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

Includes: AIG, GS, WMIH
by: Christopher Whalen

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.