WaMu's demise was lesson in regulatory failure

The failure of Washington Mutual came during the peak of last fall's panic, when the very financial system seemed on the brink of collapse.

The government had taken over Fannie Mae and Freddie Mac, and Merrill Lynch was being forced into a shotgun marriage with Bank of America. Yet days later, Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke made the fateful and controversial decision to abandon Lehman Brothers, one of the largest and most storied investment banks on Wall Street.

The object lesson — that there would be consequences for reckless risk-taking — backfired. The panic accelerated and spread worldwide, markets nose-dived, and the government was forced to give an $85 billion emergency loan to AIG, a little-known giant whose exotic contracts were bombs within the financial system and had been lit by the Lehman collapse. Meanwhile, banking giant Wachovia was on the brink.

Yet WaMu was no mere sideshow to the real action on the East Coast. As related by David Wessel in his riveting new book, "In Fed We Trust," it emerged as a pivotal flash point between the officials desperately improvising a way out of the global crisis.

As Paulson was quietly pushing for a merger with JPMorgan Chase, customers withdrew 9 percent of WaMu's deposits in 10 days. It was a modern bank run, ending only when regulators seized the institution's two banking units, resulting in the largest bank failure in U.S. history. Chase paid a mere $1.9 billion for WaMu's deposits, loans and branches. Shareholders, who owned a company that had once enjoyed a peak market value of nearly $50 billion, were wiped out.

Paulson and Timothy Geithner, president of the New York Fed, wanted to stand by WaMu debt holders, as had happened with Bear Stearns — something they saw as critical for the health of the credit markets. But they were rebuffed by Sheila Bair, the tough chairwoman of the Federal Deposit Insurance Corp., who gained jurisdiction over failed WaMu and was determined to administer an object lesson of her own. She won a contentious debate, and it appeared as if bondholders might get only pennies on the dollar.

Yet as much as Bair was lionized, her move also backfired as investor confidence fell further and credit froze.

As Wachovia nearly went the way of the Seattle thrift, Wessel recounts, "Geithner blew up." Not only must Wachovia stay open, but its buyer must receive government help and its bond holders be protected. "It has to be this way," Geithner said. "The policy of the U.S. government is that there will be no more WaMus."

(The ultimate fate of WaMu's bondholders is the subject of continuing litigation. Depending on the outcome, at least some classes of holders may ultimately do well; but that wasn't how the markets read Bair's move then).

By October, the Bush administration and the Fed essentially had promised to stand behind all bank investors. The WaMu doctrine was completely upended, although too late to save one of Seattle's most important headquarters, its thousands of well-paid jobs, its community giving and the diversity it added to the economy.

History will remember that the 120-year-old institution was done in by the horrific management malpractice of CEO Kerry Killinger and his top lieutenants. But it should also be recalled as a tragic and costly regulatory disaster. Killinger was hardly the only greedy and reckless banker in America.

In the go-go years, WaMu might well have avoided disaster if it had been policed by a regulator as aggressive as Bair. Unfortunately the ruling ethos after the deregulation of the late 1990s was for regulators to go easy and let the market police itself, even as safety and soundness were overtaken by swindles and fraud.

The second mistake came during those crisis-filled days when depositors were pulling their money.

If the federal government had given then all the guarantees to depositors and investors it would eventually be forced to make ... if the "bad WaMu" of toxic assets had been separated and quarantined from the "good WaMu" of the viable banking business, and if accounting rules had been changed to improve the value of its holdings ... Washington Mutual might have survived.

Yet the thrift's timing was bad, it wasn't politically well-connected, and it became one more footnote in the great panic of '08. The loss to Seattle was grievous. The lost opportunity went far beyond the Northwest.

Today the banking system is more concentrated than ever. The banks that posed a systemic risk because of their size a year ago are even bigger, raising alarms from such observers as Nobel laureate economist Joseph Stiglitz and former Fed Chairman Paul Volcker. Regulatory reform is fading. The surviving bankers are bringing out new "innovations." None of this bodes well for the long-term health or stability of the financial system.

A determination to create a better regulated, more diverse financial system, with more players rather than fewer, and banking centers across America — all this might have begun with the insistence that WaMu remain independent under new, prudent management.

Alas, it was not to be.

You may reach Jon Talton at jtalton@seattletimes.com