The Wells Fargo / Wachovia Story from 1994 to 2012

So, I bought a bank. I know...I know. I said I wouldn't. Then again, that was a year or two ago, when I couldn't understand what the hell these guys were doing to make money. CDOs. Sub-prime mortgages. I would try to read the annual reports, and they would make my head spin.

Fortunately, the days of "creative" investing is over...for now. I have full faith that Wall Street will ensnare the markets in another mess in the next ten or twenty years. Still, banks will eventually return to "normal" for at least a while. (That is, of course, once they get through this "panic" mode.)

In a "normal" environment, banks aren't all that difficult to understand. The lend money; the sell investments and financial products; they make money on interest rate spreads. With blood pouring through the streets in the banking sector, much of it for good reason, we'll look at Wells Fargo and Wachovia, separate and together.

Grab a cup of coffee. This is a long one, Then again, we're expanding our sphere which ain't light reading.

Wells Fargo, from 1994 through 2008

An analysis of Wells Fargo starts in 1994 — the earliest date we can get annual reports from the SEC's IDEA Database (formerly EDGAR). I'll spare you the historical details prior to 1999. Needless to say, Wells Fargo was a very strong bank. Its merger with Norwest in the late 1990s turned the company into a giant.

Of course, the merger wasn't without growing pains. In the first few years after the merger, Wells Fargo would take $500 to $800 million hits to earnings based on non-cash amortization charges, as well as non-recurring (or short-lived) restructuring charges and integration charges (like software purchases to bring the two entities onto one computer system, advertising to keep customers well-informed during the transition, etc.)

From 1999 through 2002, Wells Fargo would report aggregate net income of roughly $16.8 billion. Its actual cash earnings were closer to $20.1 billion during that time, generating nearly 20% cash returns on equity.

From 1999 through 2007, cash earnings grew from $4.9 billion to roughly $9.4 billion a year. In addition, Wells Fargo periodically repurchased shares, increasing the intrinsic value per share as the company grew.

We'll get into the actual valuation after we explore the businesses at length. For now, as you can see on the chart below, let's just say that Mr. Market did a pretty decent job of valuing Wells Fargo for most of 2000 through 2007. For the moment, ignore the 2008 section of the graph. We'll look at that as we pick apart today's valuation of the combined Wells Fargo/Wachovia entity.

Wachovia, from 1999 through 2007

Wachovia's earnings were much more sporadic than those of Wells Fargo in the early 2000s. Like Wells Fargo, however, Wachovia had a ton of non-cash charges and non-recurring charges that should be accounted for in calculating intrinsic value. Remember: It's the accountant's job to record the business; it's our job to evaluate it. In that light, we need to figure out what Wachovia would have earned had it not taken those special charges.

Don't get me wrong: Those charges are real. Still, because they were non-recurring or short-lived, and because we're looking into the future, we need to figure out what Wachovia would look like after it's done taking those charges.

Once again, Mr. Market did a good job of pricing a business. Wachovia generally traded right around its intrinsic value, with very little margin of safety, from 1999 through 2007. (Keep in mind that I calculate intrinsic value for each year as though I were an investor evaluating the business at that time, and not backwards looking with today's information.)

Rather than saying Wachovia's business took a small beating early in the 2000s, I'd look at it this way: Wachovia's business was too profitable in the late 1990s. The dot-com bubble paved the way for massive trading commissions, lots of investment activity, and unsustainable profits. When that bubble burst, Wachovia had some restructuring to do to get back to "normalcy."

Part of that return to normalcy was taking more than $5 billion in restructuring and goodwill charges from 2000 through 2002. When that was done, Wachovia returned to a more "normal" state of business, generating $4 to $5 billion in cash flow — cash flow that would increase to $7.5 billion in 2007.

The Combined Companies

Together, Wells Fargo and Wachovia would have been one heck of a team from 1999 through 2007, generating $8 billion in cash flow in the early part of the 2000s, and growing that to $17 billion a year by the end of 2007.

Their cash return on equity would have been around 15% during that time. Of course, that number is suspect because of the inflated asset values of the late 2000s — values that increased their combined shareholder equity to $124 billion.

Also suspect is the cash flow, some of which was derived from mortgages, mortgage-related investments, and other bubble-type "assets" that have since lost value or appeal. So, our job as investors is to figure out the value of this combined entity and to assess, with a degree of certainty, the future cash flow that this business will generate.

Planning for Losses

In 2007, the combined entity — Wells Fargo and Wachovia (we'll call it "Wellsovia" for our purposes here) — generated $17.3 billion in excess cash, and that's after setting aside $7.2 billion in credit reserves.

On a bank's financial statements, you'll usually find a line that shows the "provision for loan losses" or "provision for credit losses." This is a non-cash charge to earnings based on what the bank expects to lose on its loan portfolio; so, it reduces earnings. Though it's technically a "non-cash" charge, we don't add it to the cash flow of the business because these are losses that are likely to materialize, in which case the charge becomes "real."

It's the first quarter of 2008 and the proverbial you-know-what is hitting the fan. The credit crisis has begun; the recession has started; Bear Stearns will be a distant memory by the end of the quarter. Wellsovia sets aside $4.86 billion for credit losses this quarter, more than half of what it had set aside in the entire year 2007 if it were a combined entity.

Though Wellsovia — the soon-to-be-combined entity of Wells Fargo and Wachovia — reports just $980 million in earnings for the quarter, it generates roughly $1.5 billion in cash, when accounting for various non-cash charges like amortization of core deposits, restructuring charges, etc. If the company doesn't take the full $4.86 billion in credit hits, that amount will show up in earnings down the road; so, we make a note of it and move on.

2008: Wellsovia Q2

As the credit crisis and recession begin to grasp the economy and markets, Wachovia has some bad news for Mr. Market — it lost a staggering $9.8 billion in the second quarter. Will it survive the credit crisis as a stand-alone company? Mr. Market doesn't think so, and he sends Wachovia's price plummeting even further.

Part of Wachovia's loss is a $6 billion non-cash hit to goodwill. Even still, Wachovia chugs through nearly $5 billion of cash in the second quarter — not good for a company with just $47 billion in cash on the books at the end of the quarter.

At that rate, Wachovia will be out of cash in two and a half years, assuming things don't get worse.

Wellsovia fares much better than stand-alone Wachovia. Thanks to Wells Fargo, the combined entity would have burned through just $3 billion with nearly $70 billion of cash in the bank. And remember — Wellsovia put $8.5 billion aside for credit losses this quarter; so, it has taken a loss but has more than enough cash to cover it and keep going, and it has planned for tougher times ahead.

2008: Wellsovia Q3

Merrill who? Lehman who? Tougher times are here, and Wachovia "loses" $24 billion. Or does it? Of that $24 billion loss, $18.9 billion is "goodwill impairment." What does that mean? From Wachovia's Q3 2008 SEC filing:

The goodwill impairment analysis is a two-step test. The first step, used to identify potential impairment, involves comparing each reporting unit's fair value to its carrying value including goodwill. If the fair value of a reporting unit exceeds its carrying value, applicable goodwill is considered not to be impaired. If the carrying value exceeds fair value, there is an indication of impairment and the second step is performed to measure the amount of impairment.

The second step involves calculating an implied fair value of goodwill for each reporting unit for which the first step indicated impairment. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination, which is the excess of the fair value of the reporting unit, as determined in the first step, over the aggregate fair values of the individual assets, liabilities and identifiable intangibles as if the reporting unit was being acquired in a business combination.

If the implied fair value of goodwill exceeds the goodwill assigned to the reporting unit, there is no impairment. If the goodwill assigned to a reporting unit exceeds the implied fair value of the goodwill, an impairment charge is recorded for the excess. An impairment loss recognized cannot exceed the amount of goodwill assigned to a reporting unit, and the loss establishes a new basis in the goodwill. Subsequent reversal of goodwill impairment losses is not permitted under applicable accounting standards.

Allow me to put that into Plain English: Wachovia carried its various business segments at a certain value on its balance sheet. When its stock price tanked, the "market value" of those businesses sank to prices well below the value carried on the balance sheet; so, Wachovia wrote off — or "impaired the goodwill of" — those segments to the tune of $18.9 billion.

No surprise there. Wachovia's market capitalization dropped $100 billion. It couldn't possibly carry its business segments at values higher than the price it would cost to purchase the entire business!

Wachovia also had roughly $800 million in other non-cash, temporary write-offs like restructuring charges and other amortization, and nearly $2 billion in securities losses — temporary losses in the sense that they should not be expected to be recurring during the remaining life of the company. (If they do, Wachovia should consider getting out of the investment business.)

As ugly as the quarter was for Wachovia, the combined Wellsovia would have done much better. After setting aside $9.1 billion for credit reserves, the combined company burned through just $600 million or so of cash. With $64 billion in cash at the end of the quarter, $600 million is but a drop in the bucket.

During the third quarter, Wells Fargo would also get $25 billion in TARP money, bringing the combined company's cash to roughly $89 billion.

2008: Wellsovia Q4

In this last quarter of 2008, Wells Fargo would complete its acquisition of Wachovia. Wells Fargo CEO John Stumpf allegedly says that he "loves" the acquisition. Why? Let's explore:

Wachovia was acquired in a stock-for-stock deal — no cash. Each share of Wachovia turned into 0.1991 shares of Wells Fargo. At the end of the third quarter of 2008 (Q4 reports haven't been filed yet), Wells Fargo had 3.321 billion shares outstanding and Wachovia had 2.136 billion shares out. So, Wells Fargo issued roughly 425 million shares — or 12.8% of its business — to acquire Wachovia for about $12 billion. In the first three quarters of 2008, Wachovia's operations burned through about $7 billion in cash — an alarming rate considering it started the year with just $33 billion in cash.

Without the merger, Wachovia alone might not have been around long enough to survive the credit crisis. Without the merger, Wells Fargo would probably have been just fine.

When the 10-Q is filed with the SEC in the next few days, we'll get a better idea of how the two fared. What we do know is that Wellsovia has taken significant hits to earnings so that it could build a $21.7 billion credit loss reserve, revalue Wachovia's business segments, complete the merger, and proceed with integration and restructuring.

So, what does John Stumpf love about the merger? Much of the fourth quarter $13.7 billion loss experienced by the combined entity was an accounting and de-risking loss which included a number or non-recurring or short-lived charges. In addition, Wells Fargo picked up all of that cash on Wachovia's balance sheet — much more than the $12 billion acquisition price. So, Wachovia was essentially free.

What a Sweet Deal!

Think of it this way: A friend of yours comes to you with a problem. He's got $100,000 in credit card debt that he can't afford to pay. If he declares bankruptcy, he'll lose his house and his family will be out in the cold. He's got $80,000 in the bank. If he uses that to pay down his debt, he'll be able to afford the monthly payments but won't have any "emergency" reserve fund. If he doesn't use that money to pay down his debt, bankruptcy is probably his only option.

So, you cut a deal. You will assume his credit card debt so he and his family can move forward. For doing so, he'll give you $70,000 cash and $10,000 of his annual earnings for the rest of his life. (You already had $100,000 in cash, little debt, and strong earnings.)

Because he will have credit again (now that you've assumed his debt), he doesn't need the full $80 grand — he can survive with a much smaller amount. You take his $80,000 and pay down the majority of the debt. Then, you pay the remaining $20,000 balance out of your own cash.

For your $20,000 "investment," you just picked up a lifetime of earnings.

That's the Wachovia deal in a nutshell. Wells Fargo paid roughly $12 billion for a company that, under normal circumstances, should generate $5 to $7 billion a year in excess cash. All Wells Fargo needs to do is assume the remaining losses on the loan portfolio.

2012: Wellsovia (Now Wells Fargo again)

What will Wells Fargo look like in 2012? Let's assume, for a second, that the credit crisis is behind us in 2012. The economy is back on track and things are returning to normal, just like after all other bank, real estate, economic, market, war, government, and other debacles we've overcome in the past. I may be wrong on the timing; still, I am right on the outcome.

How do I know? Because if I'm wrong, your/our/the world's problems are much more severe than losing money in Wells Fargo stock. If everything goes to hell in a hand basket, the least of our problems is our portfolio. Whether you have $100 or $100 million, it will be worthless because our currency would be entirely worthless.

So, we act greedy when others are fearful and know that, at some point, things will return to normal.

Wells Fargo, formerly known on F Wall Street as Wellsovia, is generating about $13 billion a year in owner earnings — a combination of Wells Fargo's earning power and that of Wachovia, net of, say, a 5% cost savings resulting from the merger.

That would mean that Wells Fargo would be worth north of $125 billion, and perhaps as high as $170 billion. Now, I can't say for certain what it will be worth at that point as the future is not entirely clear. Then again, we don't have to pin our valuation down to the nth decimal. If we know that Wells Fargo will survive this mess (and it is in a great position to do so, barring the hand basket scenario) and if we can reasonably predict its future cash flows (using, for example, the cash flow of the combined entity from 2004), we can come up with a reasonable estimation of its intrinsic value.

What Can We Expect Over The Next Two Years?

Together with Wachovia, Wells Fargo has taken quite a bit of write-offs over the last year. That doesn't mean that they're done doing so. In the 1994 real estate recession in California, Wells Fargo had a ton of exposure to that market. From March 31, 1994 through September 30, 1995, the company's shareholder equity dropped 8.5% as it wrote off some $200 million in bad loans ("provisions for credit losses") — a hefty sum to a company that, as the time, was generating just $200 million a quarter in earnings.

Today's situation is worse.

At the end of 2007, the two companies would have had a combined equity of $124 billion. By the end of 2008, that equity was just $67,000. If it continues to build its provision for loan losses, that figure may continue to drop.

As it goes through its massive merger and restructuring, earnings will be unimpressive at best, and possibly horrendous, depending on the costs of the merger, its need to continue to beef up its credit loss reserves, and its need (or desire) to amortize intangibles, depreciate assets, and "de-risk" its balance sheet.

The costs of the merger will probably stick around for twelve to twenty four months, but we'll treat them as non-recurring costs to see the "normal" state of Wells Fargo's business. The length and depth of the deleveraging process is yet to be seen. What we do know is this: The new, bigger Wells Fargo ended the year with $128.1 billion in a combination of cash, short-term investments, and "trading assets" — investments recorded at market value (so, there shouldn't be any real surprises there).

With an $864.8 billion loan portfolio, of which $21 billion has already been written off through those provisions for credit losses, a hell of a lot would have to go wrong for Wells Fargo to fall off the face of the Earth.

Because its earning power is so strong, Wells Fargo will be able to suffer quite a beating for quite some time, and still emerge a strong company. And when things return to "normal," the stock market will likely pay a very high price for its cheery consensus on Wells Fargo.

And that's why I like Wells Fargo.

Comments

[User 357217:]

this guys contradicts himself. he points out that earning will be worse, and possibly horrendous. The main figures to look at is that wells ended the year with $128.1 billion in cash, but they also have a $864.8billion in loans, of which $21billion has been written off for loan losses. Assuming the economy will not get worse. Has he not seen our GDP, and other countries GDP? He's also missing a lot of facts such as Wachovia's loan portfolio was over $500billion. Wachovia was known for risky loans in their commerical and real estate sector. Wells just took $37.2billion credit write down on 12/31 of wachovia's high risk loan. And theres more coming. Just like country wide, at least 65% of their loans ($325bill) are bad. Wells fargo's $128bill reserve will not cover all of that, and keep in mind, wells fargo "good loans" aka prime are starting to go bad as the economy deteriorates.

but yet he would still buy wells?

Feb 14 10:53 PM

[User 359374:]

You are forgetting that Wachovia/Golden West Financial has over $100billion in exposure to Option only arm California mortgages. How would a continued default rate impact those earnings?????

Feb 19 09:15 AM

[the weakono...:]

A good read, I don't fully buy it but a good read.

You could have summed it up better by saying, "none of the largest banks will fail, so their prices are super cheap right now"

Feb 19 12:27 PM

[everyotherc...:]

An accurate and clear-eyed look at WFCs future.

Several other major positives should be considered in any analysis of WFC: First and most important, WFC has an immense and low cost liability/deposit base) which allows it to fund its assets at large-bank industry-leading net interest margins. During 2008, as Indymac, Wamu and later, Bank Of America were percieved as risky deposit locations, WFC grew its deposits an astonishing 31% as customers fled those banks to move in WFC's direction. The result is that cash earnings from future net interest margins will either amp earnings markedly or cushion presently unseen asset deterioration.

Second, WFC has a history of tight underwriting of assets. When looking at WFC vis-a-vis the rest of the industry, this has to be considered. The evidence can be easily determined with an examination of past credit loss data product-by-product, and current delinquency and default rates. Put that together with loan loss provisions and you get a positive feeling about potential future asset deterioration.

Third, WFC has virtually no capital markets/investment banking business by design---its book is plain vanilla when combined with the the other banks in the top 5.

Fourth, the bank has major realestate loan originating and servicing businesses which put it into an ideal position to capitalize on a potentially much more positive real estate future. Its history of prudent underwriting is well known, as is its practice of selling vitually all of its loan production with no liability tail.

Feb 19 01:07 PM

[Between The...:]

What about the liability side of the balance sheet?

Lots of good info on cash, earnings, and loan assets, but the question of value (and solvency for some banks) hinges on the balance of assets and liabilities. Even if they have to write off another 10-30% of the loan assets, would they still be able to cover any and all liabilities due? What would be the cash position then? What about CDS or other derivative exposure, which would be booked as an asset yet possibly is a large liability in case of a default by a major corporation?
I can't "like" a bank without thorough understanding of the other side of the balance sheet.

Feb 19 03:04 PM

[ZZ:]

Fundamental analysis: How ...last year that all is. Get in fashion and watch CNBC. Listen at the talking heads all do their Technical analysis about support levels and trend lines. And for good reason: If most of the herd is traders and they are sheep to the technicians, then they are right; the market is not about how the company's are doing, it's about how the traders are trading.

I especially enjoy how they can't be content just to show their charts and talk their data. Every one can't help but make a prediction. Of course none of them want to be blamed when they are wrong, so they say something like this:
"You need to be very careful here. It may be time to nibble but you have to do your research and not get over exposed."

What does this translate to in common English? Ok here is the translation:

"Go ahead and invest in the market and remember if it goes up that I'm a genius and don't worry, I'll remind you next time I'm on TV. If it goes down, don't blame me because I warned you to be careful but you tripped and fell. Not my fault."

Feb 19 03:24 PM

[sabre_jenn:]

Your long term analysis is funny. Almost every year, you cite various "one time charges" or "short lived" I think you called them. Back in the real world, a one time charge that occurs every year is not a one time charge.

The "old" Wells Fargo has an enormous concentration of assets in California-- arguably the home of the housing bubble. It defies common sense that Wells managed to be a major bank in California and yet is not effected buy the California housing market. If I had a dollar for every useless bank CEO who claimed his bank was 'super conservative', my great grandchildren would never have to work.

Now Wells has bought Wachovia and with it, Golden West Financial. Whatever fantasy you want to believe about Wells exposure to the California housing bubble -- now it has 10x the exposure.

Meanwhile, the Gubernator has the biggest state budget deficit ever. Clearly, government spending is out of control and needs to be severely cut back -- but if history is any guide, part of the solution will be tax increases, including property taxes... whoops, there goes the Wellsovia mortgage portfolio.

Wachovia wasn't just Golden West Financial... it was a huge collection of smaller banks that were "merged" just enough to get the CEO his integration bonus. Wachovia's back office systems (plural) are a mess. Part of the reason Wachovia got into trouble is that they have no idea what is on their books... its even less believable that an acquirer has a better idea.

Every Wall Street sell side analyst has been sending out, um, research?, that suggests "Wells Fargo is awesome". Of course, these people couldnt even foresee the collapse of their own employers.

Yes, Warren Buffet owns a lot of Wells Fargo, and Buffet is infallible. Unfortunately, that didn't stop him from stepping in the nasty stuff when he bought into Salomon Bros nor did it help him when he bought GenRe.


I think the reality is that Wells Fargo is not much different from all the other banks.

Feb 19 04:14 PM

[firecracker:]

For the combined company, I refer to them as WWF, It's going to get ugly, and someone's going to get a smackdown. They're actually WWWF (World Savings, Wachovia, Wells Fargo), but it's close enough. Insert piledriver, bodyslam, and DDT reference, too.

Feb 19 04:42 PM

[investorcluzo:]

everyothercatstaken - is that you stumpf? did you forget about all those great assets you picked up in the wachovia transaction (sans government help, I might add)? they had investment banking – or did you forget? as for underwriting standards, did you forget about those golden west assets that wachovia picked up before wfc bought them? as I said, sans the acquisition, you may have a case. however, they are now just as bad as the rest. as for your “let’s not look at TCE” argument, I have a question: do you remember what wachovia paid for ag edwards? here’s a hint – wells paid less than that for all of wachovia. seems to me that all that “goodwill” turned out to be not so good…let’s not even discuss the value of the msr’s (roughly equal to 20% of common equity)…

sabre_jenn - serial acquirers only mask the true (un)profitability of their "franchises". ken lewis is now being exposed for all of the bad deals he did in the past. the big regionals knew long ago that they couldn't continue to grow organically, so they made deal after deal with the devil. now they are finding out who the junior partner is...

Feb 19 04:50 PM

[Patrick22:]

I understand that Wachovia had a bunch of bad loans. But even if they had $500 BB of bad loans, if Wells only paid $12 BB for them, how does Wells lose more than $12 BB?

Feb 20 10:03 AM

[User 360818:]

I like the article. I used to work in Wells Fargo and feel they control the risk of the business very well in wells fargo. I think once they pass by this recession, Wells will be much stronger and better. If you look for 5 to 10 years time line, the current stock price is a lifetime steal. I wish I can buy more shares of WFC to get rich. I feel confident that US Bank industry will survive and Wells will take this opportunity to become more stronger.

Feb 20 10:46 AM

[Bob228:]

Wells may not have understood the depths of Wachovia's problems when they bought them. They got two things when they bought Wachovia:
(1) Little understood by most is that Wachovia had tremendous exposure to very risky asset classes. (2) A great footprint and physical presence. That's going to be the featured race in the shaping of the future of Wells.

In an effort to be the biggest and the best, in a very short time Wachovia became (a) the second largest commercial real estate lender in the U.S., (b) among the top originators and underwriters of CMBS, (c) One of the largest structured finance (real estate high risk on book ventures and loans) Banks in the U.S., (d) One of the largest real estate Syndication groups in the world (includes on book under-writings), (e) the number one CDO Book runner in the U.S., (f) one of the largest single family builder loan portfolios in the world with over 1300 customers, (g) one of the largest Subprime exposures through the overly California concentrated Alt A World Savings, (h) a Subprime auto lender through Western Financial.

Besides the totality of their risky asset class exposure, as a relatively new entrant they differentiated themselves with cheap pricing, over-advances relative to other lenders, land, and condominiums. Geographic exposure to Florida in condos and subprime in California, they led the drive for market share with their jaw.

Wells has the best run commercial real estate finance business in the country - run by a very experienced credit underwriting culture. Wachovia is less disciplined on credit and experience. The cultures will likely clash as the integration takes place (Wells mostly west and Wachovia mostly east - except World Savings).

The positive side is the national footprint, the deposit base, a very good consumer lending and service discipline developed by Kavacevich - and now expanded by Wachovia. The Trouble with BofA could significantly benefit Wells.

The success level will ultimately be the created value of the footprint as measured against the final cost of the risky asset classes - perhaps not totally understood by Wells when they bought Wachovia. Time and changing circumstances will determine how good or bad the combination. Likely, several tough - hang on for your life years will be the challenge. California and housing will be among the major obstacles or good surprises.

Feb 20 11:47 AM

[cuban:]

Wells Fargo may not get a chance to succeed because Obama will take it over. They call it Nationalization and present it as saving the bank. We call stealing all of the money from the shareholders. Cuba is not going to get better, it is just going to look better as the US gets worse.

Feb 20 12:20 PM

[Mad Hedge F...:]

Wells Fargo Bank (WFC) has been in a free fall for the last two weeks, as investors bail out of the stock in fear of nationalization, or an Alt-A loan loss driven bankruptcy. The stock has vaporized 47% in three weeks, down to a new 12 year low. Veloceraptor like hedge funds have been major short sellers of the stock because it is one of the last banks with any meat still on the bone. Demand for out of the money puts is soaring. The stock is being dragged down further by big selling of bank and financial ETF’s, like the Financial Select Sector SPDR (XLF), which has WFC as its second largest holding at 8.74%.

Feb 20 12:29 PM

[Bill Thompson:]

wells is the only bank im decently comfortable with right now. But with deflationary problems becoming worse, all banks worry me, see here crashmarketstocks.com

Feb 20 03:12 PM

[Kinabalu:]

Wells acquired both assets (approximately $800 billion book value) and liabilities (approximately $750 billion book value) of Wachovia. WF assumes that the assets will be worth at least $12 billion more than the liabilities. If, in fact, the assets are worth far less than WF assumes (because the $150 billion of option arms are worth far less than their book value??), they will have to put more money in to pay off the liabilities.


On Feb 20 10:03 AM Patrick22 wrote:

> I understand that Wachovia had a bunch of bad loans. But even if
> they had $500 BB of bad loans, if Wells only paid $12 BB for them,
> how does Wells lose more than $12 BB?

Feb 20 07:36 PM

[mr freddo:]

Wells preferred shares (WCO) started out the week at 24 and opened on friday at 15. If you believe this article, you could have scooped up preferred stock yielding 14.5%.

I bailed on Wednesday at 23.2, and while the stock has recovered to 18, I am glad I got out.

It seems that in today's market perception becomes reality. Short sellers, unhindered by the uptick rule, and carefree about actually delivering any stock they sell short, are able to make a killing by driving a troubled institution into the dirt.

Feb 21 11:55 AM

[geranz:]

Why not take that goodwill impairment loss and apply it to the value of all those over valued real estate values? That would help the borrowers adjust their mortgages so that they can at least make payments and keep that cash flow coming to the lenders!

Feb 21 12:03 PM

[User 361745:]

You forgot ONE critical item. Wachovia management is now infesting Wells. All Wachovia management is capable of doing is levelsetting the tablesteaks and orchestrating their organic synergistic core-competencies in a going-forward space. I doubt Well’s management will be able to ignore the BS siren calls of the Wachovians.

WWooooooo.... transparently orchestrate. WWoooooo.... synergize your organic growth.... WWooooooooo levelset, levelset ... WWWWWWWooooo

Wells is DDDDOOOOOOOOMMMMMEEEEE...

Feb 21 10:45 PM

[Maklo:]

This was a very good article and does a good job of breaking down the problem into the most important issues.

As the author pointed out, and I can confirm through my own analysis, Wells' current capital position is indeed very solid. They have always been a very conservatively capitalized bank, relying primarily on a retail deposit network. Recent evidence of them accumulating deposit assets at an accelerating rate further enhances their position. Wells did not need $25 billion in TARP funding, but it was on such lax terms that not having accepted it would have put them at a disadvantage against competitors who did.

Wells has always had the tightest loan underwriting standards. The most toxic assets were those underwritten by third party mortgage originators and passed off to the banks who thought they could package them up (i.e. "securitize") and make fee income off them. Of course, we all know how that ended up. Lack of moral hazard led to a significant decline in underwriting standards, and when the music stopped, it was the banks left holding a lot of these toxic loans. Wells was not immune to this -- $11.9 billion in loans originated from third party originators (a.k.a. "indirect channel" a.k.a. "wholesalers") -- they recognized and accounted for it early, putting it in a special liquidation pool and taking $1.4 billion in charges in 2007 (see p2 annual report). It also represented less than 9% of the total consumer mortgages that had been originated.

Third key point is the underlying profitability of the Wells business model, which shows up in the net interest margin figure that the author points out. It is significantly higher than its competitors. This is due to a number of factors which I won't go into here, but suffice it to say, that they have a significantly superior business model, and it has been consistent for decades. This underlying profitability will allow Wells to absorb credit losses more than any of its competitors. There will certainly be losses in even a well run portfolio like Wells' but by my calculation, they can still be breakeven if loss rates hit 3.5% per year. In practical terms that means unemployment is in the 12% range, foreclosure rates are in the 17% range and loss rates are in the 25% range. If we hit that scenario (certainly not out of the realm of possibility), then Wells will hurt but should still be able to survive without help.

Finally, based on its track record, I think Wells deserves some benefit of doubt in their acquisition of Wachovia in the sense it was acquired after it was clear we were entering a severe downturn and the risks were clearly known. Wells' management went in eyes wide open and took the appropriate de-risking measures, like building in significant credit provisions against assets that were known to be bad. They clearly were not forced into this, but instead saw it as an opportunity to take the bank to the next level (i.e. coast-to-coast operations, double deposit base).

I feel comfortable with Wells' current reserves and provisions. Assuming we eventually come out of this cycle -- and based on the track record of the U.S. economy over the past 200 years, I think it is a good assumption -- Wells has the footprint to generate $20 billion in pre-tax earnings per year, and that's assuming very little improvement to the Wachovia operations that they inherited, and no future growth in deposits. That makes for at least a company that should be valued at a minimum of $100 billion if you are willing to wait for the market to catch up.

Feb 23 10:37 AM