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Originally published April 22, 2010 at 11:05 PM | Page modified April 25, 2010 at 9:15 AM

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WaMu hearings reinforce picture of a deteriorating bank

During two closely followed hearings earlier this month, a Senate investigative panel exhaustively documented Washington Mutual's slapdash lending practices and inadequate risk management, and took the defunct thrift's regulators to task for feeble oversight and petty infighting.

Seattle Times business reporter

WaMu's last year

December 2007: WaMu shares hit an 11-year low after it cut its dividend by 73 percent. The company says it's cooperating with an SEC inquiry stemming from allegations by N.Y. Attorney General Andrew Cuomo that it made mortgage loans based on improperly inflated home appraisals.

Jan. 17, 2008: WaMu posts its first annual loss since Ronald Reagan was president, due to fourth-quarter red ink of $1.87 billion.

Feb. 28: The Office of Thrift Supervision, WaMu's primary regulator, lowers the bank's risk rating from 2 (where it had been since at least 2003) to 3.

April 8: Investors led by David Bonderman's TPG pump $7.2 billion into WaMu, getting just over 50 percent of the company at $8.75 a share. WaMu reports a $1 billion quarterly loss and says it will close 186 remaining stand-alone mortgage offices, laying off 2,600 to 3,000 workers.

June 2: Kerry Killinger is removed as chairman, replaced by board member Stephen Frank. Killinger is still CEO.

June 17: WaMu says it is cutting 1,200 more jobs, including 260 at its downtown Seattle headquarters.

July 14: Investors worried about the financial sector's weakness send WaMu shares down 35 percent to $3.23, a level not seen since February 1991. In wake of failure of IndyMac Bank, worried WaMu depositors begin pulling large sums from their accounts.

July 22: WaMu posts a $3.3 billion second-quarter loss.

July 31: FDIC suggests WaMu find a "strategic partner" to help address its capital needs.

Sept. 7: CEO Killinger is forced out, replaced by outside banking executive Alan Fishman. WaMu signs agreement with OTS, requiring it to correct deficiencies and devise a plan to raise new capital. U.S. government takes control of mortgage giants Fannie Mae and Freddie Mac.

Sept. 14-19: Lehman Brothers files for bankruptcy protection, Merrill Lynch is rescued by Bank of America and the federal government takes over insurer American International Group. WaMu's shares sink to $2.01.

Sept. 25: After depositors withdrew $16.7 billion in 8 days, regulators seize WaMu and arrange a sale to JP Morgan in the largest bank failure in U.S. history.

Source: Seattle Times archives

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During two closely followed hearings earlier this month, a Senate investigative panel exhaustively documented Washington Mutual's slapdash lending practices and inadequate risk management, and took the defunct thrift's regulators to task for feeble oversight and petty infighting.

But the Permanent Subcommittee on Investigations barely touched on two questions that are of intense interest to many people here, if not in the other Washington:

Did WaMu really need to be seized in September 2008, and was the sale of its banking operations to JPMorgan Chase for $1.9 billion on the up and up?

Those questions — and they are two separate issues, though often linked — have consumed some WaMu shareholders and former employees, who vociferously argue that WaMu could have survived, or at least fetched more than what JPMorgan paid.

Longtime Chief Executive Kerry Killinger, who was ousted weeks before WaMu was shut down, told the panel the seizure was "unnecessary" and contended WaMu should have gotten a chance to work its way through the crisis.

But later testimony from the Office of Thrift Supervision and the Federal Deposit Insurance Corp. depicted a bank that was running critically low on cash and losing access to its backup funding sources.

"Critics may say it was overly harsh to close WaMu, but the reality is that mortgage losses were mounting, (credit) downgrades were occurring, and efforts to raise capital had been exhausted," the FDIC said in written testimony.

"The institution had already gone through one major deposit run and was in the midst of another. The franchise value of WaMu was dissipating rapidly. Action had to be taken."

Here's a rundown of the major questions surrounding WaMu's closure and what, if anything, was learned during the hearings.

Cash shortage

Unlike most of the banks that have failed since, WaMu was not undercapitalized at the time of its closure. In fact, by regulatory standards it was considered "well-capitalized," a fact often cited by critics as evidence the thrift was fundamentally sound.

Capitalization, though, isn't the same as overall financial strength. What sunk WaMu wasn't a shortage of capital but a lack of liquidity.

The distinction is critical. Capital — essentially shareholders' stake in the company plus reserves — is an accounting notion that allows a bank to get unexpected losses off its books; when such losses are written off, capital is reduced accordingly. Liquidity — basically ready access to cash — allows the bank to give depositors their money when they ask for it and generally carry on its day-to-day business.

In his testimony, Killinger said that when he left WaMu on Sept. 8, "deposits were stable, sources of liquidity appeared adequate, and (the OTS) had not directed us to seek additional outside capital."

But after Lehman Brothers went bankrupt Sept. 15, panic spread throughout the financial system. WaMu's depositors pulled out $16.7 billion, nearly 10 percent of total deposits, in the eight days after Lehman's failure.

As a consumer-oriented bank, WaMu relied on customers' deposits as its chief source of liquidity. But WaMu was particularly vulnerable to a deposit run: As of June 30, the last date for which WaMu filed full financial reports, 38 percent of its deposits, or $69.3 billion, was in easily moved nonretirement accounts with balances greater than $100,000 — the FDIC's insurance limit at the time. Such large, partially insured deposits were prone to leaving in times of uncertainty.

WaMu already had experienced a $9.1 billion run earlier that summer, which was reversed only after the bank began paying above-market interest rates on big deposits. This time, according to the FDIC, customers had begun requesting cash payouts rather than accepting official WaMu checks — a clear sign trust in the thrift was evaporating.

Bank runs are regulators' worst nightmare, because of the potential to create panic that can spread beyond troubled banks to healthy ones. Michael Ruggio, a former senior counsel at the FDIC, said in an interview that regulators generally want to act before a bank becomes insolvent and depositors can't get at their money.

One new piece of liquidity data that FDIC Chair Sheila Bair gave the Senate panel: By Sept. 24, WaMu had just $4.4 billion in cash on hand — what she called "a dangerously low amount for a $300 billion institution that had seen average daily deposit withdrawals exceeding $2 billion in the previous week." WaMu was taken over the next day.

Sources of liquidity

A person close to Killinger and familiar with his thinking said focusing on cash on hand could be misleading, because it ignored other sources of liquidity available to WaMu. Killinger, that person said, continues to believe that WaMu has ample sources of liquidity, at least up to the time he left the bank.

But while that may have been true in early September, a few weeks later those sources were drying up fast.

WaMu's main alternatives would have been borrowing from the Federal Home Loan Banks in Seattle and San Francisco and the Federal Reserve's discount window. But the FDIC said that by mid-September those sources combined were less than $10 billion, and that they were preparing to cut WaMu's borrowing capacity further because of the thrift's deteriorating asset quality — namely, the shaky mortgages on its books.

The OTS, in its testimony, added that "most WaMu assets that were not already pledged as collateral for borrowings at the FHLBs or the Federal Reserve Bank (of San Francisco) were of either insufficient quality to secure other borrowings or were not readily saleable."

An internal WaMu analysis from the summer of 2008, made public by the subcommittee, shows starkly what would happen in the event of "significant deposit runoff and loss of wholesale funding sources" — precisely the situation WaMu faced in late September 2008.

Under such a "break the bank" scenario (as the company itself labeled it), WaMu predicted that the $47.3 billion in excess liquidity it had in June 2008 — essentially its total emergency credit line — would be exhausted by the end of October.

The person close to Killinger said he was not familiar with either the "break the bank" analysis or the regulators' comments about narrowing access to the Federal Home Loan Bank and the Federal Reserve discount window, and could not comment on either.

Some also have speculated that had regulators held off seizing WaMu, the Troubled Asset Relief Program that was enacted Oct. 3 could have provided it with needed liquidity. However, the first batches of TARP money weren't given out until Oct. 28 — close to the time WaMu, under its own stress scenario, would have been completely out of cash.

Nor is it certain that WaMu would even have qualified for a TARP infusion. Consider Cleveland-based National City Bank, which faced many of the same issues.

Shortly after the TARP legislation was passed, National City asked its primary regulator, the Office of the Comptroller of the Currency, whether it should apply for a cash infusion. According to published reports, Comptroller John Dugan told the bank not to bother, and instead urged it to sell itself. Within a week, National City agreed to be bought by Pittsburgh-based PNC Financial Services Group for less than its market value.

JPMorgan's role

Which raises a final question: Did the FDIC, deliberately or not, scupper WaMu's efforts to sell itself, and instead hand the thrift to JPMorgan Chase for a bargain price?

A long-awaited report on WaMu's failure by the inspectors general for the Treasury Department and the FDIC deferred comment on whether the FDIC's resolution process "complied with applicable laws, regulations, policies and procedures." That assessment won't be released until continuing litigation is completed.

Based on documents made public in the various lawsuits swirling around WaMu, there seems little doubt that the FDIC was in contact with JPMorgan well before the Sept. 25 closure. But that in itself would not be considered improper, former agency officials and banking attorneys say.

When regulators decide a bank has to be closed, the FDIC typically contacts a handful of potential acquirers who've been pre-screened to make sure they can handle a deal of that size. The agency asks if they're interested in bidding, and provides financial data about the target — all out of sight of the troubled bank itself.

The FDIC had a strong incentive to find a buyer for WaMu quickly: It had estimated that liquidating the massive thrift would cost it anywhere from $25.3 billion to $57.8 billion; even a $40 billion hit would have emptied the agency's deposit insurance fund.

JPMorgan, whose offer to buy WaMu for the equivalent of $8 a share had been spurned earlier in 2008, was known to still be very interested. And in the end, though a few other banks kicked the tires, the only actual bidders were JPMorgan and Citigroup.

But Citi's offer didn't conform to the FDIC's ground rules. According to documents released late last week to The Wall Street Journal, the Citi proposal contained no upfront cash, would have had the FDIC absorb most of WaMu's loan losses, and would have capped Citi's exposure to $10 billion. Citi also didn't want to assume WaMu's uninsured deposits.

JPMorgan's conforming bid, on the other hand, contained no "loss sharing" agreement, assumed all of WaMu's deposits and paid the FDIC $1.88 billion.

William Isaac, who as chairman of the FDIC from 1978 to 1985 oversaw his fair share of bank closures, said WaMu was hardly unique: The banks and other financial institutions that ran aground in the chaotic days of September 2008 were all handled differently.

"We went from transaction to transaction hurtling along in a very inconsistent manner, and that spooked the market," Isaac, now head of consulting firm LECG's global financial-services practice, said in an interview before the hearings, "No one could tell who was going to fail next or how the failure would be handled."

Given that context, he said, the decision to sell WaMu to JPMorgan came down to a "judgment call."

"The FDIC had a buyer for WaMu that wasn't going to cost the FDIC any money, that would resolve the situation in an orderly way and take that problem off the table," he said. "The FDIC decided to take the bird in the hand and resolve it quickly rather than let it go on."

Drew DeSilver: 206-464-3145 or ddesilver@seattletimes.com

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