FDIC Won't Run Out of Money, But WaMu May Be Toast

Earlier this week, we sent out a note to our readers regarding the AP story published on Wednesday, September 17, 2008 entitled "Federal bank insurance fund dwindling." Reported by Marcy Gordon of AP's DC bureau, the story quotes IRA's Christopher Whalen on the mounting angst felt by Americans with respect to the safety and soundness of their bank deposits.

Unfortunately, for the reasons we stated in our comment, we believe that AP got the story entirely wrong:

In the chaos of the last few days, a lot of erroneous press reports are coming out about the FDIC and the deposit insurance fund. It is important for people to understand that the deposit insurance fund, like all federal trust funds, is simply an accounting entry with the US Treasury. There is no separate fund. The amount in the FDIC fund shows how much cash has been contributed by the banking industry to support the deposit fund. However, we need to make clear that the US Treasury will advance whatever cash is needed by FDIC to address bank failures and make good the deposit insurance guarantee. There is no issue regarding the bank insurance fund, but unfortunately most of the public do not understand this. The FDIC needs to make this clear in all of its public statements.

Early Wednesday we issued a statement to the media and called AP's editors to ask that they retract the story, but so far AP has refused. Yesterday the IRA spoke with Kathleen Carroll, executive editor of AP in New York, and again asked her to retract the story. Still no response.

We'd like to thank the Detroit Free Press and a number of other publications that removed the AP story from their web sites. Unfortunately, the AP report was on the front of DrudgeReport's home page all day on Wednesday. This AP report, in our view, has greatly added to the anxiety and fear in the public's mind regarding bank safety and soundness. We don't believe that the AP deliberately is trying to worsen the financial crisis, but the negative effect remains. This issue is too important to get wrong.

In fairness to the AP and the other generalist reporters who are suddenly being forced to report on and write about financial matters that they neither understand nor appreciate the significance of to the general public, let us expand on why we have put out the $500 billion number in our earlier comments as a "backstop" for the FDIC.

First, even though the FDIC has access to all of the cash needed to resolve failing banks, the average citizen has no idea about the relationship between the Treasury and the FDIC. That is why we believe that President Bush, Senators Barrack Obama (D-IL) and John McCain (R-AZ), Treasury Secretary Hank Paulson and FDIC chair Sheila Bair, need to hold a prime time press conference and announce a major funding initiative. Paulson's announcement yesterday had that effect for Wall Street, but somebody still needs to start talking to Mom & Dad, who have been terrorized and traumatized by and erroneous news reports. 

The message: The Treasury stands behind the FDIC 100% and, when the smoke clears, any funds borrowed by the agency will eventually be repaid by the banking industry.

Second, when we made reference to $500 billion in backstop for the FDIC, only part of this amount is for resolving INSOLVENT banks. Remember, our estimate for failed banks by July 1, 2009, when we hope to be heading back to Leen's Lodge in down east Maine, is 110 failed banks, $850 billion in assets. If you suppose a 30% loss rate to the FDIC against that asset total, you are talking about $250 billion in today's dollars - that is, in real terms, far less than the S&L cleanup. No biggie.

The other part of that amount should, we believe, be held in readiness for Treasury to invest in preferred stock of SOLVENT banks that are wounded but cannot raise new capital. While we applaud Treasury Secretary Hank Paulson for his announcement yesterday of an RTC-type vehicle to help liquefy the balance sheets of commercial banks, we agree with our friend Josh Rosner of Graham Fisher in New York that the plan, as stated in press reports, is flawed:

Today, in Washington, there are active discussions about the "need" for the government to buy up the distressed mortgage backed securities and CDO assets that a year ago everyone knew were being hidden, overvalued and mis-marked by financial companies... Let us be clear, it is not citizen groups, private investors, equity investors or institutional investors broadly who are calling for this government purchase fund. It is almost exclusively being lobbied for by precisely those institutions that believed they were 'smarter than the rest of us', institutions who need to get those assets off their balance sheet at an inflated value lest they be at risk of large losses or worse.

While we have no problem at all with the Treasury taking preferred equity positions in undercapitalized but still solvent commercial banks, we've got a big problem with Hank Paulson's proposal to bail-out the remaining dealers like his former firm Goldman Sachs (NYSE:GS). Indeed, the rescue of AIG (NYSE:AIG) was clearly not a bailout for the shareholders of that firm, but rather for the dealers in credit default swaps who were counterparties of that firm in the credit derivatives market. As one IRA reader said this week:

I am sick of  Reuters, AP, CNBC et al calling this a bailout. Nothing could be further from the reality of the situation. The AIG common shareholder was wiped out and the U.S. bought the largest insurer in the world for $85 billion - and using a loan with an interest coupon of 8 1/2%! Very similar to two great investments of the past, Mexico and Chrysler. The Treasury and Fed are stealing assets from stupid AIG shareholders. Goldman was going nuts yesterday trying to get enough money together to do the deal. Has to be close to the bottom when that happens.

We notice that the FDIC has instructed banks with losses on Fannie Mae and Freddie Mac to take third-quarter writedowns. Writing down impaired assets is the only way to get markets to clear. The joyous reception from congressional Democrats to Paulson's latest, massive bailout proposal smells an awful lot like yet another corporatist love fest between Washington's one-party government and the Sell Side investment banks. The good news is that the process of unwinding cares nothing for Washington's chattering mob.

Why WaMu May be Toast

We have spent a lot of quality time with members of the media this week.  Many of them had just one thing in mind: Washington Mutual (NYSE:WM). Of course, most of the national media, who are the de-facto partners of the short selling hedge fund crowd, would not know a loan default if it bit them in the cojones. Twice even. But we are happy to spend time helping them understand these issues.

So how do we see WM? Let's start with some numbers as of 1H 2008:

Washington Mutual	Q2 2008 ($000)
Total Assets	$307,021,614.00
Capital	$24,379,747.00
Loss Reserves	$7,446,193.00
Charge Offs	$3,626,910.00
Provisions	$9,422,769.00
Income	$7,331,139.00
ROA	-2.70%
ROE	-35.50%

Notice that while the lead bank of WM reported a loss as of June 30, 2008, it generated $7.3 billion in pre-tax income in the first two quarters of the year. The trouble is, all of that income had to be diverted to loan loss provisions to cushion future charge-offs. Thus the almost 3:1 ratio between provisions and actual charge offs.

With the negative ROE, WM earns an overall rating of 21 on the IRA Banking Industry Stress Index vs. 1.4 for the industry. Remember, the maximum index value is 100. For ROE, WM is already at 100 vs. 1.8 for the industry. The rising default rate earns WM a 4.8 rating vs. 2.1 for the industry.

WM was at 300bp or 3% charge offs at the end of the second quarter on an annualized basis. WM management has guided the Street to a 20% increase in charge off-activity in Q3, less than the increase in Q2 to be sure, but this suggests that the full year number could be over $8 billion. Our run rate projection for 2008 pre-tax income for WM's lead unit is $14 billion, assuming that expenses and revenue remain stable. But that assumption is tenuous with rising funding costs and expenses, part of the steady rise in the efficiency ratio of the entire industry. For the next few quarters, WM will be putting just about every penny of income into maintaining loss provisions.

If Hank Paulson et al in Washington are serious about bailing out the banking industry with RTC II, they can start by putting about $10 billion in new preferred equity into WM. At yesterday's closing price of $3 per common share, that gives the Treasury a two-thirds stake in the wounded bank. If David Bonderman, the founding partner of TPG who led a group that invested $7 billion in WM earlier this year at a much higher valuation, does not care for that scenario, then he can always get out his check book and take up all or part of the capital raise. After all, if you're going to be diluted down to nothing, might as well do it yourself. But with "only" $3.3 billion in net worth according to Forbes, this opportunity may beyond even Bonderman.

Comments

[Dr Payne:]

Another Idiot!

2008 Sep 19 10:12 AM

[poncawolf:]

Oh How I got - Trampled Today – Banker Everywhere

I went to ask congress for a woman’s shelter – near my city – But Oh how I got trampled today - All the Bankers - everywhere.

I went to ask congress for - A after school program to keep the kids out of gangs – But oh how I got trampled today - All the Bankers - everywhere.

I went to ask congress today – About a little health care - But oh how I got trampled today - All the Bankers - everywhere.

I went to ask congress today – About a little help for cleaning up our water supply - But oh how I got trampled today - All the Bankers - everywhere.

I went to ask congress today – about A American jobs - protection bill - But oh how I got trampled today - All the Bankers - everywhere.

I went to ask congress today – About Helping the millions of families keep there homes - But oh how I got trampled today - All the Bankers - everywhere.

I went to ask congress today - But oh how I got trampled today - All the Bankers - everywhere.

2008 Sep 19 10:24 AM

[thewarlock:]

I am sorry but fairly idiotic analysis here. Yes, All the income for the next year goes into covering the loan defaults but happens when they are done? You go back to making 7b/qtr...I fail to see how the company is toast especially if there is no run on deposits as your article says there should not be.....Please explain in english

2008 Sep 19 10:39 AM

[ipohunter:]

Wow. What a moron. Lets see if they have enough liquidity to last through this crisis before the government announcement of this new entity, then how the hell do you expect it to go under.
Simply put this WaMu will have billions in profits within 18-24 months.

2008 Sep 19 11:03 AM

[User 265645:]

I agree. He is proclaiming WM dead while it still has heartbeat and is recovering. The FED action basically removes a lot of doubt about financials and the "unknown" value of existing loans. This guy must have written this article about 2 months ago and just published it today. I wonder if he has appeared on CNBC.

2008 Sep 19 11:17 AM

[Christopher...:]

Thanks for the comments. People who call people names, and don't have trhe courage to use their real names, usually are beneath contempt. When I put up a post, I used my real name so you know who is talking. People who hide behind screen names are cowards and have no credibility. That said, I understand that folks are under the gun this week.

Bottom line on WaMu: 1) how high does the loss rate go and 2) how long does it stay there. WaMu is already 2x peer in terms of loss rates w/o the rancid Providian credit card book. Add the cc book, which is around 1,000 bp of default now, and life gets real interesting. That is why I expect WaMu to be recapitalized by Uncle Sam.

Sleep well kiddies.

2008 Sep 19 11:18 AM

[jetski:]

The federal government failed to properly regulate the securities markets and then used this failure and the illegal market manipulation by short sellers to steal AIG from its shareholders.

Unlike the public the short sellers were not limited by lack of transparancy. They kenw or knew others who knew all about the credit default swaps on AIG's books and the mortgage backed securities on Lehman's. This material non public information was used to make billions. And I guess they are to big and p[owerful to be held accountable.

2008 Sep 19 11:28 AM

[whidbey:]

Yesterday's war. The Treasury cum Fed program to fix the mortgage clog is heroic and sounds good, but Congress will work it over adding bells and and mud flaps and it will look a little different when signed into law. The FDIC is the very least of our concerns, we know it is solvent in dollar terms, but not in inflationary terms. This is a massive inflationary program, which will go on for years, and the results will be nil until the consumer is fixed. That personal or household debt problem waits in the wings and it will not be fixed so readily, yet it has the potential to render this policy null and void. We have no Fix.

2008 Sep 19 12:03 PM

[Kostya Tszy...:]

From The TimesSeptember 11, 2007

British billionaire snaps up 7% holding in Bear Stearns

Chris Whalen, of Institutional Risk Analytics, said: “What the investment shows is that Bear Stearns looks like good value at this level. Bear Stearns is a sound bank, I’m not worried about their future.

2008 Sep 19 12:13 PM

[Reinko:]

The article is correct in stating there is no true FDIC fund at all; it only measures how much banks have contributed. And these contributions are spend a long time ago.

All the money the FDIC spends is borrowed money via newly issued Treasuries. And by the way: maturing Treasuries are not paid with tax money but with fresh new Treasuries.

As long as there are sucker investors out there that think it is a sound investment, this circus will go on and on.

The real problem is: There are no reserves anywhere in the system.
Nowhere, it is all revolving loans & more Treasuries.

2008 Sep 19 12:55 PM

[downtoearth:]

Mr. Whalen:

There is an "un-toast" manner in which you can analyze this situation (with the background facts) as well:

Here are some WaMu details which actually indicate the soundness of WaMu.

WaMu’s retail deposits at the end of August were $143 billion (SEC Form 8-K and related press release of September 11, 2008). But I'll grant you they might be less than this now in light of the media's analysis of Wamu - based not on fundamentals, but on short-sale price results and the ever so trustworthy results of the unregualted, unknowable CDS "market")

Wamu’s Tier 1 leverage and total risk-based capital ratios as of June 30, 2008 were 7.78% and 13.98% (SEC Form 8-K reported July 22, 2008, Exhibit 99.2, page WM-1). Compare these to the June 30, 2007 (year before) ratios of 6.07% and 11.04%, respectively (ibid). These figures are significantly above the regulatory requirements for well capitalized institutions.

The Fannie and Freddie bail-out hit WaMu to the extent of only $280 million (WaMu's press release of September 11th); recent news articles repeat Wamu’s statements to the effect that the company had “de minimis trading exposure to Lehman Brothers Holdings and no trading exposure to AIG." Downgrading WaMu’s credit rating primarily due to market conditions, Standard & Poor’s nonetheless acknowledged that WaMu had enough cash to get through 2010 (the press didn't mention this but tangentially).

WaMu’s exposure to the type of bond investments which killed Lehman and almost killed AIG is limited. Of the $239.6 billion of loans held in WaMu’s portfolio, only 18.2 billion (or 7.6%) are the dreaded “mortgage backed securities” (SEC Form 8-K reported July 22, 2008, Exhibit 99.2, page WM-4). And these MBS’s still generated $335 million of income in the second quarter (ibid, page WM-2). (However, I would love to see the new RTC purchase these for even 30 cents on the dollar as that would add another $6 billion to WaMu's cash).

WaMu’s gross interest income for the second quarter was $4.2 billion (similar to the quarter before), and after interest expense due on deposits and borrowings of $1.9 billion, yielded a net income of $2.3 billion for that quarter (ibid, page WM-2; it also reported additional net non-interest income of $561 million for the second quarter). The “loss” which WaMu reported against this income (which translates to a loss for the quarter) is a “PROVISION for loan losses”. That is not an actual out-of-pocket expense suffered by WaMu, but an amount set aside in anticipation of future loan losses based upon the statistics of non-performing loans measured during that quarter. However - and this is important - the loan loss provision of 5.9 billion dollars in the second quarter (ibid, page WM-2), has now been updated with a lower loan loss provision of $4.5 billion (as reported in the recent September 11th press release). WaMu is finally seeing the “bottom” of its non-performing loans. But more on those non-performing loans below.

Aside from the $18.2 billion of the mortgage backed securities, the majority of the loan portfolio owned by WaMu is proprietary in nature (i.e. WaMu owns them and services them) . The $52.9 billion portion of the proprietary portflio, those Option ARM loans in WaMu's portfolio, some of which are, no doubt, non-performing, or less than perfectly performing, are not threatening for two reasons:

(1) WaMu does not have to re-set a proprietary ARM. For instance, if WaMu is satisfied with its current overall income, and expects the California and Florida markets to recover (which they always do, and before all of the others), it need not “force” the higher interest rate on an ARM borrower, but instead agree to receive, for awhile longer, the lower option rate which was granted with the original loan (the borrower has a similar motivation to continue existing payments: the foreclosure alternative will affect the borrower’s ability to purchase another home for at least 7 years; it will also affect the borrower’s ability to rent a substitute home in the meantime (as landlords of the “better” homes do check a prospective tenant’s credit first); and who wants to move if they don’t have to?) In summary, there is no realistic threat from option ARM loans which WaMu can’t , in its own discretion, keep under control.; and

(2) if one or more of these Option ARM's becomes terribly non-performing, WaMu can pass it to the RTC - another 30cents on the dollar into the cash coffers.

In addition (though watering stock never quite assists the investor like it does the flowers in my backyard), WaMu does have an additional yet unissued 1.4 billion shares of capital stock - another way to generate capital and more cash for operating purposes.

So not all is lost.... wouldn't you agree?

And if not, be more specific with your facts, sir.

Generalized facts laced with hyberbole never helps the market or investors.

Michael Hanson, Tax Attorney

2008 Sep 19 01:30 PM

[downtoearth:]

Mr. Whalen:

Actually on a second read of your article, there are adequate facts included, so I owe you an apology.

However, I guess we have to disagree on the eventual outcome as evidenced in your title, that being the sensationalist title of "toast".

WaMu in my estimation has considerable options on the table at this point. Merger, recapitalization, and, preferably, the soon to be established RTC II which will, hopefully, purchase much of the troubling debt which WaMu carries on its books.

And reading back over my own analysis, I would think WaMu could actually negotiate 50 cents on the dollar on this debt. After all, the securing properties are primarily in California and Florida (better locations for eventual recovery), and a 50% discount is more than adequate to protect the new RTC II - as a lender, or as the holder of a foreclosed property.

But, again, will there be that many foreclosures?

The new RTC II, if it holds a loan, can negotiate new and more favorable terms with the borrowers involved. If RTC II negotiates and obtains even a 2% payment on a loan they acquire from WaMu, they will be receiving what the Fed wants for its loans - 2% (i.e. therefore no loss to the federal government as a whole - at this point - certainly inflation later). If the 2% rate being received is on the full value of the loan (which has been discounted 50% on its acquisition) the actual realized interest rate to the Treasury is 4%. Nice.

Now if RTC II owns foreclosed real estate, it can also sell it under very favorable rates - with Freddie and Fannie at its (immediately available side). Utilizing those very favorable rates in the sales will (1) help to sustain a higher (not as high as I would like to see, but at least a stabilizing) price for the real estate market, and (2) start the movement of cash/blood in the economy/body again.

For all we know, the government may actually make a profit on this deal.

The RTC II assumes loan receivables at a 50% discount, makes a great rate after negotiating the loan payments down to the lowest possible rates, and if a borrower defaults, the RTC, forecloses and sells the property using its ready reserves. "Creating Wealth" advisor Robert G. Allen would be salivating at the thought.

2008 Sep 19 03:25 PM

[milkchaser:]

I very much enjoyed the article and the counter-argument by Michael Hanson. Mr. Whalen, do you care to respond to the effects of RTC II on your analysis?

2008 Sep 20 11:33 AM

[Kelly Liebe...:]

Sure...He says, go tell mom and dad that your bank deposits are safe!
Of course the govt can print all the money they want to make sure those deposits are safe...but than your $50,000 will only be able to buy you $40,000,then $30,000, then $20,0000 then $10,0000 worth of goods. How low will it go?
Take the money out, and go buy gold and silver. The govt will hate you for it...

2008 Sep 20 12:54 PM

[notsosmart:]

the real toast-the american people,for generations to come.lots of smirking faces around the world at the new conservative socialism america.

2008 Sep 20 03:39 PM

[Peter Lynch:]

Mr. Whalen's analysis is all good and fine. Wamu wouldn't be up for sale or other strategic options if its real estate book weren't performing poorly.

However, the latest development in Washington is a game changer for Wamu. FDIC doesn't want to take over wamu...they want it sold or recapitalized. With the $700 billion RTC package in development, wamu has just become a lot more attractive to a lot more banks and priviate equity firms. And this RTC-like package also bought wamu something that they didn't have before just two days ago - time.

2008 Sep 20 09:38 PM

[Distressed ...:]

wow, if this really gets bad, banks will have online bank runs, that could be interesting! 5 seconds and capital reserves are wiped out!

2008 Sep 20 11:24 PM

[downtoearth:]

My New RTC

They purchase loans for pennies on the dollar....

lower the interest rates so that the borrowers can comforatbly pay, say 2% (much more considering the discount)

with foreclosed properties, they sell them at a nice (and higher, market-stabilizing) price, and on great (discount) terms with "ready Freddie" (and Fannie) at their side.

This is looking great.

I want to be a stockholder in this.

Wait a minute...... I already am !

2008 Sep 21 04:15 AM

[WEBISKING:]

The short selling banon financals needed to be done.WM will be bought out by C BAC or JPM

2008 Sep 21 09:25 AM

[Kinabalu:]

"the rescue of AIG (NYSE:AIG) was clearly not a bailout for the shareholders of that firm, but rather for the dealers in credit default swaps who were counterparties of that firm in the credit derivatives market"

This is the most important point in your article. And you got it exactly right. People have to think every time they hear the word "bailout". Who is being bailed out? I think these CDS are the perfect place for Congress to require a haircut in any bailout.

But it goes downhill from there. Your calculation of a 30% loss severity for the FDIC sounds okay on $850 billion of assets at 110 banks, but you also have to apply a frequency ratio. 100% just won't fly. I would suggest 40%, and that's a lot of bad loans. That takes your $250 billion down to $100 billion.

Your comments on WM are not so good either. I think you messed up your table of financial numbers, particularly the "Income" line. Did you forget to put a minus in front of that $7.3 billion. It doesn't square with negative ROA and ROE. Or did you really mean Pretax, Pre-loan-loss-provisio... Income? Of course, this is Seeking Alpha, and nobody really looks at numbers here.

2008 Sep 22 02:22 AM