JPMorgan Chase & Co. stands to reap a $29 billion windfall thanks to an accounting rule that lets the second-biggest U.S. bank transform bad loans it purchased from Washington Mutual Inc. into income.

Wells Fargo & Co., Bank of America Corp. and PNC Financial Services Group Inc. are also poised to benefit from taking over home lenders Wachovia Corp., Countrywide Financial Corp. and National City Corp., regulatory filings show. The deals provide a combined $56 billion in so-called accretable yield, the difference between the value of the loans on the banks’ balance sheets and the cash flow they’re expected to produce.

There are a few interesting storylines embedded in the piece. One is that the $29 billion writedown on Washington Mutual’s loan portfolio may actually have been too small. Calculated Risk notes that the figures JPMorgan used to calculate expected losses corresponded to a much shallower recession than has actually been experienced. PNC, for example, has been more conservative than JPMorgan in estimating anticipated accretable yield income, based on lingering uncertainty in housing markets.

But the piece also touches on two other related, and important, issues.

Namely, the decision to seize WaMu and the impact of the resulting mood on subsequent banking transactions. There is a line of thought in the financial world, originating with John Hempton but receiving a vote of confidence from Felix Salmon today, which states that it was the WaMu collapse, rather than the Lehman failure, which did most of the damage during last autumn’s financial crisis. Both incidents involved significant pain for bank debtholders — the chill wind that froze the credit markets. But while Lehman’s demise was the bigger and more stunning of the two, WaMu’s takeover was the event that turned debtholder pain from a one-off into a trend — which said, basically, that bank creditors everywhere should be nervous (a message they heeded).

What seems indisputable is that if allowing Lehman to fail was a bad decision, the seizure of WaMu was an incredibly bad decision. Increasingly, WaMu stakeholders seem to have a sound case that they received a raw deal, but it also looks as though National City, Wachovia, and Merrill Lynch were handed over on terms far too generous to the buyers, all thanks to the climate of terror that prevailed on Wall Street in the wake of the September crisis. A reference point — Bank of America’s expected accretable yield on its Countrywide portfolio is far more anemic than its anticipated yield on its Merrill loans. The difference? The world wasn’t panicking when Bank of America bought Countrywide.

What this all points to is the desperate need for clear authorization and a clear procedure for the orderly nationalization of systemically important banks in a time of crisis. We broke the glass last year and found nothing available save an extinguisher meant for much smaller fires.

Just a few months ago, after the failures of Washington Mutual and IndyMac Bancorp shook the financial world, industry consultant Bert Ely would have bet it was time to shut down the Office of Thrift Supervision. The government regulator doesn’t exactly have a track record to brag about: It’s at the forefront of the most severe housing market meltdown in a generation. The government last year seized three of the largest institutions it regulates. It oversaw Washington Mutual, by far the largest bank failure in American history. Officials on both sides of the political aisle, from Treasury Secretary Henry Paulson to regulatory experts, want to see it disbanded.

Illustration by: Matt Mahurin

But these days, Ely isn’t so sure. Although yet another scandal hit the OTS recently – a senior regulator was demoted after allegedly approving backdated IndyMac documents that made the bank appear more viable than it actually was, two months before it failed – the OTS may have discovered a way to survive. The agency, the primary regulator for savings and loans that specialize in mortgage lending, is finding new customers – and supporters – in the insurance industry.

At least three large insurance companies are waiting for approval to buy troubled thrifts and become eligible for bailout money from the government’s $700 billion Troubled Assets Relief Program, both the firms and the industry’s trade group said. The intent of TARP was not to help insurers buy ailing thrifts, and the insurers themselves are not in financial peril. But the companies applied in November, on the deadline for signing up for TARP money, to become savings and loan holding companies. The move would allow them to buy thrifts and qualify for government help – and, as an added bonus, be regulated by the OTS, instead of subject to stricter oversight by the Federal Reserve, Ely said. American Banker reported that four companies reached out to OTS to find troubled thrifts for them, and OTS cooperated.

The deals are still pending, OTS spokesman William Ruberry said. Until sales of the thrifts are final, the Treasury Department can’t make a decision on awarding the funds. One firm, Aegon NV, has since has withdrawn its application. But Jack Dolan, spokesman for the American Council of Life Insurers, an industry trade group, said additional insurers also have sought to buy thrifts and get TARP money, although his group doesn’t track the exact number. “The list may be longer” than just the three companies, he said.

Ely said the fact that insurers are trying to forge a partnership with the OTS to get the bailout funds means the troubled agency has gained some powerful political friends, who might not just sit back and watch if a new Obama administration tries to downsize or eliminate the OTS. Paulson last April called for the agency to be folded into the Office of Comptroller of the Currency, the nation’s top banking regulator. President-elect Barack Obama pledged recently to substantially overhaul the financial regulatory system.

“I was ready to say the OTS was history, but now I’ve changed my handicapping system,” said Ely, a leading banking industry observer. “It has gained a new set of allies – the insurance industry.”

The notion of insurance companies buying thrifts to get government money and avoid stricter federal regulations at the same time should be troubling, Ely said. If the companies bought banks instead, they could still get TARP money – but as bank holding companies they would be subject to tougher oversight, including more stringent requirements for reserves set aside to cover possible losses, among other things. “I can’t help but conclude that plays a role in why these companies are going out and buying crappy thrifts,” Ely said. “This ought to be generating some questions and concerns.”

Arthur Wilmarth, a George Washington University law professor who specializes in banking regulation, said he also believes insurers are drawn by OTS’ reputation as a “loosey-goosey” regulator, likely to go easy on its customers. “It’s not like there aren’t any sick banks to buy,” Wilmarth said. “There are 171 or so banks on the FDIC problem list. They must think that, at least for a time, they’ll be under an easier regime.”

The three firms that filed on the TARP deadline are the Hartford Financial Services Group, Lincoln National Corp., and Genworth Financial Inc. Representatives for Hartford and Genworth declined comment. Lincoln National did not respond to a request for comment. Aegon said in a statement it anticipated a stronger 2009 and decided not to seek TARP money. Private equity investors seeking to buy IndyMac also want to operate as a savings and loan holding company and be overseen by the OTS, the agency said.

Dolan, however, said he didn’t believe the insurers chose to buy thrifts just to come under the OTS umbrella. “Thrifts and banks do function somewhat differently,” he said. “The reason some insurers may be seeking thrift charters is that they fit the business model better than a bank charter.”
But regulatory experts say they see little other reason why insurers would choose specifically to buy thrifts, besides the OTS’ role in regulating them. As bank failures mount, they say, the agency’s actions during the housing boom, and its zeal for deregulation during the past eight years, are under closer scrutiny.

Patricia McCoy, a University of Connecticut law professor who specializes in subprime securitization and banking regulation, said inadequate OTS oversight in the past few years has included firms from failed subprime lender Countrywide Financial Corp. to insurance giant AIG and its involvement in credit default swaps. (AIG bought a savings and loan nine years ago.) The failures show how entrenched the agency’s problems have become, she said.

The OTS has been headed by “two very ideologically tilted directors who believe in deregulation with a passion,” McCoy said: James Gilleran, who began his term in 2001, and current director John Riech, who took office in 2005.

In 2003, Gilleran posed with the three other federal banking agency officials for a photo to illustrate the Bush Administration’s commitment to cutting red tape. Gilleran wielded a chainsaw instead of garden shears.

A review of the agency’s history of enforcement actions prior to bank failures or takeovers show that its actions were either late, or inadequate, McCoy said. Thrifts would be cited for compliance problems with flood insurance certificates, for example, rather than mortgage quality. The IndyMac backdating controversy is the latest debacle that should put an end to the question of the agency’s ability to function in its current form, she believes.

“The OTS is the worst federal regulator on the block,” she said. “It has a culture of being so permissive and cozy with the thrifts it regulates, that you can’t really break it without major reform. What we’re seeing is not only an attitude from the top but a pervasive way of doing business that has permeated even the front line examiners at OTS.”

Washington Mutual, which was seized by federal regulators in September, serves an example, she and others said.

The OTS had examiners on site at WaMu, “all the time, 24-7, and 365 days a year,” said Wilmarth, of GWU. Yet regulators somehow missed big problems at the institution, including those involving John Parsons, a supervisor of a mortgage processing center and a methamphetamine addict. Parsons told the New York Times in a jailhouse interview that his job was to churn out loans without regard to the borrower’s income or assets. And his drug problem was no secret, the Times said:

“In our world, it was tolerated,” said Sherri Zaback, who worked for Parsons and recalls seeing drug paraphernalia on his desk. “Everybody said, ‘He gets the job done.’”

“You would think they might have noticed that,” Wilmarth said. “How could they not have?”

The case of Darrel Dochow, the senior employee demoted in December over the backdated IndyMac documents, also summarizes the agency’s problems.

The Treasury Department’s inspector general concluded that Dochow approved an IndyMac strategy to overstate the strength of its financial condition, shortly before its failure in July, which cost the federal bank insurance fund nearly $9 billion. OTS also allowed other troubled banks to record capital infusions earlier than they had actually received them, which made them appear to be more financially viable than they actually were, the inspector general found.

It wasn’t Dochow’s first brush with trouble. Dochow was demoted from his position as head regulator of the Federal Home Loan Bank Board over his role in putting off for two years the shutdown of Charles Keating’s Lincoln Savings & Loan, which collapsed in 1989, one of the most well-known bank failures of the savings and loan crisis. McCoy said that keeping the thrift open was an unnecessary move that ended up costing taxpayers. “Lincoln did a huge amount of damage,” McCoy said.

The Federal Home Loan Bank Board was replaced by the OTS in 1989, as a move to tighten regulatory standards. Dochow and many other former employees, however, were hired on, McCoy said.

Dochow worked his way back up the bureaucratic ladder at OTS, and redeemed himself in 2006 by helping to persuade Countrywide Financial Corp. to switch its regulator from the OCC to the OTS, according to a Washington Post probe of the agency. The story described the OTS as having an “overly close identification with its banks.”

Aided in part by the Countrywide deal, Dochow was promoted to head of the agency’s western regional district by 2007, McCoy said, giving him the distinction of being at the center of two of the worst bank crises in recent history.

But OTS’s issues go beyond Dochow. As GW’s Wachter noted, the OTS competes with other regulators for its customers and relies on fees it charges the banks it oversees, giving it a problematic setup similar to that of credit rating agencies. Adding insurance companies into the OTS mix can only make things worse because of the secrecy and lack of openness regarding the TARP program, Wilmarth said. “There’s no transparency here,” he said.

But Ruberry, the OTS spokesman, said OTS unfairly gets tagged with responsibility for large bank failures, considering companies such as Citigroup and Wachovia, which are regulated by the Federal Deposit Insurance Corp., also would have failed, but were helped out by the government. Thrifts also were more vulnerable because of their emphasis on mortgage lending. “It hit the industry particularly hard,” he said.

He also said it wasn’t true that the OTS went easier on banks than other regulators did. The agency did the best regulatory job it could during the housing boom, considering the large majority of subprime loans were made by independent lenders, not OTS banks, he said. Congress, Ruberry added, will have to decide the agency’s future, but the OTS believes it has a necessary role in representing smaller, community banks.

Despite all the controversies, the OTS could end up surviving, McCoy and others predicted.

Pairing with insurance companies to rebuild its customer base could strengthen the agency and help it fend off reformers, McCoy said. And, as Ely pointed out, insurers have a well-funded lobby to come to the agency’s side.

“The insurance companies WILL try to defend the existence of the OTS,” McCoy said. “This is an agency fighting for its life.”

With the help of government bailout money and powerful friends, it just might succeed.

U.S. Federal Reserve Headquarters (Flickr: NCinDC)

The complex structure of modern capital markets is increasingly the cause of financial crises. External shocks like a decline in housing prices are intensified as they move through the convoluted chains of dealings that link market participants. Concentration of trading among a small group of dealers only heightens the many risks.

In hindsight, the Federal Reserve’s decision not to bail out Lehman Bros. was a major miscalculation that helped generate the wave of financial anxiety, distrust and uncertainty that doomed American International Group and other institutions. It also helped freeze up credit markets that are only now beginning to thaw. If government overseers had shown greater appreciation and knowledge of the plumbing of the financial system they regulate, some form of Lehman might still be around.

Illustration by: Matt Mahurin

In any case, central bankers and finance ministers frequently act like Pritzker Prize-winning architects charged with trying to unstop clogged plumbing. As a result, they find, as Woody Allen described: “Not only is there no god, but try getting a plumber on weekends.”

In fairness, even experienced professionals struggle to understand the structure of modern markets. One is Jeremy Grantham, chairman of GMO. He recently rated his knowledge of the markets this way: “I want to emphasize how little I understand all of the intricate workings of the global financial system. I hope that someone else gets it, because I don’t. … It is just so intricate that all I can conclude, by instinct and by reading the history books, is that it will be longer, harder and more complicated than we expect [to solve the financial crisis].”

One consequence of the system’s complexity and interconnectedness is that it is difficult to analyze the solvency of financial institutions. The speed with which liquidity and access to funding can evaporate — as with the Dutch bank, Fortis — renders financial statements virtually meaningless.

Agreements governing a firm’s ties to other financial companies also increasingly affect perceptions of its solvency. For example, the downgrade of AIG to below an “AA” credit rating triggered margin calls in excess of $10 billion from the company’s lenders. It also gave AIG’s outside trading parties the right to terminate certain contracts, triggering losses of $4 billion to $5 billion. AIG did not have the resources to meet its obligations — and the government had to step in and bail out the world’s largest insurer.

How a company’s financial distress will affect the overall system can depend on how it is restructured. In the case of Lehman, it was the holding company that filed for bankruptcy protection. The investment bank’s other businesses continued to run. That means financial institutions doing business with Lehman were differently affected by its collapse.

The effects of the demise of Washington Mutual, the largest bank failure in U.S. history, were different. The Federal Deposit Insurance Corp. seized the Seattle thrift following a wave of deposit withdrawals. J.P. Morgan Chase subsequently agreed to acquire WaMu’s banking operations and assume its loan portfolio in a $1.9 billion deal engineered by the government regulator. WaMu’s customers were largely unaffected.

Lehman Bros., New York (Flickr: James Chen)

What’s predictable when financial institutions fail is that investors lose money. With Lehman, unlucky creditors included banks on every continent that had bought Lehman securities and bonds. Because J.P. Morgan did not assume WaMu’s senior unsecured debt, subordinated debt and preferred stock, investors in those financial instruments lost out.

Those losses can be steep. Market estimates of how much Lehman’s debt is worth range from 10 cents to 15 cents on the dollar — a potential loss to investors of 85 percent to 90 percent. In general, recovery rates will be determined by the nature of the assets that Lehman’s counterparties hold — private equity stakes, principal investments, hedge-fund equity, complex slices of risk in structured financial instruments and derivatives. The difficulty in valuing these assets — and the illiquidity of others — may exacerbate investor losses.

One way to examine the complexity of today’s financial plumbing is to focus on a Chapter 11 bankruptcy filing. When a firm files for bankruptcy, all contracts that it has had with trading partners — and the number can be huge — would usually terminate. Lehman reportedly had about 2 million open contracts.

Add to the sheer number of contracts the possibility of incomplete documentation, or plain error. Then throw in operational risks and problems of logistics.

All this triggers a complex chain of events.

The net value of an individual financial contract between a counterparty and a distressed firm may be settled if the contract specifies the amount. If it is the counterparty that owes the amount, it must pay it to the bankruptcy trustee. This means an immediate — and possibly large — cash outlay for the non-defaulting party. If the distressed firm owes the amount, then the counterparty must supply documentary proof to the bankruptcy trustee and await payment.

If the counterparty holds collateral to secure its exposure, then the collateral must be sold to cover the amount due.

If the contract was used as a hedge, its termination exposes the counterparty to its underlying risk. The counterparty must then enter into new contracts to re-hedge itself to avoid additional risk. In general, hedging must be done on a contract-by-contract basis, with limited scope for retrieving net value.

Because this process is complex and time-consuming, the amount of losses sustained may not be certain for some time.

The Chapter 11 filing may also trigger contracts concerning the firm itself. For example, Lehman’s bankruptcy filing would have required settlement of credit default swap contracts that, in effect, insured some of the investment bank’s debt. If a Lehman counterparty held these contracts as hedges, they would ease its losses. In all cases, settlements would create potential losses and claims on available liquidity and funding. Settlement of credit default swaps on Lehman’s debt, for example, came to about $365 billion.

A firm’s bankruptcy affects other parties through “contagion.” Counterparties that had dealings with the distressed firm either face losses or suffer cash outflows as they meet termination payments. They may face additional losses on sales of collateral or from re-hedging positions. These losses affect their credit quality, possibly leading to a fall in their share prices and increases in their borrowing costs. If credit ratings are affected, margin calls may be the result, further threatening solvency.

The overall market is also affected. Greater volatility in asset prices may reflect liquidation of positions, re-hedging activity and sales of collateral. Trading liquidity falls as the number of counterparties drops. Credit becomes scarce, limiting firms’ ability to deal with each other.

Uncertainty over the fallout of a company going under can cause trading in the inter-bank lending market to freeze up. That, in turn, further increases volatility and exposes weaker firms to failure.

Bankruptcy proceedings inevitably accelerate the need to deal with assets that are difficult to value or are illiquid. In resolving the matter, trustees and administrators, acting in the best interest of creditors, can adversely affect the overall market.

And because bankruptcy law is jurisdiction-specific, different sets of trustees and administrators have to grapple with how to best manage the assets of a firm to settle with its creditors. In the case of Lehman, there are already disputes about transfers, totalling $8 billion, made between the investment bank’s London office and those in the United States.

They may also differ in their approaches to dealing with assets. The U.S. trustee in the Lehman bankruptcy indicated that “time was of essence” in dealing with the bank’s assets. In contrast, the British administrator anticipated a long drawn-out affair. All this creates uncertainty about the effect of Lehman’s demise on its creditors and the overall market.

Assets held in a fiduciary capacity can become entangled in this mess. Where Lehman acted as their prime broker, hedge funds and other asset managers face potentially lengthy delays in recovering their investment. About $45 billion in assets, and $20 billion in short positions, are affected. Here’s another problem: Though unable to deal with their assets, legal owners may face margin calls if the value of their positions deteriorates.

A bankruptcy filing can thus reveal the complex networks that tie together all participants in modern financial markets. The chains of risk can spread problems from distressed financial institutions to weak ones, and can ultimately affect even strong firms seemingly remote from the problem.

Assume Bank A, a sound financial institution, has large hedges with Bank B, another sound institution. If a counterparty to Bank B has difficulties, its resulting losses may imperil Bank B, which, in turn, might affect Bank A.

The risk spreads through direct losses, liquidity calls, funding problems or uncertainty. Confidence in the financial system is undermined and financial transactions grind to a halt. It’s a contagion that resembles a hungry wolf pack systematically hunting down the weakest prey in a herd.

Understanding the financial system’s detailed connections, while unglamorous, is the key to anticipating the evolution of a crisis and preventing further exposure to events. It is also where long-term reform efforts should be directed.

John W. Gardner once observed: “The society which scorns excellence in plumbing as a humble activity and tolerates shoddiness in philosophy because it is an exalted activity will have neither good plumbing nor good philosophy: neither its pipes nor its theories will hold water.”

Shoddy monetary philosophies caused the financial crisis. Now inadequate plumbing of the global financial system is greatly increasing its risks.

Satyajit Das is a risk consultant and author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.”

At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article although he may be an owner indirectly as an investor in a fund.

WaMu was one of the more notorious subprime lenders – remember this pool of WaMu Alt-A loans we talked about last spring, the one where all the loans were quickly going into default? – so its failure wasn’t unexpected. But as Steve Waldman at Interfluidity points out, why was WaMu seized by the government on a Thursday? The Federal Deposit Insurance Corp. uniformly announces bank failures at the end of the day on a Friday, to reorganize things for Monday and to avoid setting off any bank runs or panic.

But WaMu’s demise comes out in the midst of tense negotiations over a $700 billion bailout of Wall Street that the Treasury Department and the Bush Administration say are desperately needed to stabilize the nation’s financial system. An agreement on the bill seemed on track early Thursday, but by the evening the talks had imploded.

Admitting it’s possible he’s just another conspiracy theorist, Waldman nonetheless can’t help asking the question the Thursday failure begs: Why did Friday come early this week, of all weeks

I am dark. Secretary Paulson could have offered any number of proposals to help ensure that this collapsing house of cards is a controlled demolition. He and Dr. Bernanke had months to put together policy options, long months between the fall of Bear and the fall of Lehman to create orderly processes for disorderly events they knew could come. At the last moment, they offered one option, a particularly unpersuasive plan imperiously presented as a fait accompli. When Congress balked, they relented and offered a few crumbs so that the people we elected could nibble at the edges without altering the core. And today, when it looks like those crumbs might not have been enough, we have the largest bank failure in American history, announced, oddly, on a Thursday night

When all this is over – I say that with a sense of hope rather than any proof that there’s some good ending here – the timing of both the Treasury plan and the WaMu seizure will be scrutinized closely. Shut down a bank when you don’t normally do in the middle of a pitched battle and you’ve raised some serious questions. Are the markets really that close to failing? Or does the government just want its way?