Citi, Merrill, WaMu: Death Spiral Financing

by: Michael Shedlock July 23, 2008 | about stocks: C / MER / WM    
Michael Shedlock

Michael Shedlock

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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. ...

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.

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 (WM) 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 considerWashington 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 considerLack of Transparency = Shareholders Get Ratcheted.

Following are a few highlights from the above lengthy, but well written article. I nquiring 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. ...

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. ...

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.

Add Citigroup To Those In Death Spiral Financing

The above article mentioned Merrill Lynch (MER) and Washington Mutual in death spiral financing schemes. Add Citigroup (C) 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 inFannie 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 deserved 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.

 

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This article has 17 comments:

  •  
    Jul 23 09:06 AM
    Mish,you seem to be the only person on the planet who understands the financials crisis...or the only one willing to express it...hope the mind police don't snatch you up.

    David Fry said in his post that the primary dealers were loaned 20bn yesterday,presumably to prop up the financials....WOW!
    Reply | Link to Comment
  •  
    Jul 23 09:32 AM
    Mr. Shedlock, I grearly appreciate your article. It is a refreshing change of honesty and candor compared to say, MSNBC. It's clear that looking at the details of some of these capital raising agreements makes all the difference in the world.
    If you watch that show for your financial news/information the talking heads and "gurus" would have you believe that the banking crisis is over and that is strong buy sector. These guys have sunk to boiler room operators. What a pity !!!!
    Reply | Link to Comment
  •  
    Jul 23 09:32 AM
    Thanks, I bought Jan puts last Friday on MER & C that are current losers, but you have added courage that the short covering will end sometime this month and more will see the light as additional bad news shocks the "we hit the bottom crowd" that have been scammed again.
    Reply | Link to Comment
  •  
    Jul 23 10:24 AM
    Excellent post and excellent comments. The damage to FDIC when these companies crash will be a wipeout for everyone including the FDIC.
    Reply | Link to Comment
  •  
    Jul 23 11:23 AM
    The "death spiral" clause TPG inserted isn't meant to be taken at face value. What it does is give them a place at the negotiating table if further investment is required. No one is going to sink more dollars into WM if a big slug of it goes right out the door to TPG and crew. The TPG crew owns about half the bank now. If WM continues down it's current path and requires more capital, TPG may be faced with the dilemma, do they want to own 20% of a solvent bank or 50% of nothing. I'll wager on the former.
    Reply | Link to Comment
  •  
    Jul 23 12:49 PM
    Dead Elephant Bounce. I'm beginning to wonder if people watch the cheerleaders at CNBC for a parody to financial news.

    But someone needs to lead the herd by the nose hair.

    Great article/comments.

    California foreclosures up 261%. Hank Paulson claims a "turn in housing in months". 12? 24 months? Which Hank? The primary dealers won't be helping this malfeasence.

    Blasphemy.
    Reply | Link to Comment
  •  
    Jul 23 12:50 PM
    your an idiot
    Reply | Link to Comment
  •  
    Jul 23 04:11 PM
    Hey Axenfic"" Is English your primary language???
    Reply | Link to Comment
  •  
    Jul 23 07:44 PM
    How to explain:
    23-Jul-08 17:24 ET In Play Wachovia CEO bought 1 mln shares at $15.32-17.02 on 7/22 (17.65 +0.86) :
    Reply | Link to Comment
  •  
    Jul 23 11:40 PM
    A popular financial guru on several talk shows advises Americans to send their money to him so that, for a 3% commission, he can invest it for them in dividend paying foreign stocks in order to profit from the U.S. financial collapse. Aren't foreign stocks equally dangerous?
    Reply | Link to Comment
  •  
    Jul 24 04:50 AM
    interesting view point.. whether you agree or not, it's something to think about.
    Reply | Link to Comment
  •  
    Jul 24 09:20 AM
    Not to be picayune, but this is not what was commonly known as "death spiral" financing during the heyday of that instrument. A death spiral was a security whose conversion price was based on a discount to the stock market price; so if a company initially issued a convert at $50, when the stock fell to $40, the convert price fell to $40, and when the stock fell to $10, the convert price fell to $10. NYSE and Nasdaq essentially put an end to these, or at least put a floor under most of them. What these banks face is a "full ratchet" provision in which any subsequent issuances at lower prices triggers more shares issued to the prior purchaser. But at least the issuer remains fully in control over whether another issuance gets done; with the true death spiral, once the instrument was issued, a plunging stock price acquired its own momentum, and there was little the company could do about it.
    Reply | Link to Comment
  •  
    Jul 24 01:41 PM
    where's the disclosure???
    Reply | Link to Comment
  •  
    Jul 24 02:14 PM
    Agreed. Where's the disclosure? Its hard to believe this kind of emotional dreck doesn't have an angle to it.
    Reply | Link to Comment
  •  
    Jul 24 07:56 PM
    First let’s consider Mr Bonderman is not stupid and has more insight into WaMu situation than the average Joe. (You don’t throw 7 Billions into a risky business just for kicks).

    Second, let’s not forget that Mr Bonderman business is into take public properties out of the market and make them private.

    Third, Mr Bonderman said he has no rush to recover his investment and also has a 25 Billion war chest sitting in his lap.

    The terms of the deal with Wamu seems like it was designed to be a first round of financing to take the bank completely, wait a couple of years until the dust settles and cash his way out.

    Let’s assume WaMu needs 6 Billion more capital… I bet he will not commit that kind of money in a completely distressed business without some considerable discount. $3 Dollars per share will be around 30% discount of its current price so for simplification lets use that number (if the price is less than $3 the numbers will be much nicer for him) .

    If that were the case Mr Bonderman will invest 13 Billons, and obtain 72% of the shares at an average price of $3.36 (the book value of the adjusted shares will be $ 7.0).

    Today selloff was about 20% of the outstanding shares and most likely most of today sales were shorts, at first sight this is a no brainer short: either the company goes bankrupt and the value of the shares goes to $0 or there is a new capital injection (PLUS the “full ratchet” compensation) that will dilute the value of the shares considerably, so there is no way to lose …

    But let’s remember that someone is buying at the other side of those short sales… What would happen if some of the friends of Mr Bonderman are actually buying those shares?… What would happen if Mr Bonderman does inject the needed capital AND offers to buy the remainder shares at around $ 7.0 dollars (The new book value) in order to take the company private?

    Oh boy, that would be the perfect short squeeze! The mother of all Bear Traps

    Mr. Bonderman friends don’t need to sell any time soon. The shares will jump in value to the $ 10’s because there wouldn’t be many shares left to sell and many of those shorters may want to cover their bets…

    No matter if Mr Bonderman does indeed buy the remainder shares or not… the shares will be around $7.0 for a 100% return of his investment… And if they manage to pass the storm the bank could easily reach $ 15 in 2 or 3 years down the road…
    Reply | Link to Comment
  •  
    Jul 24 09:15 PM
    Are you shorting these stocks? If you are, then you are biased.
    Reply | Link to Comment
  •  
    Jul 25 12:49 PM
    Merrill is and has always been a $45 stock going by old standards.
    the problem Mother merrill is having is inside it`s own doors - Enter the new commander in chief / savior of the falling giant.
    mother Merrill has more sleeves with more tricks to show us - this is a good buy time.
    Billle toe dreamer.
    Reply | Link to Comment
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