As mentioned in a previous post, I am short Washington Mutual (NYSE:WM) at an average price of $11.94. I think the country’s largest savings and loan institution owns a portfolio of very risky mortgages and consumer loans that could eventually render it insolvent.

Most economists have started to accept that average home prices will decline by 20% from peak to trough. I think prices could fall 25-30%. Even if we assume that 20% will be the correct number then, according to Calculated Risk, almost 14 million single family homes will have mortgages worth more than the value of the homes.

If 4 million of these homeowners actually walk away from their homes and we get another 2 million defaults due to loss of jobs, business income, etc. then the US could be facing 6 million foreclosures in the coming years. Assuming that the average mortgage balance on these homes is around $300,000 and half of the value of the mortgages are eventually recovered then the total mortgage losses will amount to almost $1 trillion or 10% of the total outstanding mortgage balance.

If such a scenario plays out, then WaMu is in big trouble. According to its 2007 annual report, the bank held $244 billion of loans, half of which were originated from California and another 8% from Florida. Among the loans were $9 billion of credit card loans, $18.5 billion of subprime mortgages, and $61 billion of HELOC. In addition, $110 billion of mortgages to prime borrowers were held of which half were option ARMs. Also, half of the $110 billion prime mortgages had loan-to-value ratios exceeding 70%. And the most disturbing part is that WaMu had set aside only $2.6 billion for total loan losses.

I think there is a good chance that WaMu will have to write-off an additional $25 billion of these loans or approximately 10% of the portfolio. There could be another $3 billion of write-offs for some of WaMu’s other assets. For instance, it held $1.5 billion of asset backed securities (ABS) with underlying credit card loans that the rating agencies have rated as junk, meaning that if credit card charge-offs continue to rise WaMu’s ABS could be worth very little.

In total I think WaMu will have to write-off at least another $28 billion over the next few years. It recently raised $7 billion in a preferred share offering, but if the bank’s $7.3 billion of goodwill is excluded, then the total tangible equity amounts to $24 billion, which would be insufficient to deal with my estimate of future losses.

WaMu’s only chances of survival are raising additional equity or selling itself to another bank. But another equity offering will only be completed well below the current price and would again massively dilute shareholders. A takeover of WaMu by another bank is quite possible, however the bank recently rejected J.P. Morgan’s offer of $8 per share and instead agreed to an equity offering that almost doubled the share count. A future takeover will only be completed well below $8.

If substantially more capital is not attracted from investors, WaMu’s book value will head towards zero. Over time that will become more apparent leading to a run on the bank, which would be the final nail in the coffin as deposits are a major funding source for WaMu. The end result could be the Fed and the government stepping in and nationalizing the bank, but not before current shareholders are wiped out.

At the current price WaMu looks to me like an easy short sell.