February 20 2008: 5:50 AM EST
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Wachovia's big mortgage buy

Golden West's loans, option ARMs clustered in the frothy California real estate market, may take a hit from the housing downturn.

By Jia Lynn Yang, writer-reporter

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Herb and Marion Sandler

(Fortune Magazine) -- The street has never much cared for Wachovia's 2006 purchase of Golden West Financial for $24 billion. Even before the mortgage industry went splat, skeptics felt Wachovia CEO Ken Thompson was paying too much for Golden West's abundance of pay-option adjustable-rate mortgages, or option ARMs, clustered in the frothy California real estate market. Still, Herb and Marion Sandler, the husband and wife team behind Golden West, were legendary for their rigorous underwriting standards and had nimbly steered their S&L through the ugly California real estate downturn in the early '90s when other banks failed to. Now analysts and investors are wondering: Can Thompson pull off the same feat today, or is the bank in for some trouble?

Before Countrywide (CFC, Fortune 500) and Washington Mutual (WM, Fortune 500) joined the option ARMs race, the Sandlers were among the first to recognize their potential. In an option ARM, the borrower can make a minimum payment each month that covers only a fraction of the interest. The unpaid interest gets added to the mortgage principal. This can go on for a set period of time, typically five or ten years, or until the loan hits a limit - usually 110% or 125% of its original value - at which point the borrower has to start paying down the whole shebang. The monthly increase can be shocking.

In an earnings call in January, Thompson conceded that the housing downturn is going to result in more charge-offs than Golden West faced even in its toughest times. Nonperforming assets in Wachovia's option ARM portfolio last year totaled $2.77 billion, three times the amount from a year earlier - though as a percentage of the loans, Wachovia (WB, Fortune 500) is still holding up far better than other banks, and it expects its option ARM business to remain profitable in 2008.

One factor that makes things different from past downturns is that borrowers are showing a new willingness to walk away from their mortgages, even if it means destroying their credit. "We're in a brave new world of consumer behavior with all mortgage products," says Frederick Cannon, an analyst at Keefe, Bruyette & Woods.

For their part, Herb and Marion Sandler are busy running their own philanthropy (they made roughly $2.4 billion in cash and stock on the deal). But Herb, who says they still own a "fair amount" of Wachovia shares, remains a vociferous defender of his loans and says that if anything, his borrowers are suffering from the lax standards of other lenders in the form of rising foreclosures in their neighborhoods.

"The answer to what went wrong was wild, irrational, volume-driven loans by people who didn't give a damn about economics." Greedy, powerful lenders? Sounds like a topic for ProPublica, a new nonprofit investigative reporting outfit funded by none other than the Sandlers.  To top of page