Sorry in advance. This is long. But I'm kind of worried.
With all of the hoopla surrounding Fred and Fan, I think a bigger story in the banking sphere is being ignored. To the extent the GSEs are taken into conservatorship (read: nationalized), really, not much will have changed. Some equity holders will get wiped out, but the institutions will keep on making mortgage loans. They are already quasi-governmental. In fact, as official arms of the gov't, the GSE's may become more aggressive as avoiding losses will likely be weighed against the perceived policy benefit of lubricating the housing transaction market (I say "perceived" for a reason, but that's a discussion for another day). While it will be scary to see the U.S. of A. put the GSE's $5 trillion of obligations on the federal balance sheet, in some sense, it is already there and has always been there. Plus, the assets are generally good assets so losses are unlikely to be much more than a short-term blip in the context of the Federal government's budget. I'm sure systemic fear would tick up a notch, but regular people won't be directly impacted. No depositors exist to be hurt and lenders will be made whole. However...
I saw tonight that WaMu has started pounding the table with assertions that it is "well-capitalized" in order to calm fears about its funding position (see here for WaMu's defense). This is not exactly what you want to hear from your bank. Personally, I prefer the sweet sound of silent confidence. There is a famous Wall Street saying that those that have to defend their financial reputations have already lost them.
For context, we just witnessed the nationalization of IndyMac (IMB) and the FDIC's resultant treatment of depositors that had over $100,000 in their IMB bank accounts (the FDIC has said officially it will not guarantee their excess over $100k). Given that backdrop, if I am a depositor in a hypothetical bank - let's call it Snashington Futual (SnaFu) - and I have over $100,000 on deposit, if SnaFu attempts - hope against hope - to convince me that everything is fine - for any reason whatsoever - I'm at the bank's front door at 9 a.m. (or whenever it is that banks open) and I am taking home cash. I am not bringing home a cashier's check. Not a wire transfer to be set-up for processing later in the day. I am certainly not bringing home mere "assurances". With a can of mace in tow, I am going into the bank and demanding my account balance be handed to me in the form of some f'ing cold hard cash and I'll happily risk the walk to my car. If SnaFu also happened to be incurring enormous losses on its asset base and had a stock price down 90% in the past 12 months, I might go 3G iPhone on them and camp out at my local branch overnight after maxing out my ATM withdrawal limit.
Unlike the GSE's that cannot have their funding source go negative because they do not rely on the goodwill of depositors, banks can and do. Particularly savings and loans which are overwhelmingly deposit and CD funded. Given Washington Mutual's market price, its own defensive pronouncements, its recently displayed need for capital, the run on and subsequent nationalization of IMB, the recent collapse of Bear Stearns, the general fear around highly levered financial institutions, the ongoing collapse in home prices, and the FDIC's handling of the IMB runoff, I think WaMu may be done. Perhaps within a week or two if the fear contagion spreads quickly, as it is apt to do. Remember, WaMu is already getting crushed on the asset side due to lax lending standards (e.g., defaulting mortgages), if this spreads to the liability side (i.e., deposits) the pinch from both directions may be too great to bear.
Predicting how others will react to news and circumstances is incredibly difficult and I'm probably going to be wrong. However...
In the past twelve months, WaMu's stock price has declined from $43 per share to $3.23 at today's close, a 92% decline. This is starting to receive national attention and I suspect their assertion of a sound capital position will add to the volume of press. I also suspect the typical depositor with over $100,000 in their bank account happens to be above average in their market awareness quotient. Looking back at IMB's $19 billion of deposits, about $1 billion were uninsured (too big or not qualifying for other reasons). That that ratio is after the 11 day run on IMB that began with Sen. Chuck Schumer's (D - NY) idiotic remarks two weeks ago during which time $1.3 billion was withdrawn (article about Schumer's remarks). I feel confident that a disproportionate number of withdrawals during the run on IMB were by large depositors given they are the most aware and have the strongest incentive to bail. So, the pre-run on the bank ratio was probably something like 15:1 insured to uninsured deposits. It is worth noting that in a mere 11 days, more than 5% of IMB's entire deposit base was withdrawn. No modern bank can withstand that. It is worth noting that IndyMac does not garner the media attention that WaMu garners yet word still got around that it was on the brink and the vaults were emptied lickity split.
Much like IndyMac, which is HQ'd in SoCal, Seattle-based WaMu has a huge California presence and both specialize in Alt-A loans. WaMu will be heavily mentioned in the news tonight and in the papers tomorrow a.m. as it is the largest S&L in the United States (IMB was #8 on the list) and WaMu's stock was down another 35% Monday the 15th (it nearly kissed $3.00 at one point reaching $3.03 before closing at $3.23). In conjunction with the news surrounding IMB's nationalization, I'm predicting WaMu's deposits begin their outflow shortly, if they have not already. Imagine another day like today in WaMu's stock - we'd have a stock price looking something like "$1.50" and the media would be all over it. If you were a depositor, why would you not withdrawal? What is your upside to staying? Do you really want WaMu credit risk? This is like Lehman on the weekend after Bear's debacle but before the Fed stepped in. Who wants that risk? And for most depositors, we are talking about their livelihood. What is your upside? I know WaMu's "stores" are brightly lit, chicly furnished, and in convenient locations with good customer service, but I suspect the family with a $500k nest egg is going to say, "I am not willing to pay $400k for customer service."
This sort of thing feeds on itself and I'm not sure there is enough capital that can move quickly to plug the hole in the dam short of the Federal government. If the $7.2 billion that TPG's consortium does not convince people of WaMu's soundness, how much money will it take? Why would depositors ever be convinced to stay once the fear has set in? Plus, TPG's deal includes a ratchet that makes any new capital raises incrementally more difficult to pull off given the dilution and there are substantial regulatory barriers to non-bank holding companies buying banks. I hope against hope it does not play out like this, but I certainly would have brown undies if I were in TPG's place.
So, what happens if WaMu goes down? Let's do some quick, frightening math:
IndyMac: $32B in assets, $4-8 billion in announced expected losses by the FDIC. Prior to the IMB nationalization, the FDIC had a $53 billion deposit insurance fund which will likely be at least 10% lower after the IMB clean-up ($4-8 billion lower, in fact).
WaMu's asset base is around $320 billion. So, almost exactly 10x IMB. If somehow WM went under, and if the FDIC pronounced a similar ratio of loss estimates, the FDIC's insurance fund would effectively be wiped out. They'd be wiped out and my suspicion is the bank-bankruptcy train would just be leaving the station. The next bk would truly be on the tax payer's dime. Not saying it (FDIC takeover and/or similar loss ratios) is definitely going to happen, but I put the odds at high enough that we should be more than a little worried. Yet nobody is talking about this. I suppose it is uncouth for a media outlet to speculate on runs on banks, since they may accidentally create their own news, but this is a real problem. And I can say with confidence the FDIC is not in a position to run a bank like WaMu. I don't care how many people the FDIC has staffed up with: first off, they would be taking over an enormous institution with broad footprint and second off, on average, if they were great bank executives, they'd be working for a bank and not the FDIC.
Further, while the FDIC's funding gap would probably be made whole by tax payers (go team!), if I'm a depositor at a somewhat fragile institution (basically any regional bank with heavy southeast or southwest exposure), even -a depositor under $100k, I am probably going to the bank, cashing out, taking my bag of cash and aforementioned can of mace across the street and either getting in my car to go home and stuff the cash under a mattress or, under a more optimistic scenario, I'm going to a bigger seemingly safer institution like Wells Fargo or B of A and opening an account there. But are they really safe? Fear begets fear. As FDR said in the midst of the greatest season of bank runs in recorded history, "all we have to fear, is fear itself." Ugh.
All of this is a wee bit Chicken Little, I readily admit. But I also think the probability skew is uncomfortably high. And, if you are a lender that is "all-in" on one loan (e.g., a bank account holder), all of the sudden that 0.125% interest rate on your "free" checking account does not seem so important. Sometimes it is bed time and the hour has come for you to take your toys and go home, take a Rumplestiltskin style nap, and assess the situation on the other side.
Others that would die if WaMu goes down (randomly selected by searching for who already are the walking dead):
- Downey Financial (DSL - SoCal based and also defending its capital position - $12.6B in assets)
- BankUnited Financial (BKUNA - SoFlorida and defending its capital position - $14B in assets)
- Sterling Financial (STSA - Washington State based - $13B in assets)
See here for other S&Ls that are laggards in P/B ratio which will pretty much tell you who the market thinks is toast:
see here for P/B laggards in the S&L industry
[it is also worth noting that Lehman, which is unrelated to this in so many ways but connected by mindshare, may be lit on fire under this scenario. Lehman loses the more fear increases. Further, anyone that is levered and holding a substantial Alt-A book might be in super, duper trouble since that is WaMu and IndyMac's bread and butter...ING anyone?]
In related news, socialism received yet another boost from our incumbent government as FDIC Chairwoman Sheila Bair announced IndyMac will halt all foreclosures on portfolio'd mortgages and aggressively seek loan-modifications. I think of this as socialism squared. I'm sure IMB's uninsured depositors are appreciative!...or maybe not so much. Don't worry, it's not your money Sheila!
Before I get into the implications on our portfolio of a potential WaMu collapse, it's worth noting that crises in financial related businesses are so much more damning than other kinds of companies. When a telecom company goes under, it sucks for the shareholders, employees, and some of the lenders, but its impact is generally limited in scope and folks can see it coming. Plus, the assets of the business don't generally disappear, they either are acquired or the company re-orgs and comes out with a cleaned up balance sheet. But levered financials with deposit funded businesses are so fragile: the collapses happen all of a sudden, they impact tons of small folks right in their wallet, and they spread a paralyzing fear. This fear is rational because banks and savings & loans disproportionately owe their existence to trust - the trust of depositors. And collapse impairs that trust for a long time.
So, what does all this mean for us? First off, it has not happened and it is quite possible no big banks go into conservatorship. I am definitely spreading fear and perhaps it is not justified. But, as I noted above, all of these institutions are already getting absolutely crushed on the asset side of their balance sheet. If the liability side starts demanding repayment, watch out below. Implications: in general, forced deleveraging is deflationary. This is because the money multiplier begins working in reverse and losses are magnified 12x or so in credit contraction via the bank capitalization structure. However, our government seems to have indicated one thing if nothing else. That one thing is a refusal to allow de-leveraging and the concomitant potential for deflation to run their course. Instead, they have decided to socialize credit risk, avoid deleveraging and supplement the holes created by real losses with newly minted money. If the government chooses to address a real banking crisis (and, to be clear, to date we have not had a banking crisis, we have merely had a credit contraction - see 1932 or even 1989 for a banking crisis) by cranking up Uncle Ben's Crazy Helicopter and dropping money from the sky, we may light off the great inflation of our times simultaneous to a massive economic slowdown. Thus, the pain that banks feel on both sides of their balance sheet will spread and consumers will get a similar pinch at home.
Ways to protect yourself: gold, TIPS, curve steepeners, consumer staples with low capex and strong pricing power, Singaporean dollars, currencies of growing commodity-strong economies (Russia, Brazil, Canada (the Looney!), puts on anything equity related, continued shorting of financials (though that game is getting dangerous so I'd stay focused on marginal regional players). I'm sure other folks have ideas and my brain is drained for the night...
Again, my scare scenario has not happened but the question is do we take steps prior to the collapse, do we wait until after it becomes obvious a collapse will happen, or do we just sit tight and hope it does not happen?
On that cheery note, off to bed.
Tuesday, July 15, 2008
It isn't the GSEs we should worry about...it's WaMu
Here's a copy of an email I sent tonight. Should be interesting to see what comes: