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1 Page 1 of 6 JPMorgan: Closes Asset Deal For WaMu With FDIC, Bondholders Stranded? Company Article: 26 Sep 2008, 12:48 AM ET JPMorgan announced late Thursday that it had acquired deposits, assets and certain liabilities of WaMu's banking operations from the FDIC effective this evening Prior to this deal, WaMu was placed in receivership by the OTS with FDIC as receiver of residual holdings post-deal Excluded from JPM transaction: senior unsecured debt, subordinated debt and preferred stock of WaMu's banks. Also excluded: WaMu's holdco assets and liabilities and the holdcos' non-bank subsidiaries JPM finds the deal immediately accretive to earnings adding $0.50 in 2009 JPMorgan to issue $8 billion of common stock in order to support its capital ratios following the deal Deal creates the largest U.S. depository institution with $900 billion+ of customer deposits JPM gets new presence in California, Florida, Washington with second largest nationwide branch network WaMu bondholder value in question in unique structure with cash at holding company seemingly benefiting holding company creditors ahead of bank level; still more details to hash out Well just as things looked like they could be stabilizing in the U.S. banking system, the markets kept financial company analysts on their toes yet again with a breakdown in the bailout talks and a deal for Washington Mutual by JPMorgan. The deal structure seems to be unprecendented in that it excludes bondholders at the holdco and bank levels from the the major assets and liabilities of the operating bank. It also removes the troubled assets from the company as well so that these are not recoverable assets. Basically the bank was closed by the primary regulator (OTS) and put into FDIC receivership as worsening liquidity led to safety and soundness issues. Interestingly, uninsured deposits as well as FDIC insured deposits travel to JPMorgan in its purchase so that all depositors' value remains intact. Under this plan the FDIC will make money ($1.9 billion) as JPMorgan pays it for the operating unit assets and liabilities excluding the debt and preferreds. After the regulatory actions, JPMorgan executed an asset purchase for the operating units of the franchise honing in on the most valuable parts including the deposit rich branch system. Interestingly, JPM bought the troubled assets and will be taking material fair value adjustments ($30.8 billion) as part of the closing process which wipes out the net asset value of the disposed of bank. Combined with a common stock raising move ($8 billion) planned for Friday morning, JPM believes that on a pro forma basis that it will have a well capitalized bank (Tier 1 of 8.3%) with stabilized liquidity and bright earning prospects as it is viewed as immediately accretive. In its conference call, JPM noted that it is prepared for the economic environment severe scenario (an $18 billion swing in additional credit provisions), but still believes that it could still generate operating earnings from WaMu's legacy units that would offset those writedowns over a short time frame (within three years). At this early writing, it seems that WaMu's major debt holders have been stranded by regulatory intervention and have access to the limited assets at the holdco and non-bank subisidiaries holdings. So, as we have been suggesting in the past couple of weeks in our various reports (see: WaMu: CCC-ut by Agencies, Holding Out for Canadians or Going Over the P/A?, U.S. Banks: TARP Testimony: Start/Sputter Bank Restructuring Process?, WaMu: More-or-Less Scenarios With New RTC?, WaMu: Possible Acquisition By JPMorgan - Exploring The Merger Math, WaMu: Update of Credit/Capital/Liquidity Dynamics), WaMu was becoming a binary outcome, and with the actions tonight, the worst case developed for the major credit instrument holders. With politicians arguing over the remolding of the bank bailout proposal, it seems that once again, JPMorgan took advantage of a banking industry problem and was able to quickly size up the credit exposures and structure a transaction to protect its interests and enhance shareholder value. So, this time it took the troubled assets, unlike in the Bear Stearns deal where it offloaded them to the NY Fed's balance sheet. WaMu's weak liquidity profile had forced the issue for regulators to act quickly and with no other savior merger partners nor likely private equity investor options, JPM was in the driver's seat and drove this hard bargain that does not benefit WaMu bondholders. Recovery Analysis The conventional wisdom for recovery analysis is that the closer the claimant is to the assets, the stronger their claim is. Following the sale of substantially all the assets of Washington Mutual Bank to JPMorgan Chase, we believe in this case, the bulk of the assets remaining in the Washington Mutual
2 Page 2 of 6 legal structure reside at the holding company, Washington Mutual Inc. (WMI). After accounting for debt maturities and dividend payments, we estimated that WMI had cash and equivalents of about $2.3 billion of before the TPG capital investment of $7 billion (see: WaMu: Update of Credit/Capital/Liquidity Dynamics). According to the OTS Fact Sheet, WMI infused about $6.5 billion of the TPG capital into Washington Mutual Bank (WMB), leaving an estimated $2.8 billion of capital remaining at WMI. At this writing, we believe this cash balance comprises the bulk of the assets available for bondholders. Due to WMI being a thrift holding company, regulators have the ability to force the holding company to downstream capital to support the bank subsidiary. Now that there is no operational bank subsidiary, this creates some level of uncertainty of whether or not the cash will remain at the holding company. Therefore at this early read, we see two recovery scenarios. Scenario 1 WMI (the holding company) Keeps the Cash We estimate that WMI had about $5.7 billion of unsecured bonds, including $4.1 billion of senior debt and $1.6 billion of subordinated debt. If the cash remains at the holding company, we estimate that senior unsecured creditors at this level may see a recovery in the high $0.50 range, while subordinated claims may be able to see an ultimate recovery up to $0.10. Based on a discount rate of 20% and a year and half until recovery, we estimate the senior unsecured bonds at WMI could trade in the mid- $0.40 range with the subordinated debt trading around $0.08. In this case, and somewhat perplexing, there then could be extremely low recovery on the debt at the Bank subsidiary. Scenario 2 WMB (the bank) Gets the Cash If the cash is brought to the bank level, for reasons we are trying to investigate, we estimate the recovery on the $14.8 billion of senior debt at the Bank to fall in the mid-to-high teens, with minimal recovery on the $7.9 billion of subordinated debt. Based on a discount rate of 20% and a year and half until recovery, we estimate the senior unsecured bonds at WMI could trade around $0.13. In this case, we would expect extremely low recovery on the debt at the holding company level (WMI). In both scenarios, we expect the $3.4 billion of preferred stock and other equity claims to see minimal recovery. We note that the regulatory actions are an exchange event on the REIT preferred securities, meaning these securities are scheduled to convert into perpetual non-cumulative preferred stock of WMI. We stress recoveries in a regulated financial services company tend to be more art than science and assumptions can change rapidly as more information surfaces. We will continue to update our analysis as new data and information becomes available. Below we detail the transaction as well the strategic benfits to JPMorgan. We will in due time release followup reports on the implications of these moves for Wachovia and its heavy credit exposure level and possible implications for Countrywide. JPMorgan announced late Thursday evening that it would acquire all deposits, assets and certain liabialities of WaMu's banking operations from the FDIC effective immediately. According to a OTS Fact Sheet: "Pressure on WaMu intensified in the last three months as market conditions worsened. An outflow of deposits began on September 15, 2008, totaling $16.7 billion. With insufficient liquidity to meet its obligations, WaMu was in an unsafe and unsound condition to transact business. The OTS closed the institution and appointed the Federal Deposit Insurance Corporation (FDIC) as receiver. The FDIC held the bidding process that resulted in the acquisition by JPMorgan Chase." The announcement came just a week after reports that WaMu had put itself up for auction. However, it seems the company had difficulty attracting bidders due to its troubled mortgage exposures and
3 Page 3 of 6 uncertain status of the governments bank bailout proposal known as "TARP". We sense that the JPMorgan transaction was done at the behest of the banking regulators, who have reportedly been actively involved in prompting WaMu to find a buyer. The transaction involves JPMorgan taking on WaMu's branches, deposits, and its loan assets. However, JPMorgan Chase is not acquiring any of unsecured debt or preferred stock WaMu Bank or any of the assets or liabilities of the holding company nor the holding company's non-bank subsidiaries. Unfortunately, as we described in a recent note (see: WaMu: More-or-Less Scenarios With New RTC?), it seems this transaction therefore is closer to FDIC "purchase and assumption" route. As we stated in that report, "the purchase and assumption route could be similar to the Lehman broker case with Barclays buying the good assets and leaving the troubled ones with the bankrupt holding company, unfortunately where the bulk of the bondholder claims reside." So, it seems that we have entered a more hostile world for bank holding company and bank level creditors that has not been tested until recently under the FDIC Act of 1991 rules. Big bank failures of the 1980s and very early 1990s where significant debt was involved did not go by these rules which were not retroactive. Still, these regulatory actions should make debt capital raising for moderate risk banking companies low-a and below much more difficult going forward. TARP Not A Factor JPMorgan CEO Dimon stated that it did not do the WaMu deal in light of the possibility for TARP. JPMorgan noted that it wanted to "win the bidding" for the long-term franchise improvement that it would bring to the company. However, CEO Dimon noted that he supported the actions by Congress to create the TARP even though they did not know if JPM would even use it. Recent Events Overtook WaMu Quickly The end for WaMu came quickly, as just three weeks ago WaMu appointed a new CEO and preannounced its third quarter earnings. In the pre-release, the company affirmed its available liquidity "with approximately $50 billion of liquidity from reliable funding sources" and that the company expected its regulatory capital ratios to remain "sufficiently above the levels for well-capitalized institutions" for 3Q08. As of 2Q08, WaMu's leverage ratio (7.76%) and total risk-based capital ratios (13.93%) were both significantly above the regulatory well capitalized threshold of 5% and 10%, respectively. So, it seemed at the time that WaMu's position, while weak, was not much different than it has been for some months. According to press reports, the regulators felt WaMu had insufficient liquidity to continue operating. Beginning on September 15, WaMu had deposit outflows of $16.7 billion according to the OTS. The OTS considered that WaMu was in "unsafe and unsound" condition as a result of this deposit outflow and was then closed by the OTS. The OTS appointed the FDIC as receiver for Washington Mutual and then the FDIC held a bidding process which resulted in the JPMorgan deal. Details of the Transaction JPMorgan Chase announced it acquired all deposits, assets, and certain liabilities of Washington Mutual s banking operations from the FDIC, effective immediately. Excluded from the transaction are the senior unsecured debt, subordinated debt, and preferred stock of Washington Mutual s banks. JPMorgan Chase will not be acquiring any assets or liabilities of the parent holding company or the holding company s non-bank subsidiaries. For the transaction, JPMorgan Chase will make a payment of approximately $1.9 billion to the FDIC. Capital Effects JPMorgan announced that it would offer $8 billion of common stock in order to maintain its common equity ratios following the deal. Pro forma for the deal and the capital raise transaction, the estimated tangible equity ratio will be 4.3%, down from 4.6%. The estimated leverage ratio would be 6.9%, Tier 1 ratio would be 8.3%, and total capital ratio of 12%. JPMorgan's Shareholder Value Proposition The acquisition of Washington Mutual s banking operations is expected to be immediately accretive to earnings and to add more than $0.50 per share in JPMorgan Chase expects to incur pretax merger costs of approximately $1.5 billion while achieving annual pretax cost savings of approximately $1.5 billion by 2010, net of significant investments in the business. The bank plans to complete most systems integrations and rebranding by year-end 2010, closing less than 10% of branches in the combined network in overlapping markets. In conjunction with this acquisition, JPMorgan Chase will be marking down the acquired loan portfolio by approximately $31 billion, which primarily represents our estimate of remaining credit losses related to the impaired loans. JPMorgan Chase intends to raise additional capital in connection with this transaction to maintain the company s strong capital position.
4 Page 4 of 6 Hot Stove Loss Estimates Comparison In recent reports we recently stress tested WaMu s residential mortgage portfolio using three scenarios (base case, conservative case, and severe case). JPMorgan s remaining life loss estimates were similar to our middle case (conservative case), which included option ARMs (20% vs. JPM s 20%), first lien mortgages (3% vs. JPM s 5%), home equity (20% vs. JPM s 23%), and subprime (30% vs. JPM s 40%). We also factored in loss estimates for CRE (8%), residential construction (10%), and credit cards (2x current rate). Using our above assumptions we estimated that total losses would amount to roughly $29.6 billion, which is in-line with JPMorgan s estimated marks of $30.9 billion (see: WaMu: Update of Credit/Capital/Liquidity Dynamics). In our analysis when including year-to-date provisions, internal capital generation, as well as other potential capital options (cost savings, balance sheet reductions), the company s Tier 1 ratio could decline to about 6.8%. However, following the recent events surrounding the GSEs, the market for hybrid securities has closed for now and as a result, even if WaMu were to utilize all its remaining potential capital options, its Tier 1 ratio could decline to about 6.6%. We also indicated that in such a scenario, the company may need to raise an additional $1.5 billion to $3 billion+ in capital in order to get to the comfort zone of a Tier 1 level of 7.5%. Additionally, our severe case s total losses ($43.2 billion) are in-line with JPMorgan s deeper recession estimate ($42 billion). JPM's deeper recession scenario leads to higher remaining life losses ($8 billion) versus the current estimates used in the fair value markdown. The company indicated that its loss estimates assume a peak to trough HPA of -28% for the entire U.S., including California (-48%), and Florida (-49%), as well as unemployment at 7.5%. Our severe case loss rate assumptions included option ARMs (35%), first lien mortgages (3%), home equity (30%), and subprime (35%). In this scenario, we estimated that WaMu s Tier 1 ratio would decline to around 3.1% even after factoring in potential capital options including balance sheet reductions, cost savings and estimated hybrid security capacity. However, when excluding the potential hybrid security capacity, the company s Tier 1 ratio would drop below the 3% threshold to about 2.9%. We note that if a bank s Tier 1 ratio declines below 3%, it could be deemed to be significantly undercapitalized, which could require the company to undertake prompt corrective actions including the need to recapitalize the bank, and restrict correspondent deposits and other above-market deposit taking. So while these severe conditions were not fully baked into JPM's base case purchase structure, we sense that WaMu's dwindling capital options, skittish investors and depositors, and negative rating agency actions, eventually forced the regulatory intervention earlier rather than waiting for this to develop even worse and possibly expose the FDIC funds to more material loss exposure. Pro Forma Branch Footprint The acquisition expands Chase s consumer branch network into California, Florida, and Washington and creates the nation s second-largest branch network with 5,400 branches in 23 states. The acquisition also extends Chase s retail branch network to additional states, including Georgia, Idaho, Nevada and Oregon. JPMorgan will become the leading depository with $911 billion of deposits globally, pro forma for its acquisition of WaMu. We believe that pro forma JPMorgan would have the second largest deposit concentration in the U.S. with a market share of around 10.5%, just behind Bank of America (10.8%).
5 Page 5 of 6 Bank Regulators Appear to Have Taken Active Role Although we note the OTS comments on WaMu's liquidity, we note that this amount of deposit outflows should have been able to be replaced with secured borrowing sources such as FHLB advances, according to the company's availability. So, we cannot rule out is that WaMu attracted extra attention from the bank regulators based on its size as the 6 th largest depository in the U.S. Given our own, JPM's and probably the OTS' bleak credit exposure outlook, we can only sense that the regulator thought acting faster to intervene now was better and transferring the operating business to a stronger big bank player was better than WaMu limping along further with FHLB and other above-market CD deposits. In a sense OTS was early intervening in order to dial down potential retail deposit skittishness for this bank and reducing the knock-on effects to others. It therefore was promoting a business as usual atmosphere continued in the retail branches. So, we sense the OTS and FDIC acted more aggressively to ensure the safety of depositors through the transaction with JPMorgan Chase. JPMorgan's Previews 3Q08 Earnings JPMorgan also provided a preview of its 3Q08 earnings. JPMorgan noted that its investment bank would be profitable for 3Q08. This includes various items such as markdowns of $3.0-$3.5 billion on mortgage related assets and leveraged loans, a $400 million provision for credit losses, and a $1 billion benefit for credit spread widening. In Retail Financial Services, JPMorgan expects net charge-offs continue to trend higher and expects a $600+ million addition to the allowance for loan losses for the subprime and prime mortgage portfolios. For Card Services, the company noted that net charge-offs are performing as previously disclosed in range of 5%+. The company noted that other businesses, such as Securities Services and Asset Management remain "on track" versus prior outlook. In the corporate segment, JPMorgan expects to take $1.2 billion pretax write-down related to preferred stock of Fannie and Freddie. Additionally, there will be an auction-rate securities buyback charge of approximately $400 million pre-tax. JPMorgan expects increased credit costs related to prime mortgage portfolio. JPMorgan noted that the WaMu transaction has closed immediately. So, this transaction will have income statement accounting impact in 3Q08. JPMorgan expects no extraordinary gain for the deal. Approximately $2 billion addition to allowance for loan losses (conforming accounting booked above the line). Published in: European Morning Comment [September 26] David Hendler Baylor Lancaster Pri de Silva Adam Steer dhendler@creditsights.com blancaster@creditsights.com pdesilva@creditsights.com asteer@creditsights.com
6 Page 6 of 6 Copyright 2009 CreditSights, Inc. All rights reserved. Reproduction of this report, even for internal distribution, is strictly prohibited. The information in this report has been obtained from sources believed to be reliable. However, neither its accuracy and completeness, nor the opinions based thereon are guaranteed. If you have any questions regarding the contents of this report, contact CreditSights, Inc. at (1) in the United States or (44) in Europe. CreditSights Limited is authorised and regulated by The Financial Services Authority. This product is not intended for use in the UK by Private Customers, as defined by the Financial Services Authority.
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