Judge Considers Probe of WaMu's Chapter 11: Implications for Hedge Funds and Shareholders

 |  Includes: JPM, WFC, WMIH
by: Troy Racki

Federal bankruptcy Judge Mary F. Walrath indicated on Thursday that she may allow for an examination into allegations that four hedge funds had participated in insider trading regarding Washington Mutual's (WAMUQ.PK) chapter eleven proceedings.

Suspicions were originally raised by independent watchdog investor Nate Thoma who made statements during the company’s plan of reorganization hearing. Mr. Thoma accused Appaloosa Management LP, Aurelius Capital Management LP, Centerbridge Partners LP and Owl Creek Asset Management LP of using insider knowledge from closed door settlement negotiations between WaMu, JP Morgan (NYSE:JPM), and the FDIC to purchase parent company junior subordinated debt issues at steep discount. These 5.375% 2041 indentures which trade under the symbol WAHUQ, once sold for as low as 2 cents on the dollar, but have since soared to 58 cents on the dollar after Washington Mutual released a settlement agreement which would pay most parent company creditors in full. Representatives for the funds fiercely denied the allegations.

However their track record may prove otherwise. In July 2010, Appaloosa Management LP paid more than $1.3 million in penalties resulting from stock trades that regulators said “willfully violated” federal rules. The trades involved a Wells Fargo (NYSE:WFC) shorting maneuver in November 2008. Washington Mutual filed for bankruptcy in September 2008.

As settlement noteholders, the hedge funds participated in drafting WaMu's recently denied plan of reorganization that, had it been approved, would have allowed only them to participate in a rights offering for shares in the reorganized company valued at $145 million. However, recent filings indicate that the reorganized company could have up to $5 billion of net operating losses to use against future income. In her opinion on denying the plan the judge stated that the hedge funds did not consider this significant asset, instead only incorporating $100 million of the $5 billion into their evaluations.

Should the examination prove the allegations true, the hedge funds will have much to lose. Besides a likely formal investigation by the SEC, the judge may elect to apply the federal judgment rate to the post petition interest claims. If so this could result in a waterfall of up to $770 million in cash to Washington Mutual's preferred shareholders.

With the 5.375% 2041 indentures currently in line to receive 74 cents on the dollar, plus a rights offering in a reorganized company with billions in tax advantages, shares in WAHUQ are likely to appreciate for those with the patience for the protracted litigation. Furthermore, depending upon a proper estate evaluation incorporating the $5 billion of NOLs, shares could have an even greater upside, possibly achieving their full recovery of $34 dollars a share. These securities are preferred shares in a trust that owns Washington Mutual parent company debt. The trust, which is overseen by Wells Fargo, recently filed a statement that the shares are debt and not preferred equity, after the judge raised questions whether the debt had been properly classified in the plan of reorganization.

Disclosure: I am long WFC and am long WAHUQ and WMI preferred shares.