Market Recap

And yet another one bites the dust. Washington Mutual was last week’s casualty in a financial saga that has seen Lehman Brothers and IndyMac driven out of business, and that has led to the hastily arranged rescues of Merrill Lynch and Bear Stearns.

In what is by far the largest bank rescue in U.S. history, federal regulators seized WaMu and struck a deal to sell the bulk of its operations to J.P. Morgan. WaMu’s breathtakingly swift collapse was triggered by a wave of deposit withdrawals as many investors – proving to be prophetically right – believed the end was near. The good news is that all WaMu depositors will have access to their cash; the bad news is that holders of $30 billion in debt and all common shareholders will end up with nothing.

To get an idea of how fast and furious WaMu’s fall from grace was, last September its stock was changing hands at $35 a share. In Friday’s trading, it was changing hands at $0.16 a share, and that’s probably overvalued. The irony, if there is any, is that WaMu rejected a takeover offer from J.P. Morgan in March that valued the savings and loan at $4 a share.

Unfortunately, Washington isn’t doing much to assuage concerns of very nervous capital markets. The Bush administration wants Congress to authorize a $700 billion debt issue to allow the government to purchase collateralized debt obligations (CDOs) that banks can’t sell except at large losses, including mortgage-backed securities backed by poorly performing loans. While Democrats say the plan should include direct help for troubled borrowers and protections for taxpayers, some Republicans want any government program to be aimed solely at unfreezing the credit market’s institutions. As of week’s end, the two sides were at an impasse.

Time to Act

As of late Friday, the Bush Administration and Treasury Secretary Henry Paulson continue to woo Congress for $700 billion to buy distressed loans and CDOs. Let’s hope the wooing works; the purchases would inject much-needed cash onto bank balance sheets, helping to restore normal lending activity.

Yes, $700 billion is a lot of money, but keep in mind that it isn’t all a write-off. In 1989, Congress created the Resolution Trust Corp. to take over $125 billion in assets owned by 296 failed savings and loan associations. Over the next six years it added $394 billion in assets belonging to an additional 747 insolvent thrifts. The RTC’s job was to sell those assets, mostly real estate, at the best price it could get. In the end, the S&L cleanup cost American taxpayers an estimated $124 billion, but the RTC likely averted even worse consequences and higher costs.

Some pundits believe the current bailout could turn out to be a better deal for taxpayers. Here’s the math provided by the Wall Street Journal: Better mortgages and CDOs are selling for $0.70 on the dollar. But many are seriously distressed, priced at only $0.15 to $0.25 on the dollar. If the Treasury is able to purchase the CDOs at favorable prices (and banks are in no position to haggle), it could realize hundreds of billions of dollars in profits over the next 10 years as the market improves.

But more important, today's purchases would loosen credit markets now, virtually guaranteeing that it will be averting even worse consequences and higher costs in the future.