Illiquidity and insolvency and the takeover of WaMu

A bank can be illiquid and insolvent.  This is a nasty end-game.

It can be insolvent but not illiquid – when it has plenty of access to deposit funding but the loans it has made are heavily bad.  In this case continued operation risks further losses to depositors and the organisation SHOULD be regulated or confiscated.

It can be illiquid but not insolvent (such as when a perfectly good bank has a run).

The purpose of lender-of-last-resort things in bank regulation are to ensure that banks which are subject to runs don’t fail because they are illiquid but not insolvent.  If a bank which is solvent has a run the right thing for the government to do is to front the run – make it go away – and let the bank sort itself out over time.

The problem of course is that when a bank is illiquid it is very hard to tell whether the liquid bank really is insolvent. 

If the government were perfect at telling this they would know precisely who to bail out and who not to.  Nobody serious thinks they know that.  If I knew that I would be a much better stock picker than I am.

Anyway the reason for a bank confiscation is that the bank is UNSOUND meaning the capital is inadequate.  Illiquidity is NOT a reason for a bank liquidation. 

This comment was made by the FDIC:

Federal regulators said WaMu has suffered an exodus of $16.7 billion in deposits since Sept. 15, leaving the Seattle thrift “with insufficient liquidity to meet its obligations.” As a result, WaMu was in “an unsafe and unsound condition to transact business,” according to the Office of Thrift Supervision. 

What is strange about this is that this is precisely the reason you SHOULD NOT take over an institution – certainly without consulting it about alternative forms of liquidity (such as pledging its loans).  The whole point of government intervention is to nationalise insolvent institutions and to keep solvent ones liquid.  Now I suspect there is more to this story than this blog post.  But for the moment the explanations are inadequate...

Two weeks ago WM put out a press release that said this:

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.

If this release was not a direct lie - and there is no reason to believe it was - then the OTS thought only two weeks ago that WaMu did not require additional capital.  Very strange indeed.  

 

Is this one of the most extraordinary government actions ever?

A couple of days ago I blogged about how the FDIC was not talking to WaMu about taking them over.  That post looks really stupid now.  

But then the WSJ reports this:

WaMu's deal team, including Mr. Fishman, left New York on Thursday night and caught a plane back to Seattle, not knowing that the company was about to be taken over by the OTS and sold to J.P. Morgan.

I got a question:  is this for real?  Is this how the American government now acts?  

I would prefer think my post was wrong than the American Government acts in arbitrary capricious ways.  If the FDIC took over WaMu whilst the executives were on the plane without discussing the true liquidity situation of the bank first then I fear for all American capitalism.  

So - for the moment - I will hope the WSJ story is wrong.  I have been wrong plenty of times - so that is not something I should criticise sharply.  But this is an intellectual puzzle: what did the FDIC tell WaMu and when?  Why did it decide to take over WaMu now?  

More is sure to come in the press so I am loathe to speculate.  But this is one of the more interesting intellectual puzzles of the past few years.

John

Lehman and WaMu failures

When they let Lehman fail they thought it would be contained.  It wasn't.  

Brad DeLong pointed out that when they let Lehman go the funding market went haywire.  

There is something like 30 billion in "other liabilities" (mostly debt) at WaMu.  They let it fail too.

The credit market sieze up is just going to get a lot worse.

Its funny - the government with one hand passes out 700 billion to "free up the credit market" and at the other hand throws petrol on the flames.

I am surprised.  It cost me money.  But it was always a wild-ass-speculative bet.  

I only wish I had done the arb of going long the preferred and short the common rigged so I made money on all outcomes.  

But I did not.  My bad.

J

WaMu explanation number 1

We now know they had a deposit run.  To quote the WSJ...

Federal regulators said WaMu has suffered an exodus of $16.7 billion in deposits since Sept. 15, leaving the Seattle thrift "with insufficient liquidity to meet its obligations."

I am sure there will be more.  However it is very hard to see how JPM does not make a shocking profit on this transaction.

Just to rub salt into the wounds

Here is the FDIC press release.  

The prefs along with common and most of the debt was wiped out.

J

To my many readers who disagreed with me - thanks.

It remains non-obvious why this was precipitated NOW - though there was always a possibility of an FDIC takeover.  We will find out in due course.

Stuffed that one up

FDIC confiscates WaMu.

Now we find out what WaMu has not been telling us.

http://www.cnbc.com/id/26893741

It had (a) enough liquidity for next year (or so it said), and (b) some capital left.

I lost.  It was a moderate position - but it hurts.

J

WM preferred versus common

Washington Mutual Pref is wildly mispriced compared to the common. 

The common is behaving badly - but as if survival is a small possibility.  The common is down 24 percent but is still $1.70 giving it a market cap of 3 billion.

The preferred (K class) is down 28 percent and has a price of $1.64 - a price which compares highly unfavourably to my first purchase at about $6.

There are a few outcomes here:

(a).  The FDIC takes over.  In this case both the common and preferred is worth zero.  If I were looking at the common price I would think that was say 50 percent likely.  If I were looking at the preferred price I would say it is more than 90 percent likely.   My own analysis suggested that this was less than 30% likely when I purchased - but the market tells me I am wrong.  And the walk-out by Santander today is highly discouraging as Santander is often the buyer of last resort.

(b).  A solvent bank like JPM buys it for under the current price.  In this case the pref should be worth close to par - being an instrument of JPM.  The common will lose money.

(c).  There is an auction and the bank is purchased at a premium.  The market is telling me this is very unlikely - but the common will rise a little bit (say to $3) and the pref will rise a lot (to near par).

(d).  The bank muddles through - possibly with the help of the TARP - but it is hard to see how the common ever gets back to 25 (especially if they have to give warrants under the TARP), but the pref winds up fairly good.

(e).  They fail instantly and hand themselves to the FDIC - which has the same outcome as (a).

In every one of these circumstances the pref is a at least as good an investment as the common - althought they might both be awful.  So far they have both been awful - but I only own the pref.

This sort of mispricing wouldn't exist if it was really easy to short the common.  But for the moment anyone who owns the common should sell it and buy the pref.

I am holding my prefs to the bitter end - and the end may be bitter.  We find out this weekend.

John

The Motley Fool puts me in my place!

I don't own any WaMu common.  I do own the pref - and there is a reasonable chance that will be wiped out.  

The Motley Fool knows what it thinks of me:

The truth is, no one really knows what the future of WaMu will be, only that it'll likely be decided within the month. If you're into big-stakes gambling, WaMu's for you. If you have a sliver of financial responsibility in you, enjoy this show from the sidelines.

Washington mutual takeover news

This sucks.  I have a highly speculative bet on Washington Mutual preferred.  It runs that I think a takeover is more than 30% likely.  It may be a takeover at 50c a share - which would be awful for the common shareholder.

But I thought it pretty likely.  If you asked me I would have thought 70% likely.  The only problem being that the potential buyers have fires of their own to put out.

Anyway a buy-out by (say) Citi or JPM is not a great end for the common shareholders - but would be wonderful for the preference shareholders.

Nightmare for the preference shareholders is an FDIC takeover which would wipe the prefs as well as the common.

This is of course a wild ass speculative bet.  

But here is a possibility that I hadn't thought of - which is a deal involving private equity consortiums.  That would not be as good as being a pref shareholder in (say) Citi.  I am not sure how legal this would be but these are desperate times - and something could happen.

I suspect the pref would be worth something in this scenario - but I would much prefer the company stick around to take advantage of the Paulson plan.  

I am a little afraid here - this deal is becoming problematic.  The news that Santander - often the dumbest bank on the block - has pulled out - is not good.

J

Washington Mutual bank explores takeover possibilities: report

4 hours ago

NEW YORK (AFP) — The troubled US bank Washington Mutual has approached certain private equity firms as possible candidates to take it over, the Wall Street Journal reported on Thursday.

The private investment groups approached include Carlyle Group and Blackstone Group, which may team up with Texas billionaire Gerald Ford, the daily said, citing sources familiar with the matter.

Questions have arisen over Washington Mutual's future since last week's dramatic collapse of investment giant Lehman Brothers and the government rescue of insurance group AIG.

Washington Mutual's shares have lost 80 percent of their value since the beginning of 2008. On Wednesday the ratings agencies Standard & Poor's and Fitch lowered their ratings of the bank's holding company.

Press reports have mentioned JP Morgan Chase, Citigroup and Wells Fargo as other banking groups possibly interested in taking over Washington Mutual. The Wall Street Journal said Santander of Spain had dropped out of the running.

Jeff Matthews on Buffett and Paulson

Jeff Matthews has nailed the essence of the Paulson plan and the Buffett buy in Goldman Sachs in one sentence:

More seriously, we wonder this: how is it that Warren Buffett can cut a better deal with the best-run financial company in America than the U.S. Treasury can ask from the worst-run financial companies in America?

And that is right.  Buffett took preference shares and upside.  Paulson does not plan to.  

I would rather own Berkshire than be an American taxpayer.

Oh, I do own Berkshire - and I am not an American taxpayer.

And that is the sweetness in living in Bronte, Australia.

John Hempton