Tuesday, April 8, 2008

$7 Billion Cash for Washington Mutual

Though mainly, on this blog, I am developing a model that analyzes the value of cash, and arguing that the upcoming recession will more likely be deflationary than inflationary, there will be times for interjecting significant news stories. This latest one is a $7 billion infusion of capital into Washington Mutual, a Savings and Loan, and a major player in recent subprime mortgages. In part it illustrates concerns around fractional reserve lending (see post below).

Washington Mutual devalued existing shares in order to get the cash it needed to stay afloat. It was losing its capital base from subprime foreclosures. When it lends it can leverage its capital base by a factor of 9 (with 10% fractional reserves), but when a loan defaults, that full amount is deducted from its balance sheet (mitigated by what the bank can get from selling the house).

Though the extra cash is good news for Washington Mutual, and anyone who does business with them—it is good news only in that Washington Mutual is barely staying afloat as opposed to collapsing from bad loans. It is mixed bad news for shareholders—though their shares are declining and dividends evaporating, at least they aren’t becoming worthless. It is good news for those who paid the $7 billion—they are probably getting a good deal on a sizable piece of the bank.

Lately, this is what is considered “good news” in finances: not prosperity, but either hanging on by your fingertips, or buying troubled assets for cheap. This is a deflationary event, and if it recurs enough we face a deflationary recession.

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