Wednesday, 9 April 2008

WaMu's Great Dilution

I've written repeatedly here about the woes of Washington Mutual. Back in November I noted that Wamu's loan loss provisions would wipe out their entire profit for 2008. That now looks like an optimistic scenario.

The company now expects $3.5 billion in loan loss provision for 1Q08 up from the previously forecast $3 billion and expects costs of $1.4 billion from uncollectible loans. On top of that the company slashed its dividend from $0.15 to $0.01 and plans to lay off 3,000 employees.

Back when Bear Stearns decided to give itself away I noted that it would be worth keeping an eye on WaMu as it was a prime candidate for chapter 11 or to be taken out. Today we learnt that WaMu rejected an offer from JP Morgan to be taken out. Probably because they got a lifeline in the form of $7 billion in capital yesterday.

The company will issue 804 million new shares which amounts to almost a doubling of the number of shares outstanding. That is a massive dilution for existing shareholders who are already staring down the barrel of a 75% drop in the share price. Of course the stock rallied on the news as bankruptcy fears have receeded.

So the bottom callers continue to believe that this another sign that the end is near. However Minyan Peter at Minyanville had a different view yesterday:

WaMu's $7 billion Share Offering Doesn't Spell Bottom

Washington Mutual's (WM) capital raising effort is being cited a sign of a healthy bottoming process.

Despite how it may be portrayed by others in the media, this is an all “common” deal. The distinction between common and preferred is solely due to the number of available shares. Once the existing shareholders approve more common shares, the “contingently” convertible will become common at the same $8.75 per share price.

As I have written previously, when things get worse, banks have to issue common stock. Because of how the bank regulations work, preferred stock “credit” for capital purposes is limited by the amount of common stock below it. With its first quarter writedowns, WaMu had no choice. And importantly, many other banks that have been to the straight preferred and convertible preferred troughs recently in size are in the same position.

Big losses increasingly mean flat out dilution. Ask UBS (UBS), ask Societe Generale. That the market is celebrating all this as a sign of the bottom confounds me. Closer to the bottom? – absolutely, but bottoms are when deals don’t happen.

Be careful about the phrase “increased due to investor demand” – a near 30% discount to market is bound to drum up a little interest. Even with the deal’s generous terms, some of the investors were given additional warrants for agreeing to a five year lock up. Don’t underestimate the role of the regulators telling WaMu how much capital the bank needed to avoid action.

Finally, notwithstanding the company’s current $12.00 trading price, $8.75 is now the ceiling for additional WaMu common equity, should the bank need to come back.

I have a lot of respect for the team at TPG and have no doubt that based on their prior experiences in banking crises, WAMU looks cheap, particularly at $8.75. I would emphasize, however, the phrase “based on their prior experiences in banking crises.”

I think the problem for most market participants right now is that the assumption is what we're experiencing looks something like “their prior experiences in banking crises.” And to me that's why we have seen such a big rally over the past two weeks – because, based on prior experience a rally feels very right, right about now.

But for all the reasons I have shared before, this one is different.