Last week when Washington Mutual (WaMu) was taken over by Federal Bank Regulators, many people were shocked. How did things at WaMu change so fast, from a bank with minimal liquidity problems to a bank in serious trouble.
In trying to anticipate what may happen with Wachovia, it is helpful to understand what happened in WaMu’s last ten days.
Banks are highly leveraged businesses. Their product is money. They start with capital (equity) and take in deposits. Then they turn around and loan out money, much of which are the deposits they took in. They can also borrow money from other banks at a discount and loan that money out to their borrowers as well. The most important theory that banks operate on is that not all depositors will take their money out at the same time. It is the bank’s capital that protects the bank when there is a higher than normal withdrawal of deposits.
When a bank has a high capital to asset ratio, it is more able to meet deposit withdrawal demands, and is far more able to borrow from other banks at favorable rates. Both WaMu and Wachovia were heavily involved in making, buying and selling sub-prime mortgages during this last several years, ending in May of 2007. These loans on their books caused their bank safety ratings to drop which made it more expensive to borrow from other banks. The large portfolios of sub-prime mortgages also put them on the public’s radar screen. They have been viewed by some as similar to the Wall Street banks as having significant exposure to fail because of their large portfolios of residential mortgages.
When Lehman Brothers, Merrill Lynch, and the government sponsored enterprises, Indy Mac, Freddie Mac, and Fannie Mae began failing during the last month, confidence in banks everywhere that had large portfolios in sub-prime mortgages began seeing an erosion in confidence. It is confidence that keeps our financial system stable.
Both Washington Mutual and Wachovia suffered staggering losses during the first and second quarter this year, causing shareholders and depositors alike to have great concern over the soundness of these two previously solid institutions.
During the week days before WaMu was taken over by regulators, depositors who were fearful about the bank’s future withdrew a staggering 16.7 billion dollars from the bank. The bank’s capital could not stand such pressure on it, and because of erosion in confidence, the bank could not borrow from other banks to cover its deposit withdrawal obligations. As the Federal banking regulators watched the situation closely, WaMu could not quickly find another bank to merge with in order to protect bank shareholders. The Federal government quickly stepped in and brokered a purchase of WaMu’s assets by JP Morgan Chase.
Many experts believe we will see the same run on deposits at Wachovia during the next few days, pushing the regulators to take the same takeover action they had to do with WaMu.
Sam Thacker is a partner in Austin Texas based Business Finance Solutions.
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