The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

The well-publicized settlement this past week of the FDIC’s lawsuit against three former officers of the failed WuMu bank was widely reported as having a value of $64.7 million. A closer look at the parties’ December 15, 2011 settlement agreement reveals some interesting details about the settlement, including the specifics of how the FDIC came up with the reported $64.7 million figure for the settlement. The settlement documents also raise some interesting questions.

Washington Mutual Bank failed on September 25, 2008, in the largest bank failure in U.S. history. As discussed here, in March 2011, the FDIC as receiver for the failed bank filed a lawsuit in the United States District Court for the Western District of Washington against WaMu’s former CEO, Kerry Killinger, its former President and COO, Stephen Rotella, and its chief of home lending, David Schneider. The FDIC’s complaint also names Killinger’s wife, Linda Killinger, and Rotella’s wife, Esther. The three former officers were alleged to have caused the bank’s demise through the aggressive residential lending strategy the bank pursued. The claims against the officials’ wives were based on claims that the spouses had arranged to transfer ownership of residential properties in order to evade creditors.

There was other litigation filed in connection with the events surrounding WaMu’s collapse, including a securities class action lawsuit separately filed against certain former directors and officers of WuMu; the bank’s offering underwriters; and its auditors. As discussed here, in July 2011, the securities class action lawsuit settled for $208.5 million, of which $105 million was to be paid on behalf of the former directors and officers. The entire $105 million amount was to be funded by the bank’s D&O insurance.

Although there were advance reports that the FDIC’s lawsuit against the former WaMu executives had settled, the FDIC did not formally announce the settlement until December 15, 2011. The FDIC’s press release announcing the settlement can be found here. The FDIC also released a detailed summary of the settlement, which can be found here.

As explained in the FDIC’s press release and in the accompanying summary, and as detailed in the parties’ settlement agreement, the $64.7 million settlement consisted of several components. The actual cash component of the settlement totaled only $40 million, of which $39.575 million is to be paid on the individual defendants’ behalf by the bank’s D&O insurers. The various insurers in the D&O insurance program that is contributing to the settlement are identified on page 2 of the settlement agreement, as well as in Exhibit A to the settlement agreement. In addition to the cash amount to be paid by the D&O insurers, a total of $425,000 in cash is to be paid by the three former officers ($275,000 from Killinger; $100,000 from Rotella; and $50,000 from Schneider). 

The remaining $24.7 million nominal value of the settlements consists of the transfer to the FDIC of certain claims the three individuals have filed in connection with the bankruptcy proceedings of WaMu’s corporate parent holding company. The amount and type of these claims varies among the three individuals, but basically the claims consist of various types of retirement, severance or bonus compensation to which the three individuals claim they are entitled.

In addition to the $64.7 million settlement of the FDIC’s action against the three former officers and two of their wives, the FDIC’s December 15 press release also mentions a separate $125 million settlement agreement. Though the information the FDIC provided about the $64.7 million settlement is quite detailed, the FDIC’s press release provides few details regarding this separate $125 million settlement. The press release says only that when the $64.7 million settlement is “combined with the $125 million settlement that the FDIC will receive under the settlement agreement with WMI [the bankrupt holding company] to release its claims against 12 former WaMu directors and other officers, this settlement will result in payments and turn over of claims totaling $189.7 million.”

There are a number of interesting things about the settlement and the settlement documents.

First, the settlement against the three executive officers may have a nominal face value of $64.7 million, but the actual value could prove to be substantially less. The individuals’ claims in the bankruptcy proceeding are among the many claims asserted by unsecured creditors and are also subject to whatever defenses the bankrupt estate may have. The ultimate value the FDIC actually receives from the assignment of these claims might be nowhere near the face values claimed in the various settlement documents.

Second, the D&O insurers’ $39.575 million contribution to the settlement could use a little more elaboration. The D&O insurance program described in the settlement agreement consists of $100 million, arranged in six layers. One might assume that the insurers’ $39.575 million contribution to this settlement represents all or substantially all of the proceeds remaining in the insurance program, owing to the erosion of the limits through the accumulation of defense costs. That is probably what happened, But what is hard to figure is how this insurance and the insurers’ $39.575 million settlement contribution fits in with the other settlements described above, particularly the securities class action settlement and the separate $125 million settlement mentioned in the FDIC’s press release.

As noted above, D&O insurers are to contribute $105 million to the securities class action lawsuit settlement. If this amount seems hard to square with the $100 million insurance program described in the FDIC’s settlement agreement with the three executives, it is probably because the D&O insurance contribution to the securities class action settlement was a drawn from a separate tower of insurance. Indeed, stipulation of settlement relating to D&O portion of the securities class action lawsuit describes a very different insurance program than the one the FDIC describes in the more recent settlement. The class action settlement documents describe a $250 million insurance program (not a $100 million program), consisting of a different line up of carriers than listed in the FDIC settlement documents. Although it is hard to tell from the much less detailed description of the insurance tower in the FDIC’s settlement documents, it looks as if the FDIC settlement is to be funded out of a separate tower of insurance, perhaps relating to a separate policy year.

If it is hard to square the details of the FDIC settlement and the securities class action settlement, the separate $125 million settlement is a real puzzle. The FDIC’s press release does not explain the source of funds for the $125 million settlement. Indeed, it is hard to tell from the FDIC’s press release exactly what is going on with the $125 million settlement. The FDIC’s press release describes it as a “settlement agreement with WMI to release its claims against 12 WaMu directors and other officers.” This sentence is confusingly written, but it seems to suggest that the settlement is between the bankrupt holding company and the FDIC, and the $125 million is to be paid (by whom?) in order to secure from the FDIC a release of the FDIC’s claims against the bank’s former directors and officers.

From the comments about the $125 million settlement in the press, I am making the guess that the bankrupt estate agreed to pay the amount on the theory that if the FDIC sued the various other directors and officers, these directors and officers would be entitled to indemnification. The estate agreed to pay the $125 million, in exchange for the FDIC’s release of its claims, without the FDIC having to actually go through the necessity of actually filing a lawsuit against the other directors and officers.

Whatever else may be said about the $64.7 million settlement, it is undeniable that the three executives were called upon to contribute to the settlement out of their own assets, both in the form of cash contributions and in the form of the surrender of rights the individuals themselves undoubtedly considered to be valuable. I emphasize this because one of the questions I have repeatedly asked during the current banking crisis is whether the FDIC will seek to recover from the personal assets of directors and officers of failed banks. The FDIC’s settlement with the three executive officers shows that the FDIC may indeed seek to recover from the personal assets of individuals. One might speculate that the FDIC’s actions may have something to do with the fact that the WaMu collapse was the largest bank failure in U.S. history. It is hard to know the extent to which that aspect of this settlement is relevant to what approach the FDIC might take in connection with its other failed bank lawsuits.

While the individual executives did indeed contribute toward the settlement out of their own assets, the settlement has been criticized, mostly on the theory that the individuals did not contribute enough. For example, in her December 17, 2011 column in the New York Times, Gretchen Morgenson referred to the $64.7 million settlement as representing only a “pittance” and as “small potatoes.” She gripped that much of the cash value is to be funded by D&O insurance.

For myself, I am unprepared to judge the settlement. I would need to know more about the amounts remaining under the insurance policies. I would also need to understand more about the interaction between the amount of the FDIC’s recovery from the three executives; the three individuals’ rights of indemnification from the bankrupt estate; and the $125 million settlement. (Morgenson suggests that any additional recoveries from the individuals, if indemnified by the estate, would simply reduce the $125 million settlement.)

The reality is that if the FDIC had pressed for greater recovery or a larger settlement, it is possible that all the FDIC would have accomplished would have been further erosion of the remaining D&O insurance limits through the accumulation of additional defense expenses. The end result likely would have been an even smaller recovery. The $64.7 million settlement may not satisfy Morgenson and others, but it may have been the best available.

I will say that one particular criticism of Morgenson’s is misplaced. She disparages the settlement as a “wrist slap” and “yet another example of the minimalist punishment meted out to major players in the credit boom and bust.” Morgenson’s criticism fundamentally misperceives the nature of the FDIC’s action against the WaMu executives.

The FDIC’s action, in its role as WaMu’s receiver, was never intended as a means to administer punishment. Receivership actions are simply salvage operations, intended to try to reduce (or rather, offset) the failed bank’s losses. Whether punishment is to be sought is the business of other agencies and regulators – the Department of Justice, the OCC and the SEC. (Indeed, in the FDIC has referred cases to the DoJ and the SEC where the circumstances surrounding a bank’s failure appear to warrant, as apparently was the case with the failed United Commercial Bank, about which refer here [scroll down]). Whether or not these agencies’ inaction in connection with WaMu’s failure may fairly be criticized, it is not a fair criticism here that the FDIC acting as WaMu’s receiver was insufficiently punitive. The administration of punishment is simply not the FDIC-R’s role.

The FDIC as receiver for the failed WaMu bank sought only to maximize its recovery of dollars, and that I strongly suspect that the settlement they reached with the three executives offered the best opportunity for the agency to maximize its dollar recovery.

Special thanks to a loyal reader for providing me with a link to the FDIC’s settlement agreement.

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As recently as this past Monday, commentators were grumbling that the FDIC is moving too slowly in pursue claims against former directors and officers of failed banks. The FDIC has responded in dramatic fashion with a March 16, 2011 lawsuit filing in the Western District of Washington against three former Washington Mutual executives, as well as two of the executives’ wives.

According to news reports (here), the lawsuit seeks damages of as much as $900 million. The media stories also suggest that there is an agreement by WaMu’s outside directors to pay $125 million to settle claims by the FDIC is pending approval. A copy of the FDIC’s recent complaint against the WaMu executives and their wives can be found here.

WaMu’s September 2008 failure (about which refer here), represents by far the largest bank failure in U.S. history. The events surrounding its failure have already been the subject of extensive litigation, not the least of which is a pending securities class action lawsuit filed on behalf of WaMu’s shareholders, which, as noted here, survived a renewed motion to dismiss after the lead plaintiffs amended their complaint.

The FDIC filed its recent lawsuit in its capacity as WaMu’s receiver. The lawsuit names as defendants WaMu’s former CEO, Kerry Killinger, its former President and COO, Stephen Rotella, and its chief of home lending, David Schneider. In a rather unusual twist that shows just how aggressively the FDIC may be prepared to get in pursuing these claims, the complaint also names Killinger’s wife, Linda Killinger, and Rotella’s wife, Esther as explained below.

The complaint asserts claims against the three executives for Gross Negligence, Ordinary Negligence and Breach of Fiduciary Duty.

The complaint alleges that the three defendants caused the bank to take "extreme and historically unprecedented risks with WaMu’s held-for-investment loan portfolio." The three allegedly focused on short term gains, to the disregard of the bank’s long term safety and soundness. The executives, lead by Killinger, allegedly developed an executed a strategy to make billions of dollars of risky residential mortgages, increasing the risk profile of the bank’s held for investment mortgage portfolio.

The bank’s business strategy dictated a lending approach for which few lenders were turned away. The bank also layered multiple levels of risk with particularly risk loan products such as option ARM mortgages, the riskiness of which was further compounded by allowing stated income lending and other questionable lending practices.

The complaint alleges further that these executives continued to pursue their aggressive growth strategy even at a point when housing prices "were unsustainably high" and while relying upon an aging infrastructure that was inadequate to keep up with the enormous loan volume. The complaint alleges that the three executives knew the strategy was risky, knew the process weaknesses, and even knew there was a housing price bubble. Yet, the complaint alleges, the three executives marginalized the company’s risk management department.

As a result, when the bubble collapsed, the bank "was in an extremely vulnerable position" and, as a result of the three executives "gross mismanagement" the bank suffered losses of "billions of dollars."

The complaint also includes fraudulent conveyance claims against Killinger and his wife Linda, and against Rotella and his wife Esther.

The complaint alleges that in August 2008, Killinger and his wife transferred two residential properties to qualified personal residence trusts and appointed themselves as trustees. The complaint alleges that these transfers were made with the intent to hinder, delay or defraud Killinger’s future creditors.

The complaint contains similar allegations against Rotella and his wife with respect to an April 2008 residential real estate transfer and a September 2008 transfer from Rotella to his wife of $1 million.

In statements to the Wall Street Journal, here, Killinger and Rotella said the FDIC’s allegations are "baseless" and "lack credibility" and that the lawsuit is "unworthy of the government." I recommend that readers take a few minutes and read these two individuals' statements. Whatever may be the merits of this and similar cases brought by the FDIC, it is very clear from these statements that there will be a personal price to pay for the individuals involved. The personal pain these men are feeling is palpable, and there will be more of this kind of pain for other former bank officials as more of these kinds of lawsuits are filed.

With the filing of this complaint, the FDIC has unmistakably demonstrated that it will pursue claims against former directors and officer of failed banks when it chooses to do so. Indeed, the claims against the two executives’ wives clearly show that the FDIC will proceed aggressively.

Given that WaMu represented the largest bank failure in U.S. history, it may come as no surprise that the FDIC is pursuing these kinds of claims. What has been surprising to some, and what occasioned the criticism I mentioned in my opening paragraph, is how deliberate the FDIC has been in choosing to pursue claims. WaMu failed nearly two and one half years ago. If the FDIC were to act with similar deliberation in pursing other claims, it could well be some time before we know for sure how extensive the FDIC’s litigation activity ultimately will be in pursing claims as part of the current bank failure.

It is, however, quite clear that the FDIC will be pursuing more of these types of claims. The FDIC recently updated the Professional Liability Lawsuits page on its website (here) to show that the FDIC’s board has approved lawsuits against 158 individual directors and officers of failed banks. Since the six lawsuits the FDIC has filed to date only amount to about 40 individual defendants in total, there are many more lawsuits to come, just based on the actions that have been approved so far.

One particularly interesting detail about the news surrounding the FDIC’s recent lawsuit is the report that WaMu’s outside directors have agreed to pay $125 million to settle claims. It is interesting that the outside directors agreed to pay this amount without the intervening step of a lawsuit against them. One question that immediately occurs to me is whether and to what extent this $125 million payment is to be funded by D&O insurance.

WaMu’s D&O insurance program was undoubtedly already under pressure due to the significant presence of other claims already pending against its former directors and officers. One possibility that occurs to me is that the bank may have carried a significant layer of Side A DIC protection, which may well have been triggered by the bank holding company’s bankruptcy. Because of the bankruptcy, all of the claims represent potential Side A losses, suggesting that the bank’s Excess Side A/DIC program could well have been called in to contribute. All these are details that those of us on the outside can only wonder about; however, comments from knowledgeable persons who are closer to the situation are always welcome.

Whatever may be the case, it is clear that D&O insurance may be playing a role of some kind in all of this. At least Stephen Rotella thinks so. In his statement to the Wall Street Journal to which I linked above, he speculated that the lawsuit itself "may be a way for the FDIC to collect a payout from insurers who provided officers and directors liability coverage for the time they worked at WaMu."

As noted, with this lawsuit, the total number of lawsuits the FDIC has filed as part of the current wave of failed bank litigation is now up to six. A list of the six lawsuits can be found here.

A March 17, 2011 Bloomberg article about the FDIC’s lawsuit can be found here. A March 17, 2011 Seattle Post-Intelligencer article about the suit can be found here.

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In a detailed October 27, 2009 opinion (here), Western District of Washington Judge Marsha J. Pechman substantially denied the defendants’ motions to dismiss the plaintiffs’ amended complaint in the Washington Mutual subprime securities class action lawsuit. Judge Pechman’s ruling is noteworthy in and of itself, but perhaps even more because Judge Pechman had previously granted the defendants motions’ to dismiss all of the plaintiffs’ ’34 Act claims and all but one of defendants’ ’33 Act claims.

As discussed here, in granting the prior motions to dismiss, Judge Pechman had been sharply critical of the clarity and organization of the plaintiffs’ initial consolidated amended complaint, which she characterized as "verbose and disorganized." and as embodying "puzzle pleading."

By contrast, in her October 27 ruling, Judge Pechman stated that the second amended complaint (hereafter, the "complaint") presents "cogent and concise allegations against Defendants." She also stated that the Plaintiffs have "largely succeeded in remedying the deficiencies of their initial complaint."

As described in the October 27 opinion, the complaint alleges that the defendants "(1) deliberately and secretly decreased the efficacy of WaMu’s risk management policies; (2) corrupted WaMu’s appraisal process; (3) abandoned appropriate underwriting standards; and (4) misrepresented both WaMus’ financial results and internal controls."

The complaint’s ’34 Act claims assert claims for securities fraud against the seven officer defendants, although the complaint also alleges Section 20 control person liability against the outside director defendants as well as the officer defendants.

With respect to the plaintiffs’ ’33 Act claims, the complaint alleges different specific allegedly misleading statement as to each of the individual officer defendants. The defendants moved to dismiss these allegations on the grounds that the complaint does not sufficiently allege that the statements are false and misleading and failed to allege "particularized facts giving rise to a strong inference of scienter."

In reviewing the adequacy of the plaintiffs’ allegations, Judge Pechman reviewed each of the alleged misstatements with respect to each of the individual officer defendants, grouping the allegedly false statements in four categories "(1) risk management; (2) appraisals; (3) underwriting; and (4) internal controls."

Other than with respect to two statement of WaMu’s former CEO, Kerry Killinger, which Judge Pechman found to "lack sufficient clarity to state a claim," Judge Pechman found that the plaintiffs’ ’34 Act claims were sufficiently pleaded, and therefore (other than with respect to two of the CEO’s statements), the motion to dismiss the ’34 Act claims was denied. Judge Pechman also denied the motion to dismiss the Section 20 control person liability claims against the individual officer defendants and the outside director defendants.

In denying the motion to dismiss, Judge Pechman referred repeatedly to the allegations drawn from internal memoranda and on testimony from confidential witnesses. With respect to the plaintiffs’ scienter allegations, Judge Pechman found with respect to each of the statements (other than the two statements of the CEO that were dismissed) that the "defendants have not raised a competing inference of innocence that outweighs the strong inference of scienter."

In her prior ruling in the case, Judge Pechman had granted the defendants’ motions to dismiss the ’33 Act claims, finding that the plaintiffs at that time did not have standing to assert ’33 Act claims in connection with WaMu’s August 2006, September 2006 and December 2007 securities offerings. The most recent amended complaint purports to add several additional plaintiffs, in an effort to establish standing to assert ’33 Act claims as to the August 2006, September 2006 and December 2007 offerings.

Judge Pechman found none of the new plaintiffs had standing to assert claims as to the August 2006 offering of 5.50% Notes. Judge Pechman also found that the plaintiffs’ lacked standing to assert Section 12(a)(2) claims as to both 2006 offerings. She otherwise found that the plaintiffs had standing to assert ’33 Act claims as to the other offerings. She also found that the complaint’s allegations met the ’33 Act’s substantive pleading requirements.

In short, virtually all of the plaintiffs’ most recent amended complaint survived the renewed dismissal motions. This is a fairly dramatic turnaround from the outcome of the initial motions, in which the initial dismissal motions were substantially granted, other than with respect to the ’33 Act claims in connection with the August 2007 offering. The turnaround is all the more noteworthy given how critical Judge Pechman was of the plaintiffs’ initial complaint. It is a very long way from Judge Pechman’s assessment that the prior complaint was "verbose and disjointed" to her assessment that the most recent complaint is "cogent and concise."

But the difference in outcomes is not attributable solely to the improved organization of the amended complaint. It is also clear that the added allegations, particularly those drawing on confidential witness testimony, were instrumental in bringing about the different outcome.

This turn of events could be significant in connection with the many other pending subprime and credit crisis related securities class action lawsuits, particularly those in which initial motions to dismiss have been granted with leave to amend. If nothing else, Judge Pechman’s October 27 opinion shows that plaintiffs can successfully amend their complaints in order to remedy initial pleading deficiencies. This possibility underscores the fact that initial dismissals without prejudice are indeed provisional, and no one should assume that a case in which initial motions have been granted is done – the plaintiffs in those cases, like the plaintiffs in the WaMu case, may yet succeed in overcoming the initial pleading hurdles.

A couple of aspects of the way in which the WaMu plaintiffs overcame the initial pleading hurdles are instructive for other plaintiffs in subprime and credit crisis-related securities lawsuits. Clearly, Judge Pechman preferred the more organized presentation of the amended complaint to the "puzzle pleading" presented in the prior complaint. Clarity and brevity are indeed virtues, in pleading cases as in all other endeavors, which is a consideration other plaintiffs might well want to heed.

Another clear implication from Judge Pechman’s October 27 order is the value of allegations based on the testimony of well-placed confidential witnesses. This lesson was also apparent from the recent ruling on the renewed motion to dismiss in the Dynex Capital case (about which refer here). While not every plaintiff will be similarly able to present allegations based on the testimony of well-place confidential witnesses, that clearly is one way to overcome the steep pleading hurdles that plaintiffs face at the outset of these cases. And, as I noted in connection with the Dynex Capital ruling, even the rigorous requirements for pleading scienter under the Tellabs case can be overcome with the right kind and quantum of confidential witness testimony.

But perhaps the greatest significance of the ruling on the renewed motions to dismiss is that the motions were denied in a high profile case like the WaMu suit. As I have noted elsewhere on this blog, the defendants generally have seemed to be doing better on the motions to dismiss in the subprime and credit crisis cases. However, the WaMu ruling adds a significant counterweight to the plaintiffs’ side of the ledger, along with the dismissal denials in the Countrywide (refer here) and New Century Financial subprime suit (refer here). The WaMu ruling may be even more significant, given that the dismissal motion had previously been substantially granted.

One final note about the October 27 order in the WaMu case is that the motion was denied as to all defendants, including the offering underwriters and WaMu’s auditors, Deloitte. The fact that the gatekeepers have been kept in the case is significant if for no other reason that its suggestion that gatekeepers generally will continue to be a part of the subprime and credit crisis-related litigation, which could have important implications for how these cases are resolved, as well as what the aggregate costs of these cases might eventually be.

In any event, I have added the October 27 ruling in the WaMu case to my running tally of the dismissal motion rulings in the subprime cases, which can be accessed here.

Special thanks to a loyal reader for providing me with a copy of the October 27 opinion. I get my best material from readers and I am always grateful when readers take the time to send things along to me.

Andrew Longstreth’s October 28, 2009 article on AmLaw Daily about the WaMu decision can be found here.

Another Belated Securities Suit Filing: In several prior posts (most recently here), I have noted the recurring phenomenon during 2009 of new securities class action lawsuit filings in which the proposed class period cutoff is well in the past, in some cases nearly two years before the filing.

The securities class action lawsuit filed on October 28, 2009 against Pitney Bowes and certain of its offices pushes this belated filing phenomenon to its furthest edge of its theoretical possibilities. As reflected in the plaintiffs’ counsel’s October 28 press release (here) , the proposed class period in the case runs from July 30, 2007 to October 29, 2007. In other words, the plaintiffs filed their complaint on what appears to be the last day before the two-year statute of limitations would have expired. A copy of the complaint in the case can be found here.

The Pitney Bowes case is merely the latest (and arguably most extreme) example of this phenomenon. I have long speculated that this rash of seemingly belatedly filed lawsuits may be attributable to a backlog of case filings that built up over prior periods in which plaintiffs lawyers were concentrating on filing subprime and credit crisis related lawsuits as well as lawsuits related to the Madoff scandal. Now that the new filings in those other areas are dying down, the plaintiffs’ lawyers may be getting around to working off the backlog.

The Pitney Bowes case, as is the case with many of these other seemingly belated cases that have been filed during the latter half of 2009, was filed against a company outside the financial sector. This feature of the phenomenon seems to suggest that as the plaintiffs’ counsel work off what seems to be a backlog of cases, the mix of companies sued will shift back toward the more usual spread of kinds of companies, and away from the concentration in the financial sector that characterized filings during the period from mid-2007 through the first part of 2009.

The one thing about these belated filings is that it does create a challenge in trying to determine when a company is "out of the woods" with respect to any adverse developments the company might have had.

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Amidst all of the tumult over the Fed bailout and the Presidential debates, not to mention a host of other events large and small, news about WaMu’s collapse has already slipped from the front pages of the nation’s newspapers. Astonishingly, in one short weekend, events have superseded the largest bank failure in U.S. history.

The problem with treating this extraordinary development as just another item in the news cycle is that it could be possible, notwithstanding the magnitude of the event, to overlook its significance. Make no mistake, however; the consequences of Washington Mutual’s failure, and the specific way the J.P. Morgan buyout went down, are enormously significant, and the implications of these developments are laden with portent.

Takeover/Buyout/Bankruptcy

On September 25, 2008, the Office of Thrift Supervision announced (here) that it closed Washington Mutual and appointed the FDIC as the institution’s received. The FDIC announced that same day (here) that as a result of an auction process J.P. Morgan Chase had acquired Washington Mutual’s banking assets.

J.P. Morgan’s September 25, 2008 press release (here) provides further detail regarding this transaction. J.P. Morgan’s press release explains that in exchange for the payment of $1.9 billion, the company had acquired "all deposits, assets, and certain liabilities of Washington Mutual’s banking operations." The press release also states that the transaction excluded "senior unsecured debt, subordinated debt, and preferred stock" of WaMu’s banks as well as any assets or liabilities of the parent holding company or the parent holding company’s nonbank subsidiaries.

J.P. Morgan also announced that as a result of this acquisition, it "will be marking down the acquired loan portfolio by approximately $31 billion," which it said "represents our estimate of remaining credit losses related to the impaired loans."

The final step of this process followed on September 26, 2008, when the parent holding company filed a bankruptcy petition in U.S. Bankruptcy Court in Delaware, about which refer here.

As NYU economics professor Lawrence White noted in a September 26, 2008 Forbes column (here), for its $1.9 billion investment, J.P. Morgan acquires net assets with a nominal value of $240 billion and deposit liabilities of $188 billion, suggesting a nominal acquisition value of approximately $52 billion. Of course, the planned write-downs diminish –but do not eliminate --this nominal value. Nevertheless J.P Morgan’s $1.9 billion offer was the best bid that the FDIC received.

Clearly, asset valuation uncertainty explains this apparent disparity. J.P. Morgan’s announcement of an immediate $31 billion write-down underscores the magnitude of the valuation uncertainty. But both the extent of this disparity and the magnitude of the write-downs have major implications, as discussed below.

One aspect of J.P. Morgan’s acquisition that was widely emphasized in the press reports was the FDIC’s success in completing this transaction without any losses to the deposit insurance fund. Indeed, there were reports that the FDIC’s chairman’s highest priority in the sequence of events was protecting the fund. Had the deposit insurance been called into play, the impact on the fund would have been enormous, and impact on depositors whose deposits exceeded the insurance limits also would have been significant. Nevertheless, the particular way in which the fund was protected, which left debtholders and bond investors exposed, presents its own set of issues.

Consequences and Implications

1. Valuation Issues: The massive discount on WaMu’s asset valuations implied in J.P. Morgan’s acquisition price has great significance for other institutions holding similar assets. While mortgage assets are not uniform, and the distinct characteristics are highly relevant to valuation issues, the obvious implication of the price and of J.P. Morgan’s announced $31 billion write-down is that similar assets on other institutions’ balance sheets may be overvalued.

Professor White, in the Forbes article cited above, states that these developments are "strong reinforcement for the view that lots of other institutions’ mortgages and mortgage-backed securities are also overvalued."

Indeed, the September 27, 2008 "Heard on the Street" column in the Wall Street Journal notes that "applying J.P. Morgan’s projections on other large banks implies higher losses for those with WaMu-like assets." The Journal column specifically suggests that these concerns may explain why Wachovia’s shares plunged on Friday and that rumors of Wachovia’s possible sale also immediately began circulating. Wachovia, it should be noted, like WaMu, has a significant concentration in Option ARM loans, which undoubtedly reinforce the concerns about possible future write-downs on Wachovia's loan portfolio.

Professor White notes with respect to these valuation concerns that "most of these assets are held outside the banking system," as they are held in "investment banking firms, finance companies, insurance companies, hedge funds, mutual funds, pension funds, etc." All of these institutions will face valuation pressures in the wake of the WaMu takeover.

In any event, along with the possibility that other institutions’ assets may be overvalued is the consequent possibility that investors in those institutions may later claim that they have been misled about the true financial condition of those institutions. (Indeed, WaMu itself previously had been hit with a securities lawsuit in which investors claim that they were misled about the company’s exposure to Option ARM loans, as noted here.) All of which may suggest the possibility of significant additional litigation, as discussed further below.

2. The Insurance Fund is Safe. Bond Investors? Not So Much: J.P. Morgan’s September 25 press release carefully isolated the liabilities it was not acquiring as part of the transaction. While the company cheerfully acquired WaMu’s bank deposit liabilities, other liabilities were left behind.

As detailed in a September 25, 2008 Seattle Times article (here), J.P. Morgan’s $1.9 billion payment will go into a fund for WaMu’s creditors. The only creditors likely to get anything out of the fund are the holders of WaMu’s $7 billion senior unsecured debt, who possible will get not more than 27 cents on the dollar. Holders of over $11 billion of WaMu subordinated debt and preferred stock will get nothing, as will other WaMu debtholders. The total amount of WaMu’s debt outstanding may be as much as $28 billion.

Among others that will be left out in the cold is the private equity fund TPG (formerly known as the Texas Pacific Group), which pumped $1.3 billion into WaMu as one of several investors that invested $7 billion into WaMu just five months ago. As the Wall Street Journal noted in its September 27, 2008 article entitled "WaMu Fall Crushes TPG" (here), these "losses illustrate the peril of investing in distressed banks and financial companies."

These losses are significant in two particular ways. First, WaMu’s collapse has thrown off significant losses for bond investors, many of whom are already reeling from earlier collapses of Bear Stearns, Lehman Brothers, Fannie Mae and Freddie Mac. As these losses continue to filter out into the investment community and the larger economy, the cumulative effect potentially could be staggering (especially in combination with equity investment losses, discussed below).

These losses may also have important implications for other troubled banks’ capital raising prospects. The FDIC may well have succeeded in protecting the insurance fund in this instance. However, the incentives for any investors to consider pumping additional capital into banking institutions have been undermined. Certainly, the likelihood of another TPG-like capital infusion for another troubled bank would seem increasingly improbable in light of these developments.

By its unwillingness to liquidate WaMu now, a move that might have salvaged something for bond investors, the FDIC potentially could have set up further problems down the road. If investors are unwilling to risk investments in floundering financial institutions, additional bank failures could follow. The losses to the insurance fund potentially could be even greater.

3. "I awoke last night to the sound of thunder/ How far off I sat and wondered": The reverberations from the WaMu collapse will ripple through the economy, with many effects near and far, for months to come. Some, like the ones described above, may be readily apparent. Others will be more remote and will take longer to emerge.

Take, for example, the recondite world of collateralized debt obligations, already the subject of much scrutiny due to CDO investment in subprime mortgages. According to a September 26, 2008 Bloomberg article (here), WaMu’s collapse could also have a "significant" impact on CDOs.
 

According to the Bloomberg article, 1,526 synthetic CDOs sold default protection on WaMu. The CDOs sold notes to investors that are repaid using proceeds of credit default swap premiums. As a credit default swap seller, the CDOs must pay the buyers face value in exchange for the underlying securities or the cash equivalent after a bankruptcy filing.

In other words, as a result of WaMu’s collapse, the CDOs are likely to sustain enormous losses. CDO investors and noteholders, whose investments were already hit by the Lehman Brothers bankruptcy, will see the value of their investments fall even further.

The realization and assessment of these and other more remote consequences of WaMu’s failure, as well as other tumultuous events in the financial marketplace, may take time to emerge. It will likely be a considerable time before all of these consequences have surfaced.

4. A Billion Here, A Billion There: In the last year, WaMu’s market capitalization declined over $80 billion. In isolation, this is significant. Taken collectively with other market losses, the aggregate impact is staggering. Collectively, the failures of WaMu, Lehman Brothers, Bear Stearns, Fannie Mae and Freddie Mac represent roughly a $230 billion loss in market capitalization from a year ago.

Nor is that all. If you add in the market capitalization loss in the last year at AIG, Merrill Lynch, Goldman Sachs, Bank of American and Citigroup, the aggregate market capitalization decline in the last year is nearly $700 billion (just about the size of the Treasury bailout, by coincidence).

These stocks were largely held by institutional investors. The aggregate losses on these investments significantly affect the value of these institutions’ holdings, with significant implications for these institutions’ beneficiaries, investors and other stakeholders.

5. Knock-on Effects: One consequence of these circumstances in our blame-centric culture is that as these losses surface and become more apparent, litigation seems virtually inevitable. I have already noted (here and here) how Lehman Brothers’ failure has been significant factor in recent litigation against other companies. Similar litigation consequences from WaMu’s collapse seem likely. The wide dispersion of the consequences from WaMu’s failure raises the significant possibility that the litigation effects will not be limited to the financial sector alone.

Commercial Irony: Although ironic now with the benefit of hindsight, Washington Mutual consciously built its identity on its willingness to lend to those unable to borrow from others. The thrift built this identity with a series of commercials that remain amusing, although for some reasons now perhaps different than at the time the commercials were first created. I have linked a particularly amusing example below, which I commend for its entertainment value. (Hat tip to the Wall Street Fighter blog, here, for the video link.) Note the ironic symbolism of the disfavored borrower popping a balloon at the start of the commercial.

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