WaMu's bad loans may be $29B windfall for JPMorgan

JPMorgan Chase stands to reap a $29 billion windfall, thanks to an accounting rule that lets the second-biggest U.S. bank transform bad loans it purchased from Washington Mutual into income.

Wells Fargo, Bank of America and PNC Financial Services Group are also poised to benefit from taking over home lenders Wachovia, Countrywide Financial and National City, regulatory filings show.

The deals provide a combined $56 billion in so-called accretable yield, the difference between the value of the loans on the banks' balance sheets and the cash flow they're expected to produce.

Faced with the highest U.S. unemployment in 25 years and a surging foreclosure rate, the lenders are seizing on a 4-year-old rule aimed at standardizing how they book acquired loans that have deteriorated in credit quality.

By applying the measure to mortgages and commercial loans that lost value during the worst financial crisis since the Great Depression, the banks will wring revenue from the wreckage, said Robert Willens, a former Lehman Brothers Holdings executive who runs a tax and accounting consulting firm in New York.

"It will benefit these guys dramatically," Willens said. "There's a great chance they'll be able to record very substantial gains going forward."

When JPMorgan bought Seattle-based WaMu out of receivership last September for $1.9 billion, the New York-based bank used purchase accounting, which allows it to record impaired loans at fair value, marking down $118.2 billion of assets by 25 percent.

Now, as borrowers pay their debts, the bank says it may gain $29.1 billion over the life of the loans in pretax income before taxes and expenses.

The purchase-accounting rule provides banks with an incentive to mark down loans they acquire as aggressively as possible, said Gerard Cassidy, an analyst at RBC Capital Markets in Portland, Maine.

"One of the beauties of purchase accounting is after you mark down your assets, you accrete them back in," Cassidy said. "Those transactions should be favorable over the long run."

JPMorgan bought WaMu's deposits and loans after regulators seized the thrift in the biggest bank failure in U.S. history. JPMorgan took a $29.4 billion write-down on WaMu's holdings, mostly for option adjustable-rate mortgages and home-equity loans.

"We marked the portfolio based on a number of factors, including housing-price judgment at the time," said JPMorgan spokesman Thomas Kelly. "The accretion is driven by prevailing interest rates."

JPMorgan said first-quarter gains from the WaMu loans resulted in $1.26 billion in interest income and left the bank with an accretable-yield balance that could result in additional income of $29.1 billion.

Wells Fargo arranged the $12.7 billion purchase of Wachovia in October, as the Charlotte, N.C.-based bank was sinking from $122 billion in option ARMs. As of March 31, San Francisco-based Wells Fargo had marked down $93 billion of impaired Wachovia loans by 37 percent. The expected cash flow was $70.3 billion.

The Wachovia loans added $561 million to the bank's first-quarter interest income, leaving Wells Fargo with a remaining accretable yield of almost $10 billion.

Government efforts to reduce mortgage rates and stabilize the housing market may make it easier for borrowers to repay loans and for banks to realize the accretable yield on their books.

With mortgage rates below 5 percent, originations surged 71 percent in the first quarter from the fourth, a pace that may accelerate during 2009, said Guy Cecala, publisher of Inside Mortgage Finance in Bethesda, Md.

Wells Fargo, the biggest U.S. mortgage originator, doubled home loans in the first quarter from the previous three months, in part through refinancing Wachovia loans.

"To the extent that the customers' experience is better or we can modify the loans, and the loans become more current, that could help recapture some of the write-down," Wells Fargo Chief Financial Officer Howard Atkins said in an April 22 interview.

Banks still face the risk that defaults may exceed expectations and lead to more write-downs on their purchased loans. Foreclosure filings rose to a record for the second straight month in April, rising 32 percent from a year earlier to more than 342,000, data compiled by RealtyTrac show.

The companies bought by Wells Fargo, JPMorgan, PNC and Bank of America were among the biggest lenders in states with the highest foreclosure rates, including California, Florida and Ohio. Housing prices tumbled the most on record in the first quarter, leaving an increasing number of borrowers owing more in mortgage payments than their homes are worth, according to Seattle-based Zillow.com.

"We've still got a lot of downside to work through this year and probably through at least part of next," said William Schwartz, a credit analyst at DBRS in New York. "If I were them, I wouldn't be claiming any victory yet."

The discounted assets purchased by JPMorgan and Wells Fargo make the stocks more attractive because they will spur an acceleration in profit growth, said Chris Armbruster, an analyst at Al Frank Asset Management in Laguna Beach, Calif.

"There's definitely going to be some marks that were taken that were too extreme," said Armbruster. "It gives them a huge cushion or buffer to smooth out earnings."