Outside of the bailout bill currently under debate probably the biggest news last week was the failure of the largest thrift in our nation, Seattle based Washington Mutual. On Thursday, the FDIC took the step of seizing WaMu due to them being vastly under-capitalized. The deposits and some other assets were firesaled to JP Morgan for $1.9B, depositors were protected while both stock and bond holders were declared wiped out. This represents a marked difference from how previous bank failures have been handled by the FDIC, a change to the game plan if you will. Not withstanding he potential sweet deal JP Morgan got, there is a disastrous unintended consequence to the rest of the under-capitalized financial system.
Unintended consequences on capital structures
All companies has a capital structure that includes different types of securities. Lowest in this capital structure is common stock, followed by preferred stock, followed by different levels of debt (bonds). When a company is liquidated (for example in a bankruptcy or a typical FDIC seizure) the investors highest on this capital structure get paid first. This means that common stock bears the most risk for the holders, but these holders typically receive the highest risk adjusted returns to compensate. Usually in the event of a bankruptcy you'll see the common shareholders wiped out, preferred is often wiped out but usually the bond holders at least get something.
When the FDIC came in, waved their magic wand and simply declared the bond holders got zero, they totally changed the rules to the game and set a damaging precedent. Had the Washington Mutual failure happened through more traditional methods it's very conceivable bond holders would have at least gotten something back. How do you spell lawsuits?
So, now we have all these other undercapitalized financial institutions out there that are desparately trying to raise capital. Do you think big investors are more or less willing to recapitalize a financial institution if there is now a precident set that their investment can be zeroed without any judicial review? While the regulators keep talking about how critical it is for these institutions to raise more capital, they may have just shot themselves in the foot with this action.
Similar impacts of another regulator change
Another recent regulatory change has the same impact of discouraging recapitalization of the banking system. The banning if short selling the stocks of financial companies. Often when a major fund comes in and purchases bonds in a company, particularly one that has known problems they will "hedge" this investment by shorting the common stock of the company. If the company totally collapses they make money on their short position to compensate for any principal losses they would take on the bonds. Undoubtedly, many of the big investments you've seen in troubled financial institutions in the last year have included this type of hedging. Now that these investors don't have this mechanism available to hedge against the company completely imploding, they are even more skittish of making capital investments in financial firms.
The problems in the capital markets today are in fact being made worse by the panic'd game changes by regulators and officials. Who wants to play in a high stakes game where the rules may change next week?
See Also: Anti-Bailout video that includes discussion of this.
It appears that they have completely destroyed the capital market. I'm sure that was not their intention. But, it is surely the result.
Matt- I was just reading up on the great depression and what is interesting is that the wall street crash did not cause the depression. It was regulation and bad decisions of Hoover and Roosevelt. Read, The Forgotten Man: A New History Of The Great Depression by Amity Shlaes.
There are 2 things still going on that are not helping:
The market to market or so called fair value accounting rules that regulators have been enforcing starting in the early 90's.
Packages of subprime mortgages came to about 1.2 trillian. Maybe half of those will go bad, so that is 600 Billion. But the net assets of the US households is 56 Trillion.
If during the depression the regulations were such as they are today, we would still be in the great depression. All the banks of that time survived with the exception of one. Every one of those would have collapsed if they had the rules we have now.
If we had these regulatory rules with the S&L crisis, we would have had a second great depression instead of a recession. Most all of the large commercial banks would have failed then under these rules.
There is no reason what is going on should be happening. They need to allow the free markets to work.The reason it is fragile is because of these regulations that are not helping.
The problem is not the markets, it is the weak dollar. Strengthening the dollar is the priority.
OK Matt, Here comes a stupid question. What happens to the 1.9B that JP Morgan paid? If the stock and bond holders are wiped out where does the $$$ go?
Bryant: Good question, I've never been clear on that. Lots of details of this transaction still appear to be fairly sketchy.
I do not think B.B.s question was too stupid. I am sure it will evaporate.
Gee, Washington doing something that has unintended consequences? I can't imagine that.