Bankruptcy Fine Print Rattles WaMu Debt

Sep.23.11 | About: WMIH Corp. (WMIH)

After federal bankruptcy Judge Mary F. Walrath denied Washington Mutual’s (WAMUQ.PK) reorganization plan on September 13th, issues of WaMu’s corporate parent debt dropped profoundly, largely in part to her written opinion. These debts, which had traded for 30 cents to 1 cent on the dollar the day following the company’s September 26th, 2008 chapter 11 filing, had climbed significantly throughout the course of the nearly three year case, with issues eventually reaching a high of 122 cents to 82 cents on the dollar for the most junior issue.

The previously assumed over par payout of the bonds was based upon the belief that WaMu would award its creditors their individual contract rates which ranged from 3.22 to 8.25%. Constant delays and repeated new reorganization plans played well for both attorney billables and hedge funds which held significant amounts of the parent company debt. By two years into the case some debt issues expected returns as high as 117 cents on the dollar. A year ago I reported on this, questioning the rational of paying over par for a defaulted security, especially for such a low yield.

All of that changed, however, when the judge found colorable claims regarding insider trading by the hedge funds that hold large portions of WaMu’s debt. Consequently, she ruled that post-petition interest would be paid at the Federal Judgment Rate of 1.95% rather than the individual contract rate. Debt securities would have immediately traded downwards based on this ruling alone; however, the judge also recognized the fine print of the case, which should have maintained the high debt prices. It did not, however.

In a clause largely ignored throughout the majority of the case, the most junior WaMu debt issue known as the PIERS (OTC:WAHUQ) features a subordination provision which states that holders of PIER securities must pay higher ranked debt any lost interest. Now, since the judge has ruled that WaMu debt will be paid at FJR rather than the contract rate, this provision has been triggered. The PIERS, which in the first reorganization plan were given the impression that they would be receiving 74 cents on the dollar, then 57 cents in a second plan, now are at risk to receive nothing.

This is in part because they may have to pay the difference of interest between the individual contract rates and the FJR, an amount of nearly $500 million, assuming the case concludes by the end of this year, but also because of $340 million in possible litigation claims against Dime Bancorp (OTC:DIMEQ) warrant holders. If the provision is strictly enforced and Dime Bancorp warrants prevail entirely in their claims, this would completely extinguish any PIERS recovery. PIERS shares plunged in response to the court’s opinion dropping over 70% to 12.5 cents on the dollar. Dime Bancorp warrants remained steady at 22 cents on the dollar.

Curiously, the more senior debt that would have gained from the $500 million receivable still dropped, resulting in a “lose-lose” situation. According to the markets, more senior debt now trades at a price indicative of not receiving the additional $500 million, while the most junior PIERS debt trades at having to pay the $500 million. Since the $500 million has to go somewhere, who do you believe?

Issue

Coupon

Price 7/27/10

Price 9/19/2011

FJR Recovery

Contract Recovery

2010 Yield

FJR Yield

Contract Yield

WAMU.IE

4.00%

104.8

101.5

105.85

112.24

3.2%

4.29%

10.6%

WAMU.JB

2.95%

92

100.19

105.85

108.99

15.2%

5.64%

8.78%

WAMU.IL

4.20%

106

104.75

105.85

118.54

6%

1.05%

13.16%

WAMU.IM

3.09%

99.06

100.25

105.85

109.42

7.29%

5.59%

9.14%

WAMU.JC

5.50%

109.13

100

105.85

116.95

1.99%

5.85%

16.95%

WAMU.IP

5%

107

101.49

105.85

115.38

3.03%

4.3%

13.69%

WAMU.IO

3.50%

98.75

101.75

105.85

110.68

8.47%

4.03%

8.78%

WAMU.IS

3.22%

99.13

100.56

105.85

109.81

7.48%

5.26%

9.2%

WAMU.IT

5.25%

107.25

101.5

105.85

116.17

3.29%

4.29%

14.53%

WAMU.HE

8.25%

111.69

100

105.85

125.77

4.92%

5.85%

25.77%

WAMU.IH

4.63%

102.61

107.25

105.85

114.21

6.69%

-1.4%

6.49%

WAMU.JG

7.25%

107.25

99.75

105.85

122.55

7.26%

6.12%

22.86%

Click to enlarge

As the table displays, 11 out of 12 debt issues are trading slightly below their projected FJR recoveries and all significantly below their contract yield recoveries. Because the bond market aims for lower risk lower returns, WaMu more senior debt is stating they don’t expect to be paid the additional $500 million. This statement is seconded by data from 2010 yields, when it was assumed the contract rate would be paid. Note the similarity in yields then to yields now. Despite this evidence, PIERS traders continue to exchange their securities near worse case scenario prices.

Even the judge admits in her opinion that while internal agreements between creditors should stand, it is not the bankruptcy court’s job to act as a collection agency. She opines (.pdf) that (bold added for emphasis):

To the extent that this results in them getting more or less than their contract rate of interest, it may be a matter between them and the other creditors who are parties to a subordination agreement, but it is irrelevant to the Debtors’ obligations under the Bankruptcy Code.... provisions that give effect to the subordination provisions in the indentures and require subordinated creditors to pay senior creditors post-petition interest at the contract rate even though the Debtors are only required to pay interest at the federal judgment rate are not violative of the Bankruptcy Code. [While the PIERS may receive payment in full of their claims from the Debtors, they may be required to give a part of their distribution to senior creditors.]

In other words, while the internal agreement is not denied by the court, the $500 million is a matter between creditors and not her job to enforce. Note also her multiple use of the word, “may” and the lack of a single “must”.

So what should an investor do with a current “lose-lose” situation? The money most certainly has to go somewhere. My position is to side with the more senior bond prices which up to this point in the case have been the most accurate. If the more senior bonds are expecting to not be paid according to their current prices, then the $500 million is more likely to remain with the PIERS. At twenty-three million shares issued, an investor willing to take a stand on this uncertain money could turn up to $21.73. PIERS currently trade near $4.

Given that the judge has now ordered the entire bankruptcy case to mediation, out of an effort to preserve dwindling estate monies from further billables and interest accruals, the $500 million will be a major point for all parties to find some sort of compromise to agree upon. I would not expect the full $21.73, but certainly more than $4. Mediation for the WaMu case begins October 6th.

Disclosure: I am long OTC:WAHUQ.