Washington Mutual Reeducates Investors On Failure

There are now all sorts of articles on Washington Mutual's failure. Something that is missing from the discussion is: Why the stock was trading for more than pennies before today. Most folks will point to the SEC regulations that forbid shorting. In a normal market, people who think the bank is insolvent would have shorted WM. So all those folks that bought yesterday would have been saved from the opportunity to lose $1.99/share, because the stock would have already been trading at pennies.

However, I think those regulations are only part of the story. The real question is: Who was still holding the stock?

I can only conclude is that it was mostly held by folks who do not understand the basic capital structure of businesses. The arguments for holding the stock seem to run along the lines of "$1.99 per share?! The furniture is worth more than that!" Now would be a good time to relearn about capital structure, because the common shareholders don't see any of the money from the sale of furniture.

When a company wants to raise money, it has several options. For simplicity, we will look at only bonds, preferred stock, and common stock.

Common stock: An investor puts up money, and will see the promise of share appreciation and/or dividends as the business grows.

Preferred stock: Perhaps the company has already issued common stock and sees a clear business opportunity that requires capital to pursue. They make an offer to investors that they will take money in exchange for preferred stock, which carries a specified dividend, and they guarantee that the investors will get their money before common stockholders if the company fails.

Bonds: The company has some asset (like a building and furniture), and it borrows from a bond investor by offering the asset as collateral. If the company fails, the bond investor sells the asset to recover the debt.

So what happened in the Washington Mutual failure? The banking part of the company was taken over by the FDIC. Since the FDIC is going to take a loss on the banking part of the biz, it sold off the deposits to JPM for $2B. There are other items that need selling.

The remaining part of WaMu (the holding company) will sell off everything that remains, which is not much. The bondholders might see a few pennies, but there are back salaries (for example) to need to be paid first.

After the few pennies go to the bond holders, there is no money left for the preferred stockholders. The common stockholders might as well go out for a beer, because they have no hope of seeing any money from the carcass.

So now the question is: Why are stocks of the remaining troubled banks not at pennies? Will the shareholders learn the lesson from WaMu?