WaMu's CDS spreads surge to record high: Phoenix

NEW YORK (Reuters) - The cost of protecting Washington Mutual's (WM.N) debt with credit default swaps surged to a record high on Wednesday as investors bet more heavily that the lender would default on its debt.

Credit default swaps on Washington Mutual surged to 43 percent of the amount insured in upfront costs, up from 32 percent on Tuesday, plus 500 basis points in annual premiums, according to data from Phoenix Partners Group.

Swaps at those levels indicate the market sees about an 85 percent chance of Washington Mutual defaulting within the next five years, according to Tim Backshall, chief analyst at Credit Derivatives Research in Walnut Creek, California.

Swap spreads were also hurt by concerns about potential suitors for Washington Mutual walking away, Backshall said. New rules by the Financial Accounting Standards Board on acquisition targets' assets being valued at market prices were weighing on many potential acquisitions, he said.

Washington Mutual, the largest U.S. savings and loan, in July posted a $3.33 billion second quarter loss and said cumulative home mortgage losses would be toward the upper end of the $12 billion to $19 billion it forecast in April.

Washington Mutual's swap levels mean it now costs $4.3 million on an upfront basis plus $500,000 a year to protect $10 million of debt for five years.

"The market's shaking out who's going to be able to survive over the next year, and this is just part of the shake out," said Mirko Mikelic, portfolio manager for Fifth Third Asset Management in Grand Rapids, Michigan.

Washington Mutual's shares sank 22 percent or 74 cents on Wednesday to $2.56 on the New York stock exchange.

The surge in protection costs came a day after Standard & Poor's changed its outlook on the lender to negative from stable, signaling a downgrade to junk status is more likely over the next two years.

The change in outlook reflects a more challenging mortgage market and more scrutiny on Washington Mutual by regulators, S&P said. Washington Mutual has been put under special regulatory supervision following skyrocketing mortgage losses that are expected to weigh on results for years.

Washington Mutual has also ousted its chief executive Kerry Killinger after expansion into subprime and other risky mortgages caused its stock to plunge over the past year.

"We're not optimistic a new CEO can work miracles at WaMu, and the problems at the bank may be too overwhelming to expect an acquirer will step in at this point," Kathleen Shanley, analyst at independent research service Gimme Credit said in a note on Tuesday.

WaMu's home loan portfolio is also particularly vulnerable to credit losses because of its concentration in markets such as California and heavy exposure to adjustable rate mortgages, she said.

(Reporting by Dena Aubin; Editing by Chizu Nomiyama)