Death Spiral Financing at WaMu, Merrill Lynch, Citigroup

Reuters is reporting WaMu has $3.33 bln loss, may be cut to "junk".

Washington Mutual Inc, the largest U.S. savings and loan, posted a $3.33 billion second-quarter loss on Tuesday as souring mortgages forced it to set aside more money for loan losses.

"We are planning for continued softness in housing for the next several quarters," Chief Executive Kerry Killinger said in an interview. "The capital that we have in place is sufficient to manage through this period. We have no plans at this point to raise additional capital."

Washington Mutual said its mortgage unit lost $1.35 billion in the second quarter, while retail banking posted a $2.04 billion loss. Credit cards generated a $175 million loss, while profit in commercial banking fell 29 percent to $87 million.

Washington Mutual also said that Killinger, Chief Operating Officer Steve Rotella and Chief Financial Officer Tom Casey will not receive annual incentive payments under a company bonus plan, in light of its performance in 2008.

What a travesty of justice! It's not easy to lose money in nearly every phase of operations. One might think that such performance would be rewarded. But no! In an amazing superhuman sacrifice the CEO, CFO, and COO of WaMu will all decline bonuses.

Plans To Raise Capital vs. Need To Raise Capital

It is interesting how statements like "We have no plans to raise capital" can get completely distorted from reality.

Check out this bullish Comment about Washington Mutual I found on Yahoo: "No Need to Raise Capital....... Very Bullish. Long till 2012".

Here is the reality.

WaMu "Can't Raise Capital"

Please consider Washington Mutual Drop Wipes Out Most of TPG Holding.

Three months ago, with Washington Mutual's shares at $13.15, a group of investors led by Forth Worth, Texas-based TPG agreed to buy $7 billion of stock at $8.75, a 33 percent discount.

As losses mount, a clause in the TPG agreement makes it more costly for WaMu to raise capital or be acquired. If WaMu is sold for less than $8.75 a share or is forced to raise more than $500 million in equity, it must compensate TPG for the difference, according to filings with the U.S. Securities and Exchange Commission.

"We don't know how their investment plays out, but we also don't know how this affects WaMu to the extent they need to raise more capital," said Steven Davidoff, law professor at Wayne State University Law School in Detroit. "They really can't raise equity."

Death Spiral Financing

It is now time to explore the implications of the desperate deal that Washington Mutual made with TPG. Please consider Lack of Transparency = Shareholders Get Ratcheted.

Following are a few highlights from the above lengthy, but well written article. I condensed this down as best as I can but inquiring minds will definitely want to read the entire article.

Even though hundreds of billions of dollars of capital have been raised by the financial sector over the past several months, which of the investors in a financial institution have made money since their initial investment? Answer: Zero.

We can’t think of one. They are all underwater. When Abu Dhabi first invested $7.5 billion in Citigroup last November, Citi’s stock was $35. Subsequently, when Citi did their $14.5 billion raise in January, the stock was trading at $30. Today Citigroup’s stock is under $20... and it keeps falling. Merrill Lynch did a combined raise of $12.8 billion in December and January at $48. Now the stock is under $35… and also falling. Warburg Pinkus made their now infamous $1 billion investment in MBIA at $31 per share. MBIA has fallen over 80% since and is now trading at under $5 per share.

Those who participated in Ambac’s $1.5 billion rights issue in March are down a similar amount, 80%, as the stock now hovers under $2. Bank of America made their initial investment in Countrywide Financial last August at $18 per share (rather surprising to us, given that Countrywide looked to be going bankrupt if BofA didn’t come to the rescue). Bank of America subsequently made a takeover offer in January. Today Countrywide shares can be got for under $5 per share.

TPG invested in Washington Mutual to the tune of $7 billion at $8.75 per share, a substantial discount at the time to WaMu’s stock price of $13. Today WaMu’s stock is $6. Last month AIG raised $20 billion when their stock was trading at $37 per share. Today AIG stock is just above $30 per share. Even those who participated in Lehman Brothers’ $6 billion equity offering last week at $28 per share are already underwater, with LEH currently trading below $24 (year-to-date Lehman’s stock is down over 60%).

Ironically, thanks to full ratchet provisions, this promises to lead to further dilution and even weaker stock performance going forward.

There were at least some smart investors who noted the downward trend and successfully negotiated for downside protection. We know of at least two cases (though there are doubtless others); namely, Merrill Lynch’s $12.8 billion investment from Temasek (the Singapore sovereign wealth fund) and Washington Mutual’s $7 billion raise from TPG (a private equity firm).

Quite unbeknownst to the general public at the time, downside protection was built into these equity raises to protect these investors. They are called “look back” provisions or “full ratchet” compensation.

We believe it is more accurate to call them “death spiral” securities. They work as follows. The investors in the equity raise would have their investment “protected” by a provision which states that should the bank afterwards raise money at a lower price than what they paid, these investors would be compensated retroactively by having their initial investment priced at this lower price, thereby being issued new shares for free. It doesn’t take a mathematician to see how these provisions can result in massive dilution should the bank subsequently raise even a paltry amount of capital. A new offering will trigger a lower price because of the dilution it would cause, which would trigger even more dilution because of the lower price, which would then trigger an even lower price because of the even higher dilution, etc. This is why we call such securities a death spiral.

However, unless the bank goes bankrupt, these investors can’t lose. And we already know to what lengths the Fed will go to prevent a banking bankruptcy. It’s heads I win, tails I win.

They can even short the stock in the expectation that it will go down and still not lose. At the next financing, which is sure to come, they will be made whole... even making money on the short!

Add Citigroup To Those In Death Spiral Financing

The above article mentioned Merrill Lynch and Washington Mutual in death spiral financing schemes. Add Citigroup to the list. I talked about this way back on January 15, 2008 in Cost of Capital "Ratchets Up" at Citigroup and Merrill.

Is it any wonder that Citigroup is desperate to dump $500 billion in assets? The saving grace for Citigroup is that it has assets to dump. The big question is ho much those assets will fetch. I believe it will be far less that Citigroup thinks. I am still sticking to my estimate that Citigroup will survive, just nowhere remotely close to its current state.

Now take a good hard look at WaMu. It is losing money at nearly everything it does. It is in deep serial trouble over Alt-A loans alone.

With that in mind, many have been asking for an update on the WaMu Alt-A pool I have been tracking. The article has been out for some time. The title is certainly not obvious, and those who missed the update can find it in Fannie and Freddie Waterfalls Are Too Big to Bail.

Desperation At WaMu

Think about the implications of a company either desperate enough or dumb enough to issues $billions in shares at $8.75 when the stock was over $13 at the time. The ratchet provisions made it likely those in the deal immediately shorted it. Even if there were short restrictions, there are ways to execute synthetic shorts (writing deep in the money covered calls for example).

Even if TPG took no action on its own accord, others understanding the implications of the ratchet agreements WaMu agreed to, probably shorted the hell out of it. Any company that desperate or that stupid is begging to be shorted into oblivion.

The CEO, CFO, and COO all ought to get fired for agreeing such terms as well as for not seeing the need to raise capital until shares fell to $13. Then again, those executives paid the ultimate sacrifice of foregoing their bonus for a quarter.

WaMu Is Screwed

Washington Mutual is screwed. It cannot raise capital by equity deals even if it wants to. Those who translated "We have no plans to raise capital" into "No Need to Raise Capital" are sadly mistaken.

WaMu desperately needs to raise capital. However, those death spiral financing arrangements it made means WaMu can't raise capital. And if WaMu can't raise capital, it stands to reason it would have no plans to do so.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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