7/25/08
Note: I only send alerts when the information in it would cause me to personally take action. This alert is only available to subscribers.
I am now elevating my concern for Washington Mutual (WM), one of the banks on my sick list, to “code red” meaning I feel that there’s a better than 50% chance that WM will enter FDIC receivership either this weekend or next.
If I had money in one or more accounts at WM I would move it out to a different bank (or banks) within the next 24 hours.
Even if you do not have any funds at WM you should pay careful attention here because it is entirely possible that a WM failure could entirely consume the FDIC insurance pool and therefore impact your bank.
Here’s the data.
First, when we look at the stock price of WM (below) over the past 6 months we see a very disturbing and relentless slump that speaks of major problems. This is all the information I need, usually, because the stock price reflects the collective wisdom of a lot of sharp and self-interested people.
Based on the above chart it would have been sometime around last October that I would have begun shopping around for a new bank.
But the behavior of WM’s stock price over the past 3 days is very troubling indeed. In particular, the portion contained in the green box (below) indicates that something is terribly amiss. What could it be?
On July 23rd rumors floated around Wall Street that WM was going to be audited by the Federal Home Loan Board (FHLB) which has roughly $60 billion on loan to WM. With this news, the cost to insure against a default on WM bonds began to climb (known as a Credit Default Swap or CDS – you’ll be hearing more and more about these from me as time goes on). Then on July 24th an analyst suggested that a run on WM was underway meaning that the same dynamic of depositors withdrawing money that precipitated the final insult to IndyMac was now occurring at WM.
And today it was reported that the cost of CDS protection rose for a third straight day to a record (for WM bonds, that is):
“The upfront price that credit-default swap sellers demanded to protect Washington Mutual bonds from default for five years rose 6 percentage points to 20 percentage points, according to London-based CMA Datavision. That’s in addition to an annual fee of 5 percent, meaning costs $2 million upfront and $500,000 annually to protect $10 million of the bonds. The contracts earlier reached a record 21 percent upfront, CMA prices show.“
What this means, in plain language, is that any holders of WM bonds will not be making any money from the interest off those bonds until they’d coughed up a cash stream equal to 9% of the value of those bonds. Clearly the WM bonds would need to be paying something like 15% to 16% to even be worthwhile to an investor because otherwise it is safer and easier to simply buy treasuries yielding 4%.
So this means that WM, should it want to raise cash in the debt markets would need to offer bonds yielding the usurious amount of 15% or more. So we can rule out debt as a means of raising capital for this beleaguered bank.
And with the stock now trading below $4 equity does not seem to be an avenue that can be used either.
So with both the equity and debt markets closed off as a means of raising needed capital to stave off bankruptcy what’s a bank to do? Talk about something else, clearly.
SAN FRANCISCO (MarketWatch) — Shares of Washington Mutual Inc. slipped again on Friday on concern unsecured creditors are losing confidence in the nation’s largest thrift. Protection against a default by the company got more expensive. However, the company said on Friday that it has boosted liquidity to more than $50 billion this month. At the end of the second quarter, liquidity was more than $40 billion. Liquidity usually refers to access to cash and other assets that can be sold easily
Hey, $50 billion of ‘liquidity’ sounds good, right? Unfortunately, for a bank this is completely the wrong way to view the matter. While it’s good that WM has their assets in liquid form, banks operate under strict capital to asset rules that, once violated, result in automatic receivership by the FDIC.
Let’s take a look at those figures.
Banks have three big buckets of holdings that we need to understand.
The first is ASSETS which includes things like mortgages and other loans they hold, cash on hand, and other marketable securities that they hold.
The second are LIABILITIES which are things like checking and savings accounts and debt.
The third and final bucket is the difference between the first two (ASSETS minus LIABILITIES) and it goes by name Stockholders Equity or Capital.
For a bank the relevant figure is always the ratio between its capital and its assets. Once this ratio drops below 4% an automatic FDIC response is initiated (although the FDIC is certainly rooting around in there well before that magic moment). For a clean explanation of bank liabilities, assets and capital go here.
How much equity does WM have? According to their March 31st 2008 filing that number is a little over $22 billion dollars while their asset base stands at $319 billion (see graph below). This gives us a ratio of 6.8% which seems comfortable.
But in order for WM to hit the danger zone (4%) all that has to happen is for the equity to fall by $10 billion.
And what could cause that to happen?
Well, any sort of a loss on their outstanding loans that would then have to be recognized as loss on their income statement, for one thing. Ah. Now we know why banks have been so hesitant to record the true value of their mortgage schlock.
And here is exactly where the real problem lies for WM, among many other banks.
While WM did write down a bunch of their loans, they did not go nearly far enough. Note in this next graphic that I have extracted from page 40 of their most recent 10Q filing that WM has more than $70 billion of short-term Option ARM and Subprime mortgages held as “assets” and another $38 billion of adjustable rate loans.
These are precisely the sorts of loans that have been “going bad” in record (and rising) amounts creating heretofore unheard of losses. WM is stocked to the gills with the worst of the worst mortgages.
And here’s the main point; all that would be required for WM to be forced into FDIC receivership would be an 8% decline in the value of its mortgage portfolio.
That’s it, only an 8% decline in the mortgage assets of WM stands between it and oblivion.
Given the fact that these sorts of loans are turning in losses in excess of 25% and 30% for other outfits I consider this to be a slam dunk. I would be extremely surprised if the WM loan portfolio did not already have a fair market value that is $20 billion to $30 billion less than they are currently claiming.
Lastly, I think the FDIC will move sooner than later on WM because the FDIC recently became the unwilling overseer of a highly toxic $15 billion mortgage loan portfolio and a $200 billion mortgage servicing operation courtesy of IndyMac. By now the FDIC should realize that such toxic pools do not age gracefully and this is why I am expecting the FDIC to move against WM sooner rather than later.
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- If you have funds at WM get them out to a safer place. Now.
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- If you have funds at another struggling bank, get them out. Why? Because WM is large enough to wipe out the remaining FDIC insurance pool all by itself (under a worst case scenario). Whether or not this happens is irrelevant because even the possibility of it happening will be enough to cause a run on weaker banks.
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- Be sure you have at least 3 months of living expenses in cash out of the bank in a safe place. If WM goes down and there is a generalized run on other weaker banks I expect a banking holiday to result. Meaning Credit and Debit Cards might not work smoothly or at all. Cash will make your life a lot easier if that comes to pass.
- If any of the above happens I will expect a nasty downturn in the US stock market and the possibility of a new down leg in the dollar. Gold is a nice hedge for the dollar while you should consult with your financial advisor if you have stocks that need protecting.
Finally, I want to extend to my subscribers that open to receiving your questions via email should you want any further clarification on these matters. I always strive to answer every email I receive.
Your faithful information scout,
Chris Martenson