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Is Wachovia the next domino to fall?

This article first appeared in the St. Louis Beacon: September 16, 2008 - Bailouts for Fannie Mae, Freddie Mac and American International Group. Bankruptcy for Lehman Brothers. The buyout of Merrill Lynch. The busted IndyMac Bancorp.

Given the continuing assault on the financial services industry, could Wachovia Corp. be the next domino to fall?

On Wednesday, The New York Times reported that Wachovia had contacted Morgan Stanley about a possible merger, but no other details were available. The Times reported that shares of Wachovia fell 20.76 percent, or 2.39 percent, to $9.12; Morgan Stanley declined 24.22 percent, or $6.95, to $21.75.

Worried analysts aren't ready to pull the plug on Wachovia, a battered banking giant; but they remain concerned about its damaged mortgage portfolio, its businesses that rely on a healthy economy and its near-term earnings prospects.

Most Wachovia watchers on Wall Street are neutral on the stock; and those who recently lowered their ratings aren't forecasting a dramatic fall -- unless the company is forced to take extraordinary measures that investors would see as bad news. A sale to Morgan Stanley would generally be regarded as good news, and Wachovia's stock would be expected to go up.

"If the market senses even a chance that Wachovia needs new capital, its stock could get punished, starting a downward spiral," says Mike Mayo, of Deutsche Bank Securities, in a Sept. 14 report changing his rating to hold from buy. He doesn't own shares; his firm has had a recent investment banking relationship.

Wachovia raised $8.1 billion in April by issuing common and preferred shares. Robert Steel, the new CEO, told investors in July that he didn't want to issue more shares.

Steel told analysts he wants to stop the bleeding by cutting costs, including dismissing employees and eliminating open jobs; reducing the dividend; and selling non-core assets. After his remarks, Wachovia's stock stabilized, only to fall in recent days amid a sinking stock market.

"Anything in financial services is predicated on confidence," says Juli Niemann, executive vice president of Smith, Moore & Co. financial advisory company in Clayton.

Although Wachovia did plenty in the past to shake investor confidence, Niemann agrees with the Wall Street crowd that Wachovia doesn't appear headed in the direction of IndyMac or the now-precariously perched Washington Mutual. "I don't see Wachovia blowing up, but profitability will be a long-term quest," Niemann says.

Weakened by bad mortgage-lending practices and possessing a stock that has dipped below single digits, Wachovia's stock also has been consumed by the almost nonstop bad news about the economy and giant financial institutions.

STOCK SHOCK

Wachovia "is being hurt by the general fears associated with the bankruptcy of Lehman Brothers Holdings," says Richard X. Bove, a banking analyst for Ladenburg Thalmann & Co., in a recent research report. "This may be misplaced."

Bove tells clients that although Wachovia has been injured by its big exposure to mortgages, it is "dramatically increasing its position with depositors." Bove is neutral on Wachovia, adding that "there is some time before one buys the stock -- but selling it seems excessive at these prices."

Bove issued his report Monday when Wachovia's stock opened at $12.31. By Wednesday trading, it fell as low as $8.50 before closing at $9.12.

The stock had slipped below $10 for several days in July; before that, when adjusted for splits, the stock hadn't been in single digits since 1991. (Twelve months ago, just before Wachovia closed its acquisition of A.G. Edwards, the stock was trading in the low $50s.)

Bove issued his report just before before Wachovia said the collapse of Lehman Brothers had affected three money market funds run by Wachovia's Evergreen mutual fund unit.

Wachovia has signed "support agreements" to support the value of Lehman credit held in the funds to make sure their net asset values remain at the industry standard of $1 a share.

"These agreements are intended to ensure that the decline in the value of the Lehman debt will not result in a decrease in the net asset value of the Evergreen money market funds," says a Wachovia notice posted Wednesday on Evergreen's website.

Lehman credit accounted for 0.97 percent to 1.66 percent of net assets among three Evergreen money market funds. The three funds had a total of $494 million invested in Lehman Brothers credit.

Wachovia said Evergreen's municipal money market funds aren't affected by the Lehman bankruptcy and that Evergreen's funds aren't exposed to American International Group.

"Recognizing that continued liquidity challenges in the marketplace and ongoing media speculation may create concern for investors, we want to reaffirm that Evergreen is committed to monitoring the situation and to providing information regarding the investment strategies of the firm's money market funds," the company said.

MARKET TURMOIL

Given the furious market activity, it's not surprising that investors and financial experts can change their minds quickly. For example, the Morgan Keegan investment banking firm cut its rating on Wachovia to underperform on July 25, then raised it to market perform on Sept. 15. (Like many firms, Morgan Keegan eschews the traditional terms of buy, hold, sell.)

Robert S. Patten, the Morgan Keegan analyst, warned that Wachovia still might have to raise additional capital if the housing market turned "materially" worse in the coming months. He added that the bank's plan to raise enough money via selling non-core assets "could prove to be very difficult."

Yet, after citing a litany of concerns and remarking that "there are no easy fixes here," Patten issued a report raising his rating. Key financial ratios reveal "the risk/reward ratio has turned more neutral," he said. Patten doesn't own shares; an affiliate of his firm has received payment from Wachovia for non-investment banking services in the last 12 months.

While Patten was raising his rating, Merrill Lynch's Edward Najarian was cutting his opinion to underperform from market perform. Two months earlier, he had raised his rating to market perform from underperform. Najarian doesn't own shares; his firm has had a recent investment banking relationship.

Najarian told clients on Sept. 9 that he changed his view because Wachovia will experience "materially deteriorating credit quality" in its mortgage portfolio especially in the weak housing markets of Arizona, California and Florida. He also expects weaker retail brokerage revenue.

Najarian reduced his earnings per share estimates for 2008, 2009 and 2010. He cites the fallout from Wachovia's mortgage-lending business and the weak economy which will affect the brokerage and investment banking businesses.

Robert W. Steyer, a former business reporter for the St. Louis Post-Dispatch, is a freelance journalist in New York. 

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