Monday, September 29, 2008

Wachovia goes down on the same day Congress grows a pair - welcome to the Dark Side

Hhheewwwwwww [sound of a long exhale].



Wow. What to make of it all? These two topics (Wachovia and the bailout) deserve two distinct posts. This one is going to be Wachovia.

First off, I hate (love) to say it, but I was spot on again. Wachovia goes down. And, yes, this is a bank failure. Taking out the third or so largest bank in the United States for $1/share plus paying the government Twelve f'ing Billion dollars to insure you against losses in the event the losses on a pre-identified $312 billion portion of Wachovia's asset portfolio exceed $42 billion? That implies there could be another $54 billion of losses in that portfolio. Really? I mean, wow. Folks, that is a failure. Don't let anyone tell you otherwise. The FDIC doesn't tend to post non-failure bank mergers on their website. It's a failure. Period.

And why did it fail? Major credit agencies were poised to downgrade the Dubya Bee if it didn't raise capital ASAP. As I discussed the other day, private lenders had already implicitly downgraded Wachovia by taking their credit to junk-like spreads after the FDIC's actions around WaMu rightfully freaked them out. My post (linked above) from last Friday was prescient enough that I'll go ahead and quote the pertinent section right here:

In that first post of 2008, I said that the failure of WaMu would be more important than the failure of the GSEs. I believe that proved out today, though most people still don't realize it. When WaMu was seized by the FDIC then flipped to JP Morganington Mutual Chase Stearns & Co, it had at least one odd unintended consequence. It absolutely screwed senior creditors who certainly assumed that their loan was secured by the assets and liabilities of the bank operating companies as well as the HoldCo assets. Instead, the FDIC used its authority under a seizure to rip the assets from the bond holders and sell them to JPM. In fact, the FDIC turned a $1.9 billion profit on the flip!

If you happened to be a senior lender to the next-weakest large financial institution, like, say, Wachovia, it turns out that you may not have enjoyed witnessing your colleagues in the world of lending to banks getting publicly gutted by the Feds.

So, what happened today to Wachovia? Well, it wasn't good. Wachovia CDS spreads blew out. As noted in the link, a standard CDS contract is quoted as the cost over swaps of a five year senior obligation. Wachovia closed Thursday (just prior to the WaMu gutting) at about 695 bps over (no up front points). It closed Friday at 40 points up front and 500 bps running! Doh! So, if we assume swaps are about 3.5% today and we just evenly divide up the 40 up front points over five years (8%/year), we are looking at Wachovia's current senior funding costs at about 16.5% per annumn (3.5% + 5.0% + 8.0%). Ouch! Hopefully they don't need to tap the credit markets in the near future!

Also, this is a classic unintended consequence of the no new short selling rule: if you want to short WB, the SEC has pretty much forced you to use CDS. Idiot Cox.

Some how evil speculators and Wall Street derivatives traders will be blamed for "manipulating" Wachovia's CDS costs, but the reality is it simply reflects the new failure paradigm that the FDIC defined through its actions for large bank failures. Charging a higher cost to lend to financial institutions is absolutely the rational thing to do. As regulators continue to manipulate the natural order of things, the more frequently and painfully these unintended consequences will pop up.

Luckily for Wachovia, if they need to shore up their capital base, they can always just issue stock.

Or...maybe not. Wachovia's stock was down about 40% today to $9/share. Interestingly, if you look at the presentation JP Morganington Mutual Chase Stearns & Co. sent around last night on the WaMu acquisition, they break out bucket by bucket how they came up with the $31 billion write-off they took on WM's portfolio (page #15), they wrote off another $8.2 billion or about 13% of the remaining Option ARM portfolio. They also wrote-off another 17% of the HELOC & LOC portfolio in addition to other broad asset category write-offs. In total, JPM wrote down WaMu's asset portfolio by about 15%.

Those are enormous write-offs and, if apples to apples, would imply devestation for Wachovia. Even if Wachovia's asset base (page #4), which also has huge Option ARM ($125 billion) and HELOC/LOC ($58 billion) portfolios out of a total $477 billion asset base is of better quality than WaMu, it's only going to be modestly better and WaMu had been more aggressive in its write-offs than WB even before the JPM takeover. I first discussed WB's balance sheet issues vis a vie WM back on August 6th. Given a nearly half a trillion dollar asset portfolio, Wachovia's market cap is just over $20 billion, so the margin for error is unusually small.

Another unintended consequence of the JPM/WM deal is that if you are a potential acquiror of WB equity (in whole or part), what's the rush? The longer you wait, the more the situation develops, the lower the price seems to go, and the more desperate the Feds become for private sector help. The government's perspective surely is that a bank Wachovia's size cannot be allowed to "fail". Another issue is that Wachovia is so big, the government really cannot allow it to be swallowed by another large bank. So, that means it would be split up. By delivering WaMu on a silver platter to JPM, the FDIC has shown that it is more than happy to kill a bank prematurely if it facilitates an orderly transition. Of course, that "order" is real only if viewed in a vacuum. Each one of these government manipulations seems to spawn now uncertainties and unintended consequences.

Given the small market cap vs. the magnitude of the potential problem taken in conjunction with the cost of debt financing, Wachovia's clock is ticking. They will do one of the following, and soon: 1) prove everyone wrong and show their asset quality is such that it does not need to be marked down much more (btw, auditors will definitely look at the WM/JPM transaction for valuation comps); 2) sell itself; or 3) fail and be sold by the FDIC. Frankly, I don't think there are any other alternatives given the impracticality of raising the necessary financing.

A final unintended consequence of WaMu's failure being such an orderly failure (no depositors were hurt) is that the media, which had been fairly restrained in an attempt to help avoid causing a self-fulfilling fear-based run on a bank, now has some cover to start reporting negative bank news before it becomes overwhelmingly obvious. In fact, the media seems to have taken off the gloves and decided no holds are barred. This NY Times article on Wachovia is a case in point. This sort of article did not used to get published by the mainstream media.

So, as I said, WaMu's failure is s scary thing. Creditors and owners of weak banks everywhere are rightfully nervous

I hope your boots were strapped on, because we are knee deep in it now.
So, Wachovia "failed" because the government decided it could not allow the bank to really "fail", if that makes sense. The writing was on the wall: losses were mounting, equity was depressed to levels that limited a capital infusion, buyers had been trained by the FDIC and the markets to just wait and the price will keep declining, credit funding costs were massively non-economic, ratings agencies were about to drop the hammer, and the media was all over the story leading to a potential for a lack of confidence driven bank run. In all, the whole thing was totally foreseeable and, I suspect, an excellent deal for Citi assuming they have managed to deal with their own problems. I actually trust Vikram Pandit more than any of the major Wall Street CEOs (including Glorious Jamie Dimon and LaLaLaLaLloyd Blankfein). He was the most aggressive about raising fresh capital back when that was doable, he's not married to the company and its legacy problems, he was early in grasping that the problems the industry is facing are big, and he is well regarded for his focus on understanding risk and return. That said, so much of what is happening these days is outsripping expectations that it's certainly possible Citi has their own problems elsewhere, but my guess is Citi is fine (as an aside, Citi is the only bank that I own, though it's not a big position).

It obviously begs the question: who's next? There are several obvious small banks to medium-small banks/thrifts like Bank United and Downey that are toast. I shared this link in early September and if you look at what has failed so far, we've really only just begun to make a dent in the list. Titans like Wachovia and WaMu were not even on the list. Those are the kinds of banks I'm most curious about. It seems to me that Regions Financial, Nat City, and Sovereign are all at risk. They are big enough to have CDS, they are big enough to catch media attention, they all clearly have problem loan books, and they all have important depositor bases. If I'm a big depositor at any of those three, I can't figure out why I'm staying. I know that Linda Lou at Regions has been my banker for all of my adult life and she assures me that everything is fine, but I suspect if you go ask Beauregard the Banker across the street at B of A whether they have been getting an abnormal amount of inflows from new depositors, the answer is an emphatic yes. As a depositor (ie, "lender") at Regions, that scares me. I'm walking.

Finally, and I'll touch on this is a follow-up post about Congress growing a giant pair today and voting against the bailout, but the credit markets broadly and CP markets specifically are in shambles and that's going to have a really negative impact on a number of financial institutions, medium-large banks certainly included.

You should be nervous. Things are bad.


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