WASHINGTON MUTUAL'S (WAMU) mortgage banking unit has faltered so badly in recent quarters that the Seattle-based thrift may have no choice but to sell to a larger corporation, according to analysts.

WaMu's disastrous second-quarter figures led CEO Kerry Killinger to apologize to investors during a July conference call. The unit's net income plummeted to zero in the second quarter, down from $611 million in the second quarter of 2003, when it accounted for 60 percent of the company's earnings. Its poor performance dragged all of WaMu with it; total earnings were down 52 percent year over year. The company reduced its earnings projections for the year to $3.00 to $3.60 per share, down from $4.35. (WaMu turned down interview requests for this article.)

A drop in mortgage banking was expected: The refinancing boom is over, and total mortgage originations are projected at about $2.5 billion for the year, compared to $3.8 billion in 2003. Many mortgage lenders' costs rise during boom times, only to be contracted as lending cools.

Layoffs are part of that cycle; WaMu has announced 13,450 since last August, including about 2,500 jobs lost as the company closes 100 loan centers around the country and a mortgage loan processing facility in San Antonio.

In a separate step, WaMu also announced in July that it would shutter its 53 commercial banking centers that serve primarily medium and large businesses. (It will continue to serve businesses with $5 million or less in sales through its retail banking branches.)

Still, WaMu, the second-largest mortgage lender, has been hit harder than its chief competitors, Wells Fargo and Countrywide Financial. A series of quick acquisitions in 2000 and 2001 are chief among the reasons why, says Paul Miller, managing director of investment bank Friedman Billings Ramsey. The company bought five other mortgage lenders but failed to convert those banks' back-office systems to its own. The process of integration, which Killinger acknowledges took too long, is now under way.

Analysts also cite the company's hedging practices as a reason behind its poor performance. Banks often hedge against falling interest rates, which cause their mortgage operations to lose business, by investing in funds that prosper under those conditions. If the calculation is done correctly, the bank comes out even. Mismatched hedges can result in sizable gains—as WaMu experienced last year—or substantial losses, which happened in the second quarter, when hedging cost the company $63 million.

Richard Bove, managing director of investment bank Hoefer and Arnett, believes WaMu got burned trying to continue making money off its hedge. “They've been at the edge, not in the center,” he says. “They've been taking risks their peers aren't taking.” The company has turned to Black-Rock, a frequent hedging adviser, for guidance moving forward.

While WaMu tries to fix the mortgage unit, it's also devoting energy to continuing the expansion of its retail banking enterprise, which posted a 25 percent gain and added 66 new branches (called stores by WaMu) in the second quarter. Miller and Bove agree that the company may be better served by slowing that growth.

Though Killinger predicts the mortgage banking unit will be competitive by the end of 2005, the steps that WaMu has taken may not be enough to right the ship. “They've lost control of the cost structure,” Miller says. “It might be unfixable. I think it will be very difficult [for WaMu] to stay independent.”

Miller and Bove believe Citigroup and British-based HSBC are the most likely candidates to buy WaMu, which would increase both banks' reach across the United States. The more likely purchase by Citi-group would solidify its position as the world's largest bank, Bove says, adding, “I don't think any buyer is likely to pay a premium for the company.”