

The bank recently hired Goldman Sachs Group Inc. (GS: 163.24 +1.45%) in an effort to help it figure out what it should do with the Option ARM loans on its books, it admitted to the Wall Street Journal on June 25.

It’s not hard to see why: Wachovia’s option ARM portfolio saw non-performing assets jump by $1.6 billion in just one quarter to $4.6 billion at the end of Q1, almost 4 percent of loans; analysts expect that number could be as high as $7.5 billion when the company reports its Q2 results on July 22. Credit problems aren’t limited just to option ARMs, either — Wachovia saw its $48.9 billion in more traditional mortgage holdings double NPAs on the books between Q4 2007 and Q1 2008 alone.

The admission that Goldman was brought on board is also a surprising signal that the bank can’t properly manage the fate of loans it boarded as part of its $25 billion purchase of Golden West Financial in 2006; that ill-fated deal ended up costing CEO Ken Thompson his job roughly one month ago, and the bank has yet to find a successor.

Disclosure: The author held no positions in WB or GS when this story was originally published. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.