The reckless, irresponsible seizure of Washington Mutual: please read in Washington DC

I lost money on this – so you can take my analysis with the caveat of a slightly angry grain of salt.

But I still think the seizure of Washington Mutual is the most capricious government action of this cycle and possibly the worst thing that has happened to American Capitalism this cycle. But that takes a little explaining.

Lets do it on a typical current account deficit country bank. In a country with a current account deficit the loan to deposit ratio of the bank is usually something like 130. That is banks in current account deficit countries have more loans than deposits. Banks intermediate the current account deficit. I have blogged about that extensively – see here and here amongst others.

Here would be the typical capital structure of such a bank rebased so that total assets and liabilities equal 100.

Cash, securities, other semi-liquids 8
Loans 76
Other assets 16
Total assets 100


Deposits 59
Secured funding (say pledging assets - which happens in America more than other jurisdictions) 19
Other liabilities 3
Senior borrowing 6
Junior borrowing 3
Preferred stock 1
Equity 8
Total liabilities 100

Loan to deposit ratio 129%

I cannot spell out how common this sort of structure is. It would be a typical bank in most current account deficit countries other than that the secured borrowing may be unsecured in other countries. In the US banks can pledge assets to the Federal Home Loan banks – which is secured funding essentially backed by the US Government. In the UK there would be much less equity in the structure than in other jurisdictions. In America slightly more. If I were to rebase the balance sheet the equity in the US would be typically about 8%, in Australia about 7%, in Spain a little thinner and in the UK about 4%. After you adjust for goodwill these numbers are another percent or two lower.

Now generally (and I am talking in good times) the equity was a high return piece that got good returns under the understanding it could go to zero. Every equity holder knew (or at least should have known) that a wipeout was a possibility. The preferred stock was typically a very long dated instrument (say 30 years) with no security whatsoever and a dividend that could be suspended. There usually wasn’t much of it but anyone that thought rationally about it knew it could be wiped out. It also yielded say 500bps more than Treasuries. It was junk at pretty well all banks - though it could sometimes have a fancy rating.

But the senior debt in this structure was often medium dated, yielded say 120bps more than treasuries and was considered pretty safe.

After all – to wipe out the senior debt the equity, preferreds and junior debt needed to go first.

In this example above 12 had to be bad to touch the senior debt and 18 had to be bad for the senior debt to be worthless. As there was only 76 in loans in this table then 18/76 = 23 percent had to be bad. That was before you considered that the business would typically have some pre-tax, pre provisions earnings. So to wipe out the senior debt typically 30% of the loans had to be bad. As most of the loans in most banks in current account deficit countries are mortgages and would have a recovery rate maybe 50% of the loans need to default. With a bank diversified across a country that seems implausible even in these times of mortgage stress.

For the senior debt holders even to be hurt 30% of the loans probably needed to default. It was always possible – but the senior debt holders have (with some considerable intellectual justification) acted as if it were unlikely they would be nicked. They had plenty of protection – provided by equity, preferreds and junior debt.

Now if you notice in this capital structure the difference between loans and deposits – the lending that makes current account deficits countries possible – happens as either secured borrowing or unsecured senior borrowing. In countries without the Federal Home Loan Banks (which provide secured funding) the difference between loans and deposits is funded almost entirely with the senior.

What makes this structure possible is order of creditors and the reliability that governments/liquidators etc will honour that order of creditors and ensure that the senior debt instruments at least (and all the other debt instruments) will get a fair shake when things go pear shaped. If in a liquidation the senior was considered parallel the equity or preferred then the senior wouldn’t exist.

The seniors knew they took a risk. We know that because of the 120bps they charged. But these people think (with some justification) that they took very little risk. They relied for that justification on the notion that governments had rules which shifted the losses where they belonged, on equity, preferreds, juniors and seniors in that order. If they didn’t believe that then all senior funding would disappear and all institutions that were reliant on that senior funding would fail.

Ok – there was a minor bait-and-switch in this post. The ratios that I put out there were Washington Mutual in their final published results as a bank holding company. They are however not atypical – and the variants are fairly described in the following paragraph.

Now what has the Government done here. It has confiscated the institution and sold everything except the liabilities marked equity, preferred, junior and senior. It confiscated the liquidation rights of the senior and junior debt. [It confiscated the liquidation rights of the preferreds to but that is an understood risk in owning preferreds. And whilst I lost money here I am far more angry about the other…]

If WaMu had been placed in liquidation I am pretty sure the seniors would have got something. If the senior debtors had been allowed to conduct an auction for WaMu (compromising all the junior stuff including the prefs I owned) then they would have got something.

Except that the liquation rights – well established order-of-creditor rights – were denied by a swift US Government action.

Now I understand that there is a strong policy presumption in favour of a quick government disposal of a failing institution – and that policy presumption might at some stage trump the rights of some holders of paper. However a pretty strong case must be made.

Now lets compare the WaMu case with the IndyMac case. In the IndyMac case I think the government acted fairly. The main issue with the IndyMac case is that there is accountability. The government is liquidating the IndyMac loans in full public glare – and it is clear that they have lost (considerable) moneys. The senior debt (if there were much) would know pretty clearly that they were toast because they could see the results of the liquidation.

This visibility is not available in the WaMu case as there is no public liquidation – instead the assets were confiscated and flicked to JPMorgan as part of essentially the same transaction. The confiscation of WaMu would not have happened when it happened if there had not been a simultaneous buyer. So the senior debt holders never got their order of creditors.

The lack of visibility creates a lack of accountability. Sunlight (visibility of the liquidation) is the greatest disinfectant. In the WaMu case senior debt holders from the outside look as if they had their rights taken from them (and those rights were valuable) by a government official without any method whatsoever of auditing the decisions of said official. That is why the actions of the Government were capricious in this case. [Some comments on this blog have wondered why I think it was capricious. I stand by that wording...]

It would of course be more acceptable if there was a large body of evidence that the government put forward to justify their complete disregard for quite senior rights here. The evidence for instance in the Bank of Credit and Commerce International was pretty strong. BCCI was a criminal organisation and the dosh was simply stolen. There were criminal prosecutions. There was sunlight… and so we could be sure that the government acted with justification.

But in this case the Feds did very little to justify their decision. Lets run through some of it.

• On September 8 WaMu changed its CEO and announced it had entered a Memorandum of Understanding with the Office of Thrift Supervision.
  

WaMu also announced that it has entered into a Memorandum of Understanding (MOU) with the Office of Thrift Supervision (OTS) concerning aspects of the bank’s operations, principally in several areas of its risk management and compliance functions, including its Bank Secrecy Act compliance program. In addition, WaMu has committed to provide the OTS an updated, multi-year business plan and forecast for its earnings, asset quality, capital and business segment performance. The business plan will not require the company to raise capital, increase liquidity or make changes to the products and services it provides to customers.

Note that the business plan in this press release did not require that the bank either raise capital or increase liquidity. Moreover it did not require that the bank forecast liquidity.

• On the 11th of September the bank noted its available liquidity was about 50 billion dollars and that the bank continued to be capitalised significantly above the well capitalised levels.

• On the 17th of September the bank confirmed what everyone knew, which was that the bank was for sale. TPG (the private equity group) waved their pre-emption rights with respect to any transaction.

• On the 24th of September there were no bidders for the common equity.

• On the 25th of September it was taken over.

Now in the middle of this sequence the press became alive with stories about how bad it was at WaMu. Lots of people close to the deal were talking – as I noted in this (unfortunate) post. They were talking their book – that is spreading nasty rumours about WaMu.

We know that there was a run on deposits starting on the 15th of September with a net deposit loss of 16.7 billion. That run was almost certainly triggered by the wave of stories about WaMu and that wave of stories was triggered by investment bankers trying to buy WaMu on the cheap. In other words government action was as responsible as anything else for the run.

Moreover – and nobody has denied this – WaMu had 50 billion in liquidity. Only deposits above 100K will run if the government publicises that FDIC deposits are safe. 50 billion of liquidity less the 16.7 that ran left plenty. Its almost certain that WaMu had sufficient liquidity left to deal with its jumbo deposits. WaMu after all was a retail bank – and jumbo deposits were not the driver.

Now the clincher – in the OTS fact sheet on the WaMu liquidation is this little zinger:

Maintaining Capital – In late 2006 and 2007, WMB began to build its capital level through asset shrinkage and the sale of lower-yielding assets. In April 2008, WMI received $7.0 billion of new capital from the issuance of common stock. Since December 2007, WMI infused $6.5 billion into WMB. WMB met the well capitalized standards through the date of receivership.

Note the OTS thought that – at least as of the date in which they confiscated the bank – it was well capitalised. It was probably also liquid - after all 50 minus 16.7 is a lot when we are talking in billions.

Now the future of WaMu was uncertain. They clearly had plenty of losses coming at them. The company estimated those losses as 19 billion. JPM has estimated 31 billion. On both those numbers incidentally the senior debt holders in WaMu should – in an orderly liquidation – be made whole. Get that – on JPM’s own numbers the senior debt holders should have been made whole – and yet the rights of these debt holders were confiscated.

I don’t know the future, the OTS doesn’t know the future, and JPM doesn’t know the future. Nobody really knows what the end result for WaMu would be in an orderly liquidation. Everyone knew that WaMu was in some trouble. That was clear.

The OTS/FDIC carried a risk – the risk being that the losses would be so large that would wind up costing the government money.

The government solved its problem – and it did it by taking away the rights of the senior debt holders to an orderly liquidation – when on the numbers given by the ultimate acquirer the senior debt was likely to be whole or near to whole.

The Government did this seemingly capriciously. It changed the order of creditors and the basis on which banks all across America raise wholesale funds.

Now there is not much raising of wholesale funds by banks at the moment. But after this deal there is likely to be less. It is simply the case that there is now a new risk for people who provide wholesale funding – and that risk is that the government will unilaterally abrogate their rights – without appeal, without due process and without accountability.

In the process the OTS and the FDIC have effectively removed the main low-cost source of funds of pretty well all banks in America. They will have put the fear-of-Government into such people globally. This is the opposite of moral hazard. In the Moral hazard case people take too many risks because they believe the government will reimburse their losses. But in this case people are going to take too few risks because they know that government might unilaterally remove their rights and property.

This was – by far – the least justified government action of this credit cycle. And it spells doom for any bank in America that is ultimately reliant senior (and hence well protected) but unsecured financing because it is so capricious.

Those banks are many – but we can start with Wachovia whose destiny (failure) is now nearly certain – and for whom the precedent is set. But after that we can go for all the banks including the champions such as Bank of America and Citigroup. Creditors now face confiscation of their rights by the US Government without oversight or audit or even process.

At that point there is no creditors and the economy collapses. The trust needed to make capitalism worked has been removed. I am not a conservative - but I will argue - along with many conservatives - that the most important function of government in a capitalist society is provision of a framework by which property rights can be defined and enforced as this is the key to making a capitalist society function. The Government is now acting as if the framework does not apply to them. That is bad whatever your political persuasion.

What next

The FDIC and OTS have won the battle with respect to WaMu. They got rid of WaMu without any cost to the taxpayer. The WSJ lauded that achievement. They really did get out of their WaMu risk quite neatly – and I will bet the heads of those organisations went to bed feeling pretty pleased with themselves.

But in the process they have doomed about two thirds of the US banking system.

I am still a believer that government – whilst not stuck with great incentives will grope for right solutions. But that belief of this former (competent) public servant is being shaken to the core.
And whilst Wachovia and dozens of others will eventually hit the wall because of this decision the Government will work out that it has a bad process before Bank of America fails.

But I think it is time that the process is short circuited. The heads of the OTS (John Reich) and of the FDIC (Sheila Bair) should be sacked now and for cause. Mr Paulson better get control of this situation and let it be known that the US has a process for dealing with senior creditors and making sure that their rights are honoured.

Otherwise heaven help us.



John Hempton