Wachovia, National City tumble on bailout, WaMu

NEW YORK (Reuters) - Wachovia Corp WB.N and National City Corp NCC.N shares tumbled as talks on a $700 billion government bailout of the financial sector stalled and regulators seized Washington Mutual Inc (WM.N).

Investors fear a collapse of bailout talks could prolong the freeze in parts of the credit markets and worsen losses on bank balance sheets from troubled mortgages and other loans.

"You're talking about the largest failure in banking history, so there is going to be a negative reaction, right?" said William Smith, president of Smith Asset Management in New York. "What you're going to see is the strong stronger and the weak are going to die off."

Wachovia shares closed down $3.70, or 27 percent, at $10.

Later on Friday the Wall Street Journal online reported that Wachovia was in preliminary talks with Banco Santander and Wells Fargo, as well as Citigroup Inc (C.N).

National City tumbled $1.28, or 25.6 percent, to $3.71. The KBW Bank Index .BKX, which includes both banks, rose 2.6 percent. Downey Financial Corp DSL.N, a southern California lender with significant mortgage exposure, also was hit hard. It slid $1.87, or 47.9 percent, to $2.

Late on Thursday, regulators declared Washington Mutual "unsound" after $16.7 billion of deposit outflows in less than two weeks, and engineered a sale of the bulk of its operations to JPMorgan Chase & Co (JPM.N) for $1.9 billion. JPMorgan said it would take a $31 billion write-down for the loans it bought.

While both Wachovia and National City have several profitable businesses, investors are focused on their real estate exposures.

Charlotte, North Carolina-based Wachovia is the sixth- largest U.S. bank by assets, while Cleveland-based National City has major presences in Ohio, Michigan and Florida, all hard hit by the housing crisis.

"They're the ones with a similar exposure to Washington Mutual," said Bill Fitzpatrick, a portfolio manager at Optique Capital Management Inc in Milwaukee. "They are both mortgage finance companies at this point."

The cost rose for protecting Wachovia debt against default. It cost $2.5 million upfront plus $500,000 annually to insure $10 million of debt against default for five years, according to Phoenix Partners Group. That compared with $650,000 annually and no upfront cost on Thursday, Phoenix said.

EXPOSURES

Much of the concern by investors about Wachovia focuses on its $122 billion portfolio of option adjustable-rate mortgages, which Chief Executive Robert Steel treats as "distressed."

It got most of the ARMs when it paid $24.2 billion for California lender Golden West Financial Corp in 2006. The bank has said it could lose $14.4 billion on the portfolio.

"We believe Wachovia has not taken adequate write-downs," Standard & Poor's equity analyst Stuart Plesser wrote, echoing the views of some analysts.

"We are aggressively addressing our challenges and are working to strategically strengthen and manage capital and liquidity in this challenging environment," said spokeswoman Christy Phillips-Brown.

National City is trying to reduce the size of a roughly $17.4 billion loan portfolio related to businesses it exited, including broker-sold home equity, subprime and residential construction loans. This portfolio represents about 15 percent of the bank's loans.

"If you use JPMorgan's assumptions that they use to mark WaMu's books to market, National City is likely either a candidate for FDIC seizure, or it's a candidate for a dilutive capital raise," said James Ellman, a portfolio manager at Seacliff Capital in San Francisco.

He declined to disclose whether he has a position in National City.

Thomas Richlovsky, who is National City's treasurer and will become interim chief financial officer next week, described as "ludicrous" and "ridiculous" the idea that the FDIC might seize any part of the bank. He noted National City raised $7 billion of capital earlier this year.

"JPMorgan did a smart thing, writing down the amount to the lowest number it could justify because that gives it a clean slate going forward," Richlovsky said. "We have the capital to manage through the losses under severe stress scenarios."

(Additional reporting by Karen Brettell and Elinor Comlay; editing by Jeffrey Benkoe, Andre Grenon and Carol Bishopric)