Who lied to who and who told who what

 

The WSJ reports: 

The fall of Washington Mutual wasn't a surprise to the government. Nor was it a surprise to J.P. Morgan.

Three weeks before J.P. Morgan bought WaMu's deposits for $1.9 billion, officials at the Federal Deposit Insurance Corp. called J.P. Morgan to say the FDIC was carefully monitoring WaMu and that a seizure of its assets was likely. The FDIC said it would want to immediately auction off WaMu's assets if a seizure was necessary, people familiar with the situation told Deal Journal.

J.P. Morgan was well-prepared, then, when the FDIC asked for bids Tuesday, Sept. 23. On Wednesday night, the regulators told J.P. Morgan the bank had won the bidding, one person close to the situation said. 

So, three weeks before WaMu was taken over the FDIC told JP Morgan that they were likely to seize the assets.  

A week later the OTC agreed a deal with WaMu (resulting in the change of its CEO) that said

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.

So WaMu was – according to WaMu’s press release – not required to raise capital, increase liquidity or make changes to the products and services it provides customers.

Now I am aware that the OTS is not the same organisation as the FDIC - but somewhere the government was talking out of both sides of its mouth - and what the FDIC told JPM made it more likely that WaMu would fail to raise capital or find a buyer.

I am renewing my call.  Sack Sheila Bair for cause.

John Hempton

The end-goal of any bailout or government takeover

The US is a current account deficit country.  Get used to it.  You (and I am not an American so I can say you) have been spending more than you earn for years. 

I can’t speak too rashly though because Australia and Aoeteroa (New Zealand) – the two countries to which I am closest – are also current account deficit countries.

If you run a current account deficit for long enough your financial system will be NET short deposits.  There will be (say) 130 of loans for 100 of deposits.  [If you are the UK it can be much more extreme – with Northern Rock having a loan to deposit ratio of a few hundred.]  Individual banks will have sufficient deposits but everyone is vulnerable.

Banking can be profitable even if you are short deposits.  Indeed it was silly-profitable for more than a decade before the insane lending started.  The high levels of profitability meant that people would lend to banks unsecured in quantity at thin spreads.

Banks became totally dependent on their ability to roll the loans.  If they can’t roll this senior unsecured funding they will fail.  No ifs, no buts.  That results in failure.

Most banks in current account deficit countries have such funding.  In Australia it is called Bank Bills.  Here it is called lots of names only because financial innovation has found lots of ways to name the same stuff. 

I have calculated out the losses of banks in the US numerous times – and in no sense are the losses not able to absorbed (at some cost) by the highly productive US economy.  There may be a period of austerity as America adjusts – but the economy should bounce back.

Under the presumption it can finance itself.

But it can’t finance itself unless it can assure unsecured lenders that it is a sensible place to lend. 

The end of this financial crisis will occur when unsecured lenders feel safe lending to financial institutions again.  If this does not happen the crisis will not end – and there will be a great-depression level event in the US.  That is real – factories will be idle, and good people will be roaming looking for jobs and unable to feed their children.  

So I am going to set up policy guideline here for a bailout and for all FDIC action.  All policy should be geared towards making unsecured lenders feel safe.  New regulation should be geared that way.  The takeover of banks will be well done if it gives the appearance of respecting the rights of unsecured lenders.  The WaMu deal was bad.  The Wachovia one was better (only from the position of an unsecured lender but that is the only position that matters).  

America has – through decades of excess spending become beholden to the whims of unsecured lenders. 

Face reality.  That is who you have to please.

Incidentally the Swedish/Norwegian solution did that but wiped out almost all equity and preferred shareholders.  Bank stocks would go down a bundle from here with anything that looks like Scandinavia. 

 

 

John Hempton

 

PS.  I have no dog in this race.  I am short a few bank stocks, long a few preferreds and have no position whatsoever in senior debt of banks.

In praise of the FDIC

As readers know I think the FDIC did a terrible job with the WaMu takeover.  In the WaMu case the FDIC without seemingly any justification and with no appeal took away the rights of the senior creditors.

My view is that the financial crisis will be over when people will lend unsecured to US financial institutions and not before. 

Removing the rights of unsecured lenders without appeal hardly aids that cause.  The FDIC thus made it much worse. 

With Wachovia it was again open to the FDIC to confiscate Wachovia and sell it without the acquirer taking over the obligations to senior bond holders.  This would mean that the government would have got away without risk of loss. 

Instead Citigroup has assumed those obligations.  The FDIC has offered (for a large fee of 12 billion in Citi preferreds) an insurance policy against fat-tail losses at Wachovia.  It has – admittedly at some risk to government – not removed rights from the senior.

This is a darn good thing for America because the sooner the government protects the rights of the senior the more likely it is that people will lend again to American financial institutions.  And when American financial institutions can borrow again the crisis will be over.

On Friday I did not think the FDIC was that competent or creative. 

I am eating my words now.  I withdraw my call for Sheila Bair to be sacked.    

 

 

John Hempton

POST SCRIPT:  Looking at the deal I think the FDIC has done better than I thought plausible...  it will probably get out whole.  That said - if anyone believes that if they had not done WaMu on Thursday they would be doing Wachovia on Monday believes things different to me. 

-------------

There is little doubt in my mind that Wachovia had more time if the FDIC gave WaMu more time. 

The FDIC call on WaMu doomed Wachovia. The deal - just coming at the moment - has the FDIC essentially issuing guarantees on a very thin balance sheet - and that will probably cost it money. The FDIC got out of its WaMu problem (and I do not doubt there was a WaMu problem) by confiscating the "run-off value" of many WaMu securities. But in the process it has made it very difficult to lend to American banks because if you lent in the form of anything other than an FDIC insured deposit you had “fear of government”.  The Government could – with minimal evidence and no appeal – confiscate your assets.  There is no appeal against pressure applied by the FDIC/OTC and you can have your bank confiscated when it has adequate capital and is still liquid.

Anyway – Wachovia is only the first of many banks that required wholesale funding and which the FDIC has doomed.  There are many more.

I don’t want to pick on too many.  As Jeff Matthews has pointed out it is not exactly sensible to scream “this sucker could go down”

 

J

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

Wachovia next

Many of my regular and some of my more perceptive readers have asked about Wachovia.  To date I have studiously avoided stating my position.

Besides - as is now clear - my views are worth little.  I thought WaMu was ultimately better than Wachovia and preferred the preferreds of WaMu to many less risky bets.  I did not (and would not) own the common of either institution.  I would not - as I think at best they wind up diluting themselves massively.  I am fond of shorting commons against preferreds - but that trade is difficult to do these days.

Anway I was wrong.  WaMu was confiscated first.

In the past Wachovia has looked worse than WaMu.  Does anyone other than me remember the Money Store?

It will not be long before Wachovia's numbers are as bad as WaMu was last quarter.

I have no position in Wachovia but if I could I would short the common now.  The way the FDIC acted makes me think Wachovia is toast too.  

If you were the CEO of Wachovia you would be looking for a bride-groom or suitor now.  You would take a bid at a discount to market so the common is just awful.

The prefs in Wachovia would just be a bet on a willingness of someone to pay 50c a share for the common - and now the FDIC appears willing to confiscate the bank and even wipe out the senior debt there appears no reason to do that.  

The FDIC decision might be right - but the public information needed to justify it is simply not there.  The FDIC has some explaining to do.  [I am - I note - inclined to believe that the decision was well thought through - even if at the moment it looks like a shoot-from-the-hip ambush.]

This is important because if the decisions to wipe-out the claims of debt holders appear arbitrary you ensure that nobody is willing to be a debt holder.

And that - more than anything else - spells big problems for Wachovia.  Ultimately it might even spell problems for Bank of America or for America itself.

J

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.