Friday, September 26, 2008

Where to Begin?

Washington Mutual failed last night. It wasn't even a Friday. Given how much I look forward to checking the FDIC website every Friday evening, it's with a small tinge of disappointment that I note WaMu failed on Thursday September 25th. That said, it is with a great deal of self-congratulatory arrogance that in the same above linked post, I also noted that WaMu was "probably still six or eight weeks out" from failing. That post was dated August 2, 2008. That was just under eight weeks ago. I'm not sayin', I'm just sayin', that's all... I also have been predicting that the catalyst for WaMu's failure would not be a traditional run on the bank, but a slow motion run on the bank by large depositors who a) have more to lose; and b) on average are more market aware and thus would be the most likely people to withdraw their deposits. In the last two weeks or so, the media has reported that $17 billion in deposits walked from WaMu, driven largely by large depositors.

I first predicted WaMu's failure in this blog back in mid-July. I started talking about it privately a few months prior to that. In fact, you'll note that the WaMu failure post was actually my first blog posting of 2008. That overwhelming sense that WaMu/SnaFu was toast and that nobody was focusing on it is what actually opened the floodgates for my blogging. Since then, everything that I've expected to happen (and some) has occurred.

Now, onto news. Effectively, JPM paid $1.9 billion to the FDIC and took a $31 billion write down as the cost of the acquisition (basically, $34 billion). They expect the WaMu transaction to add $2.4 billion in earnings in 2009 and then grow in the out years. That implies that JPM was able to acquire WM at 14x run-rate earnings. I suspect that WM contributes much more than that to JPM's annual earnings over time.

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.


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