Mortgage Reform: Why Government Intelligence is Oxymoron

This post first appeared on Minyanville and our sister site Dawn Patrol.

After leading the banking sector to its largest ever one-day drop yesterday, Washington Mutual (WM), in an effort to assuage concerns that it's facing a cash crunch, released a statement claiming that the bank is "well-capitalized."

Though the stock bucked the trend this morning as the broader financial complex continued its unrelenting sell-off, shareholders aren’t likely to be comforted by the WaMu’s pleas for calm.

The largest savings-and-loan in the country has seen share prices fall below $4 following the seizure of IndyMac (IMB) by benevolent federal banking regulators; investors fear WaMu could be next.

IndyMac was reopened on Monday to handle endless lines of depositors hoping to recover their pennies from the bank’s coffers.

In a stark reminder of just how dicey bottom-picking can be, Bloomberg reminded us that private-equity firm TPG led a consortium of investors in providing the bank with $7 billion in much-needed cash in April, when the stock traded at $13. Those daring saviors have seen most of their investment wiped out.

TPG did, however, slip a protective clause into the deal: If the stock drops below $8.75 -- which it clearly has -- TPG is owed the difference, effectively putting the bank on the hook for its own equity losses. While protecting TPG's investment, this feature also makes it considerably more costly, if not impossible, for the bank to raise more capital, which would further dilute shares.

As more details emerge about these and other onerous terms with which banks have been forced to agree in their efforts to raise capital, it's becoming clear just how misguidedly optimistic investors were when such deals were first announced. Banking expert Minyan Peter wrote of the WaMu deal:

“I think the problem for most market participants right now is the assumption [that] what we're experiencing looks something like 'their prior experiences in banking crises.' And to me, that's why we have seen such a big rally over the past two weeks -- because, based on prior experience, a rally feels very right, right about now.

But for all the reasons I shared before, this one is different.”

We’re now seeing just how different this one is.

Professor Depew explained Friday how the Fannie Mae (FNM) and Freddie Mac (FRE) crisis is different from the Long-Term Capital Management failure in 1998: In this case, massive losses by financial institutions around the world are a symptom, not the cause.

A few misplaced bets aren’t to blame for the market turmoil; neither is rumor-mongering. The financial system’s problems, and by extension the economy’s, are rooted in years of mispriced risk and excessive leverage. Markets are now witnessing the destruction of that debt at a rate that’s stomach-churning to the traditional buy-and-hold investor.

The process, though painful, is necessary. The debt will be destroyed, firms will go out of business and the economy will slow, if not contract. All this is healthy. Agonizing, to be sure, but healthy.

As Toddo wrote yesterday on the Buzz and Banter, “The big picture blues will lead to an unfortunate destination, but that’s necessary to rebuild the foundation for sustainable economic growth. Once we get there, those with capital will be in a fantastic position to prosper.”