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Failed, closed and a c q u i r e d mortgage-related entities.

Behind-the-Scenes Look at Collapse of Wachovia, WaMu

FDIC testimony before Financial Crisis Inquiry Commission

Sept. 1, 2010

By staff

It was nearly four years ago that Washington Mutual Bank and Wachovia went into a tailspin and were eventually deemed insolvent. A behind-the-scenes look at the demise of the two companies by a regulatory insider reveals two different strategies used in resolving the institutions.

On Sept. 25, 2008, Washington Mutual Bank was seized by the Office of Thrift Supervision. JPMorgan Chase & Co. stepped in to acquire the bank. Parent Washington Mutual Inc. subsequently filed bankruptcy.

Former WaMu chief executive officer Kerry Killinger testified in April before the Financial Crisis Inquiry Commission that the failure of the West Coast-based bank was unfair, and it was not afforded "the benefits extended to, and actions taken on behalf of, other financial services companies within days of Washington Mutual's seizure."

But John Corston has a different perspective.

Corston is acting deputy director, complex financial institution branch, division of supervision and consumer protection, for the Federal Deposit Insurance Corp. He testified before the Financial Crisis Inquiry Commission Wednesday, according to a transcript of his prepared statement.

Concerns about Wachovia began in March 2008, when the FDIC downgraded the bank's Large Insured Depository Institution rating/outlook to "C Negative." The rating is given to banks considered to have an elevated risk profile.

"Wachovia posed 'increased risk as a result of weaknesses in risk management, asset write-downs associated with continuing market disruption, and rapid credit quality deterioration in certain portfolios, primarily the pay-option ARM [adjustable rate mortgage] portfolio,'" Corston stated.

FDIC discussions with Wachovia's regulator, the Office of the Comptroller of the Currency, were followed three months later by a downgrade of Wachovia's CAMELS rating to a composite "3" rating. CAMELS is a supervisory risk rating system used by bank regulators that analyzes capital, asset quality, management, earnings, liquidity and sensitivity.

Concerns about structured finance mark-to-market valuation adjustments and increased loan-loss provisions contributed to the downgrade. Wachovia was unable to unload its inventory of subprime mortgages, syndicated credits within collateralized loan obligations and commercial real estate credits because of market disruptions. In addition, credit quality declined on the assets and Wachovia wrote down the goodwill established for its acquisition of Golden West Financial Corp.

Wachovia's outlook turned more bleak in late September 2008 following Lehman Brothers' bankruptcy, and mostly large commercial depositors yanked more than $8.3 billion in deposits out of the bank -- prompting a meeting between senior executives and FDIC staff.

The situation became more dire on Sept. 25 when two regular Wachovia counterparties declined to lend to the firm. The OCC issued a statement to the FDIC on Friday, Sept. 26, however, indicating Wachovia's liquidity position remained manageable.

But shares of Wachovia plunged anyway. Credit default swap spreads widened sharply, and many counterparties began requiring collateralization on any transactions. At the same time, Friday's deposit outflows accelerated to nearly $6 billion.

"By the end of the day, Wachovia management informed bank regulators that with the lack of market acceptance of Wachovia's liabilities, the institution faced a near-term liquidity crisis," Corston stated. "This set in motion a highly-accelerated effort to find an acquirer for the institution that would provide for protection of depositors and minimization of damage to the wider financial system."

Wachovia was found to pose a systemic risk, and the FDIC had little time to develop its options for resolving the Charlotte, N.C.-based institution. Citigroup Inc.'s bid to acquire Wachovia in a deal where the government would eat the first $42 billion in losses was approved by regulators along with a systemic risk exception on Sept. 26.

But on Oct. 3, Wells Fargo & Co. stepped in with a bid that required no government assistance and gave Wachovia stockholders a better deal -- leading to the Dec. 31, 2008, closing of Wells' acquisition of Wachovia Corp.

Corston noted that resolution of WaMu was far simpler. While its assets were huge -- $300 billion -- it operated under a "vastly simpler" structure compared to its peers. Its main institutional focus was on mortgage lending; it didn't use derivatives as part of a market-making operation, it held no foreign deposits and there were no major holding company subsidiaries involved in significant financial services.

Seattle-based WaMu began marketing itself in early 2008, and several interested institutions conducted extensive due diligence. By the time the FDIC began making plans for an orderly resolution of WaMu, many potential acquirers had already done their own due diligence -- easing the pressure of a short period for the bidding process.

By the time JPMorgan acquired the bank on Sept. 25 -- one day earlier than plan -- the FDIC was able to arrange for the orderly transfer of more than 2,300 WaMu branches in just one day versus the usual required time of a full weekend.

"The contrast between WaMu and Wachovia -- two large, FDIC-insured depository institutions that collapsed during the same week in late September 2008 -- illustrates how the complexities of resolving large institutions could, under the rules in place in 2008, result in disparate treatment for investors and counterparties in different institutions," the FDIC official stated. "In the case of WaMu, the FDIC had adequate time to develop strategies and understand the risks associated with those strategies.

"In the case of Wachovia, the FDIC wasn't informed until the weekend of its collapse and as a result, had very limited information that could be used to understand the market implications -- especially in a market that was extremely unstable -- or to develop a resolution strategy."

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