Friday, September 26, 2008

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.  



Anonymous said...

you nailed WM's losses right on the head.

Bloomberg reports that, “As many as five banks had considered bids for WaMu without making an offer, balking in part because the lender faced as much as $19 billion in mortgage loan losses.”

Kudos & Cheers

Anonymous said...

Why are you so confident that the WaMu press release was not a lie?

It's not as if that kind of behaviour has been unprecedented (see Lehman's PR over the last few months, and the $100Bn black hole in their post-bankruptcy balance sheet).

With both Lehman and WaMu, behaviour of the prospective buyers suggests that the buyers could see the black hole in the books.

FBI is already investigating Lehman; maybe it will add WaMu to its case load.

Anonymous said...

Mr H: you've probably been had. WaMu (just like Lehman Bros) looks as if it was trading for an extended period while hoplelessly insolvent. I would bet that their press release was indeed a lie (with some level of collusion from regulators, to boot).

FBI are looking at Lehman already. Keep an eye on the prospective recovery rate for WaMu bond holders. That may indicate whether FBI will also take a peek at WaMu.

John Hempton said...


I am not convinced the WaMu press release was not a lie. BUT it was the first press release announcing a new CEO.

The NEW CEO had nothing to gain and little to lose by telling the truth. So the truth was probably told.

WaMu did lots of stuff that worth investigating. I purchased this when I thought the pay-off for a buyout was 2 to 1 and the risk of an FDIC takeover was one in three.

I do not mind getting that wrong. Its just my analysis suggested that the FDIC takeover - if any - was next year. I do mind getting that wrong.

So far very little about this deal makes sense.

I really have no problems losing money - it was about 1.5% of wealth position and I can afford to lose a few of those. What pisses me off is being so comprehensively wrong.

I really would like to understand why. I still cannot work out why this was taken over now - and if I can't work that out my willingness to play just goes down a lot.


John Hempton said...

I meant the new CEO had nothing to gain by lying and little to lose by by telling the truth.

The NEW CEO got a 7.5 million dollar signing bonus. He will keep that. He was there for two weeks.

Still why would you lie about the FDIC deal when you signed up. Surely it was the first (maybe the only) due diligence he did on the new position.

Anonymous said...

Loss of capital is one issue. Loss of confidence of repayments can be expected to follow. Both can be repaired, and rather quickly at times. Loss of credibility cannot be restored so easily. Unfortunately, the system is losing credibily faster than capital or confidence.

Wait, regulation with SOX will...ah nevermind. It clearly is a failure.

Great blog, btw.

Anonymous said...

Didn't mean to post two versions of the same comment - sorry.

Having looked at the timeline a bit more closely, both the appointment of Fishman and the release re OTS were on the 8th. My guess the press release was concocted by the old management and once the new CEO had his feet properly under the desk and could get at the real story, he broke the news as quickly as he could.

Anyhow, the bankruptcy proceedings will be illuminating - anything north of a $30Bn balck hole explains things perfectly.

And lastly - commiserations. It is not a good feeling when the rules get rewritten halfway through the game.

Richard Smith

Anonymous said...

The press release sounds like a bank operating under your "insolvent but not illiquid case". Regulators dial back risk so continued operation will not cause "further losses to depositors" (or, especially in this case, further losses to FDIC reserves). There was no run two weeks ago, so no need to confiscate. Game Plan: Give WM a chance to earn their way out of the hole, but handcuff them so they don't take stupid risks in the process.

Since then things changed due to a slow run. Was that enough to justify seizure? I don't know. FDIC was justifiably very nervous due to WM's size and portfolio. Perhaps they jumped the gun. Perhaps the run was unstoppable, in which case better to move now than later.

Another factor: WM already had substantial FHLB advances. Perhaps they were close to maxing out?

Anonymous said...

"Illiquidity is NOT a reason for a bank liquidation."

Untrue. TEMPORARY illiquidity is not a reason for bank liquidation. WaMu has been illiquid for more than a year as it's heavy reliance on FHLB financing (aka the dole for banks) makes clear.

A good call by regulators -- and a shot over the bow for the banking system. Your irritation is, however, understandable since the regulators gave no sign of fulfilling their responsibilities prior to WaMu.

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