Clarification on Why WaMu Won't Fail

In my last blog, I wrote a story, from a source, about why Washington Mutual is too large to fail. In that story, I mentioned the amount of FDIC insured deposits, $181 billion dollars, at Washington Mutual. I also talked about a loan that the Federal Home Loan Bank of San Francisco gave Washington Mutual to the tune of $58 billion dollars. The Federal Home Loan Bank of San Francisco sent me the following note in response to two points that I made in my last blog.

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As a spokesperson for the Federal Home Loan Bank of San Francisco, I would like to correct two factual errors about the Bank that appear in this news story.

You state, “The Federal Home Loan Bank of San Francisco is losing money.” In fact, the Bank’s net income for the second quarter of 2008 was $223 million, for the first six months of 2008 was $463 million, and for 2007 was $652 million. The Bank’s net income has been positive every quarter and every year since 2000, as indicated in financial disclosures posted on the Bank’s website at www.fhlbsf.com.

You also state, “If Washington Mutual were allowed to fail, they [the Federal Home Loan Bank of San Francisco] would have no protection against the money they lent to Washington Mutual.” In fact, by statute, all advances from the Bank are required to be fully collateralized by eligible collateral.

Amy Stewart
Vice President, Corporate Communications
Federal Home Loan Bank of San Francisco

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I’d like to address the two points made above and some of the commentary posted on the last blog. One, their net income is solid. In the story I broke, I should have clarified when I said the Federal Home Loan Bank is losing money, that they are reportedly losing money on the collateral used to back the loan. Two, the Federal Home Loan Banks are protected first and the FDIC insured depositors are insured second. They are absolutely right and I stand corrected. I should have clarified that. Although, that makes me even more concerned about the health and well-being of the FDIC.

Karen Petrou of Federal Financial Analytics in Washington D.C. sent my colleague the piece below. It explains the risks much that better than I can explain them. When reading her note, keep in mind, that there are 12 Federal Home Loan Banks or GSE’s (Government Sponsored Entities) which function like Fannie Mae and Freddie Mac. Like Fannie and Freddie, they provide local lenders with liquidity which help them offer mortgages at the lowest possible rates to consumers. They do this mainly by advancing funds to lenders, and in advancing funds, they ask for collateral and protection from default. One way to get protection is to ask for a claim on a lender's assets, called a "lien." In an interview this morning with a former FDIC CFO he told me that the FDIC (the entity which insures our deposits), has $46 billion dollars and access to a $30 billion dollar loan from the Federal Reserve Bank, should they need it.

Here is the report:
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GSE Activity Report
September 18, 2008
Wading Through WaMu
Summary

In the midst of market mayhem, many have lost sight of the Federal Home Loan Banks. Here, we turn again to them and posit the System’s prospects in light of WaMu’s problems. As before, we think the System’s prior lien poses significant FDIC risk, and we wonder if the San Francisco and Seattle Banks will push the point if there is a WaMu failure or instead make use of the new Treasury liquidity facility to handle any short‐term funding problems.

Analysis

When Indy Mac failed, we noted that the San Francisco FHLB took out about double its advance exposure in exercising its prior lien against the failed‐bank’s

assets in the FDIC’s hands. In essence, the FDIC’s initial recovery was halved by the prior lien, sharply increasing the projected loss to the FDIC and making certain the pro‐cyclical premium hike set for October. WaMu is a far larger Bank customer and, as a result, its problems will have strategic impact not only on the FDIC, but also on the FHLB System.

First, to the FDIC. WaMu’s most recent data show outstanding advances of $58 billion. If the Home Loan Banks similarly covered all possible risk by exercising a prior lien over double this total, the Banks would hold a prior lien on $116 billion or about 37 percent of WaMU’s total assets of $310 billion. This would, of course, have grave consequences for the FDIC, leading Congress in the next GSE‐reform round to end the Banks’ prior lien in the course of still more dramatic structural reform of the Home Loan Bank System.

Recognizing this, we expect the Banks with WaMu exposure to look for alternatives that will at least ease the pain to the FDIC. Options here are sorely limited, but a significant one is the new Treasury GSE liquidity facility. Importantly, the San Francisco Bank has completed all the paperwork necessary to access the fund if needed; Seattle has said it doesn’t expect to use the facility, but we expect that it nevertheless is similarly completing the administrative work just in case.

The Federal Reserve has already told San Francisco what to expect in the new facility: a 13% discount on advances posted as collateral. This is a significant hit to funds presumably fully secured by current, high‐quality mortgages and we think it reflects the Fed’s all‐too‐clear understanding that a lot of Bank collateral is, in fact, anything but. The Fed too is counting on the system’s prior lien in its discount calculation, but still refusing to back dollar‐for‐dollar support from Treasury. This position complicates the value of the Treasury facility to the Banks and could well force them to exercise the prior lien in full in the event WaMu fails to find a buyer.

Now, to the second issue: the Banks’ future. Even if WaMu finds a buyer, it isn’t going to be the big FHLB borrower it’s been for years. In the short run, the rescued WaMu will, like many other institutions, be forced to rely on the System because liquidity elsewhere is hard to come by outside the Federal Reserve’s facilities – it currently accounts for 17% of total System capital stock. In the near term, though, a WaMu buried in a bigger bank like Wells or Citi will use FHLB advances far more strategically and in considerably lower amounts. WaMu holds 29% of Seattle’s advances and 19% of San Francisco’s. Taking them out of the Bank to even a minor degree takes a very big customer out the door.

Outlook

As noted, we think the FHLBanks are going to get a strategic overhaul along with Fannie and Freddie when Congress gets down to a GSE‐charter rewrite next year. We know many in the Bank System think its cooperative structure will save them, but we don’t. The Banks have too much risk backstopped by too much money from the FDIC with too few customers to remain a viable liquidity system going forward – and that’s not even taking into account the revised mortgage market and the new role of Fannie and Freddie once Congress gets done with them.