By Shannon D. Harrington and Abigail Moses
Sept. 26 (Bloomberg) — The cost to protect against a default by Wachovia Corp., the fourth-largest U.S. bank, soared to distressed levels after Washington Mutual Inc. was seized by regulators and its deposits sold off to JPMorgan Chase & Co.
Credit-default swaps protecting $10 million of Wachovia bonds from default for five years traded for as much as the equivalent of $3.5 million initially and $500,000 a year, according to broker Phoenix Partners Group. That compares with $670,000 a year and no upfront payment yesterday.
Wachovia’s 2006 purchase of Golden West Financial Corp. saddled the company with option adjustable-rate home loans that allow borrowers to make minimum payments less than what they owe, which is then added to their total debt balance. With JPMorgan saying they expect 20 percent losses on WaMu’s option ARM portfolio, Wachovia may need to raise $11 billion in capital to protect against losses from its loans, Deutsche Bank AG equity analyst Mike Mayo said in a note to clients today.
Wachovia is an “attractive target,” though “it’s not clear who wants to take them on at this time,” Bert Ely, president of consulting firm Ely & Co. in Alexandria, Virginia, said today in a Bloomberg Television interview.
Seattle-based Washington Mutual was taken over by the government yesterday after customers had withdrawn $16.7 billion from accounts since Sept. 16. New York-based JPMorgan acquired WaMu’s branch network for $1.9 billion.
The initial cost for credit-default swaps on Wachovia bonds dropped back to 25 percentage points, or $2.5 million, after the New York Times reported the Charlotte, North Carolina-based bank is in preliminary talks to merge with Citigroup Inc.
Wachovia has entered into preliminary discussions with banks including Spain’s Banco Santander SA, San Francisco-based Wells Fargo & Co. and New York-based Citigroup, the Wall Street Journal reported, citing a person familiar with the situation.
Morgan Stanley broke off merger talks with Wachovia to focus on a partnership with Japan’s Mitsubishi UFJ Financial Group Inc., CNBC reported earlier this week.
“We may yet see that type of deal,” Ely said. Morgan Stanley, along with Goldman Sachs Group Inc., “at some point in time need to acquire a large banking franchise, and Wachovia certainly becomes a very attractive target.”
Wachovia’s credit-default swaps are trading at levels that imply a 63 percent chance the company will fail within five years, according to a JPMorgan valuation model. That assumes bondholders would receive 30 cents on the dollar in the case of a default.
Wachovia’s $750 million of 4.375 percent bonds due in 2010 plunged 29 cents to 51 cents on the dollar, as of 1:03 p.m. in New York, according to Trace, the Financial Industry Regulatory Authority’s bond-pricing service. The yield increased to 51.6 percent, or 49.6 percentage points more than Treasuries with similar maturities.
“We are focused on managing our company and serving our customers with excellence,” Wachovia spokeswoman Christy Phillips-Brown said. “Our core franchises — retail banking, the nation’s third largest brokerage firm, wealth management and our commercial and corporate banking activities — are extremely valuable and continue to operate well relative to our competition.”
Chief Executive Officer Robert Steel, a former Treasury official who was hired to replace Kennedy Thompson in July, has said he’s firing workers and cutting more than $1.5 billion in annual costs to cope with losses from the loan portfolio.
Credit-default swaps on Morgan Stanley also rose to distressed levels today, coming close to a record high reached last week after Lehman Brothers Holdings Inc. filed for bankruptcy protection. Morgan Stanley and Goldman both won approval from the Federal Reserve to become bank holding companies, moving away from a business model that investors have deemed too dependent on borrowed money, or leverage.
Morgan Stanley contracts traded at 17.5 percentage points upfront in addition to 5 percentage points a year, according to Phoenix Partners. That compares with 783 basis points a year and no upfront payment yesterday, CMA data show. They earlier traded at a record 22 percentage points upfront, Phoenix prices show.
Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company’s ability to repay debt. They were conceived to protect bondholders against default and pay the buyer face value in exchange for the underlying securities should the company fail to adhere to its debt agreements.
Credit-default swaps on other banks also rose today. Contracts on Merrill Lynch & Co., which agreed to sell itself to Bank of America Corp. last week as Lehman collapsed, rose 94 basis points to 415, according to CMA. Goldman contracts rose 86 to 449.
Contracts on Citigroup jumped 115 basis points to 325 basis points, CMA data show. Bank of America rose 13 basis points to 161 basis points, Wells Fargo increased 38 to 159 and JPMorgan climbed 34 basis points to 156 basis points.
Contracts on the Markit CDX North America Investment Grade Index, a benchmark gauge of credit risk linked to 125 companies in the U.S. and Canada increased 2.5 basis points to 163.5 basis points, Phoenix prices show.
Contracts on WaMu traded at 61 percentage points upfront today, Phoenix prices show, down from 74 percentage points earlier.
Last Updated: September 26, 2008 18:13 EDT