The following is a statement from the FDIC's website, regarding JP Morgan's (JPM) purchase of Washington Mutual (WM):

"For all depositors and other customers of Washington Mutual Bank, this is simply a combination of two banks," said FDIC Chairman Sheila C. Bair. "For bank customers, it will be a seamless transition. There will be no interruption in services and bank customers should expect business as usual come Friday morning."

"WaMu's balance sheet and the payment paid by JPMorgan Chase allowed a transaction in which neither the uninsured depositors nor the insurance fund absorbed any losses," Bair said.

JPMorgan Chase acquired the assets, assumed the qualified financial contracts and made a payment of $1.9 billion. Claims by equity, subordinated and senior debt holders were not acquired.

The second statement above seems to be a real simple statement, but when you look closely at what it means, you will begin to notice some real important implications. I think some of these implications could have far reaching un-intended consequences for capital markets.  Consequences such as businesses and institutions reduced willingness to lend money to businesses.  At the very least, the borrowing costs for businesses could continue to increase dramatically as the nation moves forward through this crisis.

Essentially in this JPM-WM acquisition,  that was obviously orchestrated by the Fed,  all stockholders and bondholders of Washington Mutual are effectively wiped out.  They will not receive anything back on their original investments.  In the event that they are repaid, it will most likely be a small fraction of their original investment.  The bondholders have become general creditors, in line with everyone else seeking to get paid.  The stockholders are in line after the bondholders. The FDIC (USA) has made the claims of the counter-parties of all the swap contracts, futures contracts senior to those of the bondholders in the capital structure.

This is a HUGE deal. Why were the counter-parties given precedence over the debt holders of the firm ? The claims of the holders of "Qualified Contracts" should be pari-passu (see definition below) with other debtors of the firm.  The obvious reason that it was done this way,  was to try to maintain some stability in the financial markets.  Unfortunately, in this case,  it was done at the expense of the bondholders of the firm.

Think about the logic for a minute here. WAMU sold bonds to investors and used that money to go out and leverage up their firm so that they could increase their returns to their equity holders. The investors loaning WAMU that money took risk for a fixed rate of return (interest rate on the bonds).  WAMU then used this money from investors to enter into swap, derivative and futures contracts with other counter-parties.  The other counter-parties entered into Agreements with WAMU to earn a return on those Agreements for their respective firms.

The counter-parties knew that there was a certain amount of risk, entering into those Agreements with WAMU.  Their main risk as a counter-party was default risk.  They ought to share in some of the financial loss as well.  Their bad decisions to do business with WAMU was equally as bad as the bondholders decision to lend WAMU money!

The sad part of this is that most people are probably not even aware of this.  As all the focus and attention is on the $700bn bailout, things like this are going on every day and are not receiving any attention because most people don't pause to think about them. I'd love to get some feedback from readers about what they think or how they feel about this article. I'd love to hear your comments.

Definition of Pari-Passu: This term is also often used in bankruptcy proceedings where creditors are said to be paid pari passu, or each creditor is paid pro rata in accordance with the amount of his claim. Here its meaning is 'equally and without preference'.