Modern history is littered with the corpses of collapsed banks. From the Great Depression in the 1930s to the financial crisis of 2008 banks have gone down, taking depositors’, lenders’, and shareholders’ funds with them as they fell. All too often they’ve taken the entire economy with them as well.
This is the story of one bank’s failure — WAMU’s. We’ll use it to show how asset quality, capital, and liquidity worked together to determine WAMU’s fate. And we’ll see how WAMU’s experience applies to banks in general.
At the end of 2007, WAMU was the 6th biggest bank in the United States, with $328 billion in assets, $250 billion in the form of loans. WAMU funded its assets mainly with $182 billion in deposits, $107 billion in debt, and $25 billion in shareholders equity. With a total regulatory capital ratio of 12.3%, the bank was officially well capitalized.
WAMU’s loans were mostly higher-risk mortgages: 78% of loans were mortgages, and 67% of mortgages were higher-risk adjustable-rate and sub-prime loans. When home prices fell 10% from the start of 2007 through the first half of 2008, many of WAMU’s customers stopped making payments. The bank’s delinquent loans grew by 304%.
That forced WAMU to take $12.5 billion in charges against the value of its mortgage portfolio. That in turn caused $4.5 billion in net losses, along with dividends and share buybacks, driving shareholders’ equity down by $6.3 billion, a 30% decline from 2007. The company had to raise $7.2 billion in new equity from a private investor in the second quarter of 2008 to make up for the loss of capital.
WAMU is a classic example of the connection between asset quality and capital.
Step 1 — Start with a portfolio of unusually risky loans. Step 2 — Because of declines in collateral value and increases in payment defaults, write down those loans to their collectible value. Step 3 — Record the write-downs as an expense. Step 4 — If credit costs get big enough, record a net loss. Step 5 — Reduce retained earnings in shareholders’ equity by the net losses. Step 6 — Reduce capital by the drop in shareholders’ equity.
As WAMU’s losses mounted, depositors’ confidence fell. They got even more nervous after IndyMac, another bank with a lot of high-risk mortgages, failed in July of 2008. From March 2007 through June 2008, WAMU’s retail deposits fell by $24 billion (an 11% drop) in spite of the fact that most were insured by the US government. Wholesale deposits fell by $17 billion (a 99% drop).
When Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, and ten money-market mutual funds all failed in September, something like panic set in. That month WAMU lost another $15 billion in deposits. By September 25 WAMU had only $13 billion left in liquidity from cash and un-borrowed lines of credit. That day the FDIC seized the bank and sold its assets to JP Morgan for $1.9 billion.
WAMU is a classic example of the connection between capital and liquidity.
Step 1 — The cost of loan write-downs climbs. Step 2 — As credit costs grow, so do net losses. Step 3 — Net losses threaten to reduce capital by a significant amount. Step 4 — Depositors become more and more worried about their potential losses. Step 5 — Uninsured deposits run off entirely and even insured deposits start to shrink. Step 6 — The bank uses too much of its cash and credit lines to replace lost deposits.