Seeking Alpha
Deep value, long only, special situations, long-term horizon
Profile| Send Message|
( followers)  

<< Return to Part 1

Billions at Stake

The hedge funds stand to lose possibly billions should equity eventually prevail at trial. Together the four funds hold approximately $2.5 billion of the parent company’s debt which is at risk for disallowance. The equity committee has also made a motion to litigate seeking that the hedge funds pay the estate’s legal fees and compensate the estate for interest accruals because their actions have unduly prolonged the bankruptcy process. So far legal fees in the case have amassed at $240 million in conjunction with over $785 million in bond interest. In all the hedge funds could possibly be on the hook for over $3.5 billion.

Then there is the matter of the SEC. One of the hedge funds involved already has had a recent run in with the law. In July 2010, Appaloosa Management paid more than $1.3 million in forfeited profits and 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. The fine included a civil penalty of $421,250 and disgorgement of $842,500 in profits. Should a future ruling of insider trading come down strong enough it is possible authorities would then make their own pass at the hedge funds, with accompanying civil penalties in the hundreds of millions. If the SEC were to exact a 50% civil penalty on the hedge fund’s total WaMu (WAMUQ.PK) holdings, the fine could be up to $1.25 billion, two and a quarter times more than Goldman Sachs (NYSE:GS) record $550 million settlement. Finally there’s the possibility of loss of goodwill in the form of negative publicity and lost clientele from an SEC investigation and penalty.

All in all, a lost trial could possibly cost some of the hedge funds their businesses entirely.

An Urge to Settle, Impassioned Shareholders

As all parties head towards mediation there is certainly an urge to settle as far as the hedge funds are concerned. If they do not make an adequate settlement offer then the shareholders will likely fight on with the intent of inflicting the maximum financial penalty. Currently with how the debtors have structured their reorganization, shareholders have nothing to lose and everything to gain by going to trial.

The dilemma the hedge funds now face is entirely of their own creation. Early on in the case WaMu, likely highly influenced by the hedge funds blocking position of debt holdings, repeatedly urged the courts that the parent company was insolvent and that the shareholders should have no official representation. By doing so the hedge funds only managed to accomplish infuriating thousands of individual shareholders, resulting in the independent objections like Nate Thoma’s which has since placed them at this financial precipice. Had the hedge funds brought equity on board early with even a small recovery they may have not faced the resistance they do now.

Instead the shareholders have good reason to be upset, considering the suspicion generated by the current hedge fund influenced GSA. In it, $10 billion of cash and tax refunds are split among WaMu, JP Morgan (NYSE:JPM), and the FDIC with such financial precision that that the “goal posts” of distributable money land almost exactly between WaMu’s debt and equity. By all appearances the hedge funds seemed only concerned about themselves at the bargaining table. When they were assured full payment of their claims they stopped trying to maximize any further recovery for the estate.

According to WaMu’s last reorganization plan the money comes just $40 million short of equity in an estate worth over $8 billion. Restated, the shareholders currently stand just one half of one percent out of the money; in a plan that also pays JP Morgan $2.1 billion in tax refunds.

"Bonanza" for JP Morgan

The legitimacy of the $2.1 billion payment to JP Morgan remains questionable to some, given the terms under which the bank accepted TARP. In order to skirt the law, the current arrangement is for WaMu to receive all of their tax refunds from the IRS, after which they will then make a recourse payment to JP Morgan and the FDIC. Put plainly, WaMu will act as a middleman to help JP Morgan circumvent the law. Whether this is legal or equitable has never been decided by the court. Instead Judge Walrath admits that:

"The Court's conclusion in the January 7 Opinion was not a decision on the merits of the underlying claims but merely a determination that the settlement of those claims by the Debtors on the terms of the GSA was reasonable."

In other words the judge is allowing for “under the table” agreements to exist, regardless if JP Morgan actually has a legal right to the tax refunds. If most all parties agree to it, her intent is to support any form a “reasonable” settlement so the case can be resolved. Keep in mind that in bankruptcy court, the bar for “reasonableness,” like the current insider trading claims, is exceptionally low. As the hedge funds have now suddenly learned, in Delaware the sword cuts both ways.

So far the collapse of Washington Mutual has been called a “bonanza” for JP Morgan, according to Peg Brickley of Dow Jones Daily Bankruptcy Review (article later redacted). As I reported previously, according to the GSA’s current terms JP Morgan will receive $5 billion in HELOC backed securities valued on the open market at 60% of par, $193 million in Visa class B securities, $2.1 billion in cash, and a $20 million wind farm, all from WaMu. Given the initial purchase price of WaMu for $1.9 billion in 2008, these additional assets received means that JP Morgan will pay a negative $3.4 billion for their purchase of the bank.

The very lucrative nature of this settlement leads American Banker to believe that JP Morgan may eventually chip more into the pot to pay shareholders. Banker concludes in their most recent article, “Many creditors are looking to JPMorgan Chase to drive mediation discussions, as it can't get the benefit of its deal until Washington Mutual's Chapter 11 plan is in place.”

Uncertainty and "Skepticism"

It is uncertain how much WaMu’s shareholders will receive from mediation. Unless the terms of the current GSA change, all equity will be able to recover is what debt claims the hedge funds are willing to part with to settle not going to trial. Then even among equity there is a hurdle, with approximately $7.5 billion in preferred stock that under the typical waterfall scenario should be paid in full before common shares receive a payment.

WaMu however is far from the typical bankruptcy. The standard waterfall scenario will likely be overlooked in an effort to reach a compromise among everyone. One possibility would be for the hedge funds to reduce their claims sufficiently to allow equity to take full ownership of the reorganized company. An agreement would also likely include enough cash for WMMRC to operate going forward. It would then be up to the shareholders to make the most of the company’s large NOL asset.

Some however are not so optimistic. CRT Capital Group analyst Kevin Starke told Dow Jones Daily Bankruptcy Review that he was "skeptical" mediation would resolve the impasse. I think otherwise. The fact that the case nearly settled once before is a hint there may be a second chance at success. Back in May the stakes for the hedge funds were much lower. Now with the judge’s preliminary ruling in favor of the equity the funds have to weigh out the real risk of what insider trading would do to them and what that risk is worth to them.

WaMu’s shareholders are likely to get something. The million dollar question is how much. To that no one knows the answer, except for the insiders.

Source: Washington Mutual Reorganization Part 2: Fund Insider Trading Charges Prompt Mediation Order