Despite Settlement Uncertainty Remains For WaMu Junior Debt

by: Troy Racki

Last Monday, after six previous plans of reorganization and two failed confirmation attempts, Washington Mutual finally announced a long overdue settlement between its creditors and shareholders after weeks of intense mediation. While the settlement carves out a recovery for WaMu's preferred (OTC:WAMKQ) and common stock classes (WAMUQ.PK) it also resulted in a doughnut hole for the holding company's junior most creditors.

According to the seventh plan of reorganization's disclosure statement investors in WaMu's Trust Preferred Securities (OTC:WAHUQ) have seen their recoveries plunge from a previous estimation of 32% to a paltry 9% or $3.20. These prices are a far cry from May 2010 when the trust preferreds traded at a high of $27 on expectations of a 75% recovery and ownership in the reorganized company. Since then copious legal fees and mounting interest has steadily eroded away at the class' recovery. But now even nine cents on the dollar is beginning to look out of reach.

While WaMu's settlement helped bridge the gap between creditors and equity, there are still several loose ends which could prove to be major disruption at the next confirmation hearing unless otherwise addressed. The largest of these are disputed unsecured claims between WaMu and holders of litigation tracking warrants in Dime Savings Bank of New York (OTC:DIMEQ). The warrants were created when WaMu acquired Dime in 2002 and were issued to Dime shareholders to track potential recoveries related to 1995 litigation between the FDIC and Anchor Savings Bank which had since been acquired by Dime. In 2008 the Federal Claims Court ruled that Anchor should receive some $356 million in damages, monies that ultimately should have been delivered to Dime Savings shareholders.

However during settlement negotiations between WaMu's creditors, JP Morgan (NYSE:JPM) and the FDIC, the creditors made the decision to relinquish ownership in the Anchor litigation damages as belonging to WaMu bank and therefore JP Morgan, even though the recovery was due to Dime shareholders. WaMu Incorporated then rejected DIMEQ’s claim to any recovery with the reasoning that because the Anchor damages were contracted to be converted into WaMu common shares and because WaMu was insolvent and common shares were worthless, Dime shareholders should see no recovery. Dime shareholders believed that the damages belonged to them regardless of conversion, and levied a claim against WaMu, winning a reserve of $337 million pending final determination of their claim's classification. As of last Thursday the claim has gone to mediation, further highlighting its merits as legitimate.

While WAHUQ's current trading range near $2 currently promises the possibility of a 60% return in just over two months, it comes with serious risk. Unfortunately for WaMu's junior most creditors the DIMEQ mediation could be detrimental as the current liquidation analysis assumes the claim will be relegated to equity at no cost to the estate. By only setting aside $375 million to cover the possibility of up to $850 million in disputed general unsecured claims, the analysis provides no room for error. Already $380 million in allowed unsecured claims has been spoken for. Should DIMEQ be placed as an allowed general unsecured obligation all of WaMu's junior creditors beneath it will be extinguished. WAHUQ also has to worry about the speed of confirmation. At the debtor’s projected burn rate of $30 million a month in intercreditor interest and professional fees should WaMu's bankruptcy procedures extend beyond May 13th 2012, any recovery they would have seen will have been consumed.

WAHUQ's dire recovery situation is mostly attributable to its subordination provision which states that it is on the hook for any lost principle or interest due to higher ranked creditors. While the judge has ruled that the going interest rate in the case is only the federal judgment rate of 1.95%, WaMu's senior creditors argue that WAHUQ must pay the difference between their contract rates and the judgment rate. This has created a massive $599 million obligation which awards some creditors up to 130 cents on the dollar yet could leave junior creditors with nothing.

Some have questioned why WaMu's junior most creditors have not fought harder to protect their recovery. After all, their contract simply says to pay lost interest and makes no definite indication in the situation of bankruptcy when there is a difference between contract and federal judgment rate. Junior creditors could argue and win that the federal judgment rate supersedes the contract rate. However since 70% of WAHUQ is held by four hedge funds which hold a large position in more senior debt, the funds are simply taking money out of one pocket to put it in another. Consequently, minor creditors in WAHUQ are simply out of luck if they hope someone will fight for them.

Is WAHUQ worth the risk? If DIMEQ mediation results in a cash concession from senior note holders similar in design to the payment WaMu shareholders received but otherwise remains as equity, then the 9% recovery is likely achievable. Furthermore if the disputed unsecured claims are extinguished and allowed claims are adjusted below the $375 million reserve and the WaMu liquidating trust or litigation trusts receive higher than expected proceeds, WAHUQ will also benefit, up to the maximum recovery $10.87/share. In November 2010, the liquidation trust was valued between $100 and $150 million, of which $60 million would be held for litigation, less expenses. However given the heightened uncertainty surrounding the DIMEQ mediation, and either a $0 or $3.20 recovery I am electing to sit this one out.

Disclosure: I am long OTC:WAMKQ.