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Commentary
The WaMu Story
Lawrence J. White 09.26.08, 6:20 PM ET
I'll start with the good news.
The largest bank failure in the history of the U.S. was handled smoothly by the teamwork of the government and the private sector. The system worked!
Let's explore this a bit further: Since the 1930s, depositors in commercial banks, savings banks and credit unions have been protected by government deposit insurance. Beginning in 1980, the insured amount has been $100,000 (although only the effort and bother prevents anyone from spreading any larger amount across two or more banks). The Federal Deposit Insurance Corporation covers banks; a separate agency covers credit unions.
When a bank is insolvent--when its assets don't cover its liabilities (which are largely deposits)--the FDIC takes control. The owners are wiped out, since their equity position is negative. Senior management is dismissed. Unsecured creditors are unprotected.
The FDIC then usually finds an acquirer--a solvent bank--to take over the deposit liabilities and the assets of the failed bank. The insured depositors are kept whole; their deposit claims are now the obligations of the acquiring bank.
If the acquirer takes all of the assets, the FDIC writes a check to the acquirer for the negative equity "hole" so that the acquirer is getting a "balanced" (assets equal liabilities) deal. In some instances the acquirer declines to take some of the assets, so the FDIC writes a bigger check and those hard-to-value assets become the property of the FDIC, which eventually liquidates them.
In the WaMu transaction, JPMorgan Chase won the auction that the FDIC held among potential acquirers earlier in the week. JPMorgan Chase assumed all of WaMu's deposit obligations--uninsured as well as insured. These deposits totaled about $188 billion. It also absorbed all of WaMu's net assets, which were mostly residential mortgages and mortgage-backed securities. Some of WaMu's assets had been pledged to secured creditors (such as the Federal Home Loan Bank System, which lent WaMu around $60 billion) who could immediately grab collateral that satisfied their claims. The net assets acquired by JPMorgan Chase had a nominal value of around $240 billion. Implicitly, there was also "brand name" value that JPMorgan Chase acquired, since WaMu had an extensive branch network and a good reputation in many states where JPMorgan was absent but longed to expand.
In this resolution, the FDIC didn't pay anything to induce JPMorgan Chase to absorb WaMu. Indeed, JPMorgan Chase paid the FDIC $1.9 billion.
So, the good news is that the system of deposit insurance worked smoothly, as did the FDIC resolution of a large troubled bank. There was only a small "run" of depositors withdrawing their money from WaMu branches earlier in the week. The FDIC moved in Thursday night, rather than waiting until Friday night (as it usually does). It probably feared that the depositor run would get worse on Friday, and it didn't want images of depositor lines outside WaMu branches in newspapers, newscasts and Web sites over the weekend.
This all bodes well for the troubled bank resolutions that the FDIC will conduct over the next few months.
So what's the bad news?
Recall that JPMorgan Chase absorbed $240 billion in nominal assets and $188 billion in deposit liabilities, plus some unstated value for the branch network. The net value of this package should be somewhere north of $52 billion. But JPMorgan Chase paid the FDIC only $1.9 billion--and this was the best bid that the FDIC received!
As had been feared, WaMu really did hold a slew of poorly performing mortgages whose nominal value greatly exceeded their market value. Yet WaMu had a reputation (until recently) of being a well-run organization that didn't undertake excessively risky activities or engage in abusive lending practices.
If WaMu's mortgage assets are poorly performing and overvalued, this is strong reinforcement for the view that lots of other financial institutions' mortgages and mortgage-backed securities are also overvalued. Although WaMu's resolution shows that the banking system can handle the problems and that insured depositors need not fret (or run), much--probably most--of these mortgages and MBS's are held outside of the banking system: in investment banking firms, finance companies, insurance companies, hedge funds, mutual funds, pension funds, etc.
In some cases, the recognition of the losses will reduce the value of the fund. Pension claimants will be worse off and mutual fund holders will be less wealthy. But for other non-depository institutions, the losses may lead to bankruptcies and the resolution processes will not be smooth.
Fears of mortgage-based losses and bankruptcies throughout the financial sector are clearly slowing the flow of credit through the American economy. Financial institutions are reluctant to lend to each other or to nonfinancial borrowers. There is a great deal of mortgage-related "sand in the gears" of America's financial machinery.
The WaMu takeover shows that at least one part of the system can clean out the sand. But, alas, it also indicates that there is much more sand that will be harder to remove.
Lawrence J. White is a professor of economics at the NYU Stern School of Business. During 1986-1989 he was one of the three board members of the Federal Home Loan Bank Board.
