I have been thinking carefully about WHI's reserves to see if I think they are sufficient. There was one issue that I realized I didn't understand well enough and that was charge-offs. I read through the 2007 (restated) 10-K again and realized the following important fact.

The loan loss reserve we have now, $247MM, looks kind of small because we have already charged-off the collateral deficiency of many of our loans.

In 2007 (from the 10-K), we charged off $92MM for Inyx and left about $52MM of the Inyx loan outstanding. We also charged-off $28MM from a few ABL loans leaving $51MM outstanding on those loans after charge-off.

In 2008 and the first two quarters of 2009, we charged off $107MM in the three categories construction, CRE and C&I loans.

So now we have $1478MM in non-accruals with a reserve of $247MM. The ratio of reserve to non-accruals is 16.7%. However, that is ignoring the portions already charged off. Adding back the $100MM or so (non-Inyx) charge-offs, we really have about $1578MM in non-accruing loans balances and a loss reserve of $347MM. That ratio is 22.0% which is quite a bit better.

The main point is that the reserve looks small because much of the value of the loan over the collateral value has already been charged-off.

Futhermore, in the end of 2007, we actually had $1789MM non-accruing loans. We actually have less now ($1478MM) and only 1/3 of the improvement is due to charged-off balances. They also say in the 10-K that they have $175MM of specific allowances. That is the difference between the total allowance then ($339MM) and the specific allowance is $164MM and this is the non-specific allowance.

It is important to keep in mind these charge-offs when considering what price the local government might pay for a loans. Consider a loan for $90MM that was made at say 90% LTV. Suppose today's collateral value has dropped by 30% over the expected value. That means the value is only $70MM. Now WHI might have charged off $15MM already and created a $10MM reserve. So the carrying value of the loan (i.e. remaining balance) is $65MM and the collateral is worth about $70. So it might make sense for the government to pay $65MM for the loan that will return $70MM upon foreclosure. That isn't a good investment but they won't lose money. If they do that, they are essentially paying 100 cents on the dollar versus the carrying value of the loan. Note this is not the same as paying 100 cents on the dollar on the original value of the loan, i.e. $90MM.

So in summary, don't ignore the charge-offs when consider the adequacy of reserves.