Mat Heaton, Founder of ActiveRain and the WaMu Seizure.....
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.
