Market Epicurean


The Month I Could Never Forget: A Not-So Happy Anniversary – PART SEVEN

Pipe

WaMu, FDIC, and other Four-Letter Words

When Bear Stearns went down in March of 2008, 100% of Wall Street was familiar with the venerable financial giant, but I suspect a very small percentage of Main Street was.  And in September of 2008, again, 100% of Wall Street knew Lehman Brothers, but I doubt a large percentage of regular folks did.  Both Bear Stearns and Lehman Brothers were top 5 investment banks (the others being Goldman Sachs, Morgan Stanley, and Merrill Lynch), pillars of finance, institutional trading, asset management, prime brokerage, and so much more.  But they were not commercial banks – branded on Main Street – brick and mortar type shops which people routinely visited or interacted with.

Throughout late 2007 and into 2008, the financial crisis was underway, meaning, the most preposterous of bubbles that our national housing market had become was well in the midst of a violent burst.  Housing prices had cratered, real estate and construction related jobs were disappearing, and the consumer spending boom of 2003-2006 that had been made possible by home equity extraction was collapsing.  And yet, the corporate failures of September 2008 were, so far, mostly on the “Wall Street” side of the fence.  Lehman, Bear, even Merrill, and Goldman were elite white-shoe firms, and while things like money market failures and TED spread widenings had profound impacts on Main Street, the headline connectivity was not yet there.

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Now, before I make the point I am about to make, you will recall that in January of 2008, Countrywide Financial, a significant retail brand name in the mortgage space, had fallen into the loving arms of Bank of America (an acquisition that should go down in history as one of the most cursed, value-destructive deals ever known to mankind).  Bank of America would pay $4 billion for the firm which at that time had essentially a negative $45 billion value (based on settlements and fines that would end up being paid).  Countrywide was certainly a household name, but their failure was not doing damage to Americans as much as Americans inability to service their mortgages had done damage to Countrywide.  Systemically, Countrywide being swallowed up by Bank of America had no impact on the lives of Americans.

Washington Mutual was a different story.  This behemoth household bank, heirs of the old Home Savings & Loan brand, particularly known up and down the western United States, was a respected banking franchise, well-branded, and formerly associated with smart underwriting and disciplined banking practices.  By September 25, it would be the largest banking failure in American history.

Washington Mutual (WaMu as it was commonly known) had 20% of its loan book in loans with 0-10% down payments.  That may seem like a conservative figure, but when multiplied by its volume and the inevitable default rates in this low-quality segment of the mortgage market, it became devastating.  The bank earned profits of $3.6 billion in 2006 but took losses of $6.7 billion in 2007.  The secondary market for mortgage-backed securities was dead, and WaMu was holding toxic assets on its balance sheet, and in a desperate liquidity pinch.  What was keeping it alive was customer deposits.

That all changed after the Lehman bankruptcy.  $16.7 billion was withdrawn in the next nine days, a classic “run on the bank” if there ever was one.  The FDIC was monitoring the situation, still reeling from the July bankruptcy of IndyMac.  On Thursday the 25th, they announced that WaMu did not have sufficient funds to function.  The FDIC has a rather tight and defined process for “winding a bank down,” handling the insurance of depositor funds, and implementing a transition.  But their experience was not in taking over failed behemoth banks, just small ones.  Like everyone else, the FDIC turned to the Fed in this tumultuous time, and the Fed (and Treasury) reinforced that there would be no federal government bailout outside of FDIC protocol.  However, they turned the matter over to JP Morgan, and JP Morgan was all too happy to jump in.

I remember seeing the headline come across my screen that the FDIC was seizing Washington Mutual (it was Thursday the 25th and I had arrived in New York City for what would be an unforgettable week in our nation’s financial capital).   I can’t recall how much time went by between the first headline of the FDIC’s seizure, and the second headline that they were selling the bank to JP Morgan for $1.9 billion, but it was less time than it took me to unpack my suitcase in midtown Manhattan.  The fact of the matter is that JP Morgan between its Bear Stearns acquisition and the WaMu deal did receive some very quality assets, at very low prices, that would represent long-term value for the shareholders of JP Morgan.  But at the time, WaMu didn’t even have another bidder (a reflection of the impairment across all bank balance sheets), and JP Morgan (under their famous “Chase” banking moniker) would end up writing down $31 billion of bad debt.  They added $300 billion of deposit base but had to inject $8 billion of capital to keep the lights on.

The WaMu failure represented two profound moments in the crisis: (1) It was a retail Main Street name that reinforced how broad the carnage was in this crisis, even well outside of Wall Street; and (2) The bondholders were wiped out.  As we will see in the months ahead, besides the bankruptcy of Lehman Brothers, there was no carnage that was allowed to happen to the bondholders of these firms.  From the Fed/JPM bailout of Bear Stearns back in March to the countless deals impacting Fannie, Freddie, and TARP-firms, bondholders got made whole.  But not at Washington Mutual.  The policymakers obsession with protecting bondholders did not apply to WaMu – a historically significant fact.

The crisis would reel in a couple more banking giants in the days ahead (see tomorrow’s issue), but only WaMu would end up in the pile of massive banking names brought down by reckless lending practices and a run on the bank that no banks in a fractional reserve system could ever survive.  JP Morgan’s purchase of Washington Mutual averted the disaster that faced depositors and allowed the Fed and Treasury to re-focus on their next priority: Wachovia.  It also allowed the FDIC to stay liquid and solvent, as there would be plenty of smaller bank failures which would have a healthy need for the FDIC’s resources.

Wall Street and Main Street were now inexorably linked.

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