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Wachovia Cut to Underperform by Merrill

While broader market indices appear set to rise on Tuesday, Wachovia Corp. (WB) was headed in the opposite direction in pre-market trading after analysts at Merrill Lynch & Co. (MER) downgraded the North Carolina-based bank to underperform, citing concerns over investment banking and a growing likelihood of impairment charges. Shares in Wachovia were off just over 4 percent, to $18.22, when this story was published. The downgrade comes as Wachovia CEO Robert Steel is set to present later today at a financial services conference in New York. In his presentation, filed Tuesday morning with the Securities and Exchange Commission, Steel reiterated that the company will layoff approximately 6,950 active employees, while also eliminating 4,400 open positions and contractors. The bank also said it expects to cut its 2009 expenses by $1.5 billion. The bank also disclosed that it will take a $171 million pre-tax hit on the sale of $509 million of GSE preferred shares, which the company said it liquidated on July 21 -- serendipitous timing, given the Treasury's bailout of both Fannie Mae (FNM) and Freddie Mac (FRE) this past weekend. Outside of a sale of preferred securities, Wachovia also has pulled back on investment banking activity to the tune of $5 billion at the end of August, as part of a move to de-leverage its balance sheet. Merrill said it now expects Wachovia to post a Q3 loss of 10 cents a share, compared prior estimates of 28 cents per share in earnings. Pick-a-Pain Beyond impairment charges and investment banking declines, Wachovia's now-infamous pick-a-pay loans continue to hurt the bottom line, as well. Option ARMs constitute $122.2 billion of the bank’s $488.2 billion in total loans; no other U.S. bank has as much exposure to option ARMs in real-dollar terms. Steel said Tuesday that 66 percent of borrowers in its option ARM portfolio have some deferred interest balance, which has driven $3.9 billion in paper income for the bank. The current average loan-to-value ratio of its entire option ARM portfolio is now up to 90 percent -- and that's an estimate that is based on May 2008 data, meaning it's already four months old. It's a safe bet that the average LTV is now well over 90 percent. Steel said that Wachovia is aggressively looking to mange its exposure to the troubled loans, noting that "holding loans on balance sheet and servicing them ourselves provides flexibility and allows for return maximization." While there is some truth there, we doubt the issue here is "return maximization" as Steel suggested; it's probably far more apropos to say the goal is "loss minimization." After all, it's not as if Wachovia chose to portfolio its option ARMs because it wanted servicing flexibility; it did so in order to book the interest income and pump up its balance sheet. Steel touted the banks plan to make initial contact with 100 percent of option ARM borrowers by year end, and said the company now operates 3 loss mitigation centers with 425 fulfillment staff and 500 sales personnel. Disclosure: The author held various put option contracts on WB when this story was published; indirect holdings may also exist via mutual fund investments. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.

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