Last Updated: April 8, 2008: 3:05 PM EDT
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The smart money saves WaMu

Expect big buyout firms to spend the next year bankrolling the beginnings of a banking-sector recovery.

By Colin Barr, Fortune senior writer

Doomsday on Wall Street
Washington Mutual landed a $7 billion cash infusion from private equity firm TPG and other investors

NEW YORK (Fortune) -- Bank investors are crossing their fingers that Washington Mutual has drawn a road map that shows a way out of the mortgage meltdown.

The Seattle-based thrift scored a $7 billion capital infusion Tuesday from a group led by private equity shop TPG. Washington Mutual (WM, Fortune 500) shares dropped 10%, but their avoidance of a bruising selloff in the wake of the highly dilutive deal is testament to the faith investors have in TPG founder David Bonderman, whose experience in the industry dates back to the savings-and-loan crisis of the late 1980s.

Investors are also hopeful that the smart money is ready at last to brave the financial sector, which has been in decline for the past nine months. Some investors are betting that the WaMu investment will pave the way for similar deals at other financial firms with hefty mortgage exposure, particularly in so-called speculator states such as California, Florida, Arizona and Nevada.

Cleveland-based National City (NCC, Fortune 500), which last year made an ill-timed move into the now sickly Florida mortgage market, reportedly is considering a merger with KeyCorp (KEY, Fortune 500) that could involve a capital infusion from private equity titan Kohlberg Kravis Roberts. Fannie Mae (FNM) and Freddie Mac (FRE, Fortune 500) could each to raise $2 billion to $5 billion in new capital over the coming year, "given the non-trivial potential impact of worse-than-expected credit performance on these highly levered businesses,"Goldman Sachs analysts wrote Tuesday morning.

Roger Ehrenberg, a former Wall Street executive who writes the Information Arbitrage blog, expects to see much of the new money for hard-hit firms like National City coming from buyout shops, which have raised billions of dollars but have had little opportunity in recent months to deploy big chunks of money. "You will see more of this kind of deal because of the liquidity in private equity," he says.

If Washington Mutual proves to be a model for future dealmaking, investors are likely to pay a steep price. Washington Mutual will issue new stock equivalent to 20% of the outstanding share base at $8.75 a share - a price well below recent trading levels.

Still, WaMu investors welcomed the deal despite its rough terms. The bank's strong new ownership will undoubtedly find a way to make the most of Washington Mutual's huge retail deposit base and nationwide branch network. Along with TPG partner Jim Coulter, Bonderman was behind Texas billionaire Robert Bass' 1988 rescue of the failed California thrift American Savings Bank, the Wall Street Journal reported Tuesday. Bonderman and Coulter made $750 million in selling the thrift to Washington Mutual in a 1996 deal that put Bonderman on WaMu's board. He stayed on the board till 2002.

"In TPG we have found a great partner with a terrific investment track record," said Washington Mutual chief Kerry Killinger. "We are particularly pleased that David [Bonderman] will rejoin our board. He has a long history with the company - having previously served as a Washington Mutual director - and we are privileged to once again benefit from his insight and experience."

Killinger, meanwhile, stays on as CEO in spite of Washington Mutual's problems on the mortgage front. The thrift profited mightily in the first half of this decade as the housing boom sent house prices rocketing nationwide. But WaMu shares have been in free fall since the mortgage securities market collapsed last summer. The firm has over the course of two quarters slashed its quarterly dividend to a penny a share from 56 cents and sharply raised its reserves for possible loan losses.

Until today, there was a sense that Washington Mutual may have been soft-pedaling the extent of its problems. Finance chief Tom Casey, for instance, told investors in October, when the bank posted a 72% drop in third-quarter earnings, that the bank expected to take a 2007 credit loss provision of $2.7 billion to $2.9 billion. But when the company posted fourth-quarter numbers in January, its full-year credit provision was $3.1 billion.

Similarly, Killinger said in January that WaMu expected to take first-quarter credit loss reserves of $1.8 billion to $2 billion. But the company said in making its blockbuster TPG investment announcement Tuesday that its actual first-quarter credit provision was nearly double the low end of that range - $3.5 billion.

That trend, along with continued housing slump nationwide, means that, for all of its expertise, TPG is buying into a highly uncertain environment. Further deterioration in housing industry fundamentals could leave the WaMu investment under water.

Ehrenberg, the former Wall Streeter who now invests in small companies, notes the cautionary tale of private equity firm Warburg Pincus' investment in bond insurer MBIA (MBI).

In December, Warburg agreed to buy $500 million worth of MBIA stock at $31. But the ink was barely dry on that pact before MBIA shares lost more than half their value, amid worries about the firm's exposure to deteriorating structured finance guarantees. Warburg completed the agreement on Jan. 31 and bought more stock at lower prices, supporting MBIA's need for additional capital and bringing Warburg's cost basis down.

As smart as Bonderman is, Ehrenberg says, the MBIA episode raises an uneasy question.

"Where is the bottom?" Ehrenberg asks. Even with the WaMu deal struck at an attractive per-share price of $8 and change, he adds, there is no way now for investors to be sure the stock isn't "headed to $3."  To top of page

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