Wells Fargo Earnings: What's Real, What's Not?

Wells Fargo (WFC) -- what a press release, eh?

The company blew some serious smoke last Thursday to brag about earnings and indirectly tout its stock. "Brag" and "tout" are strong words - and purposely chosen. The focus on "three billion in profits" and "fifty five cents per share" and some of the adjectives in the press release sent the stock soaring this morning. I tend to focus on some other things -the balance sheet among them - and I zeroed in on "provision expense of approximately $4.6 billion, including $1.3 billion credit reserve build, bringing the allowance for credit losses to $23 billion." Twenty three billion, wow, what a big reserve! Not really.

Wells bought Wachovia and with that purchase came options ARMs - lots of option ARMs, the majority (analysts estimate 60%) in California. Total exposure at Wells to option ARMs was $122 billion at time of purchase and if I read their incredibly complex financial documents correctly their exposure is now between $90 and $100 billion. Let's say $95 billion. Wells stated $59 billion were "credit impaired" and wrote down $24 billion in Q4 related to the Wachovia purchase. They are forecasting a 29% default rate going forward. Wow! Aren't they conservative.

Home owners with option ARM mortgages that will reset in 2009 and 2010 face an average monthly mortgage payment increase of 63 percent. These resets peak - get this - in August of 2011 based on the dates option ARMs were let. So, given these realities, what is the ultimate default rate going to be in the coming quarters? Is it going to be just 29%?

Ratings agency Fitch sees it at around 45%. Goldman Sachs says 61%. Whitney Tilson, an analyst with Amherst Securities covering this market better than most, believes option ARM defaults, as a class, could go as high as 70%. Moody's recently downgraded Wells in part due to option ARMs, saying the 29% number is probably too low and will have to continue to mark down assets through 2009 and 2010.

Who is right, Wells at 29%, Fitch at 45%, Goldman at 61% or good old Whitney at 70%? Fitch is a ratings agency, Goldman makes money trading these forecasts, so, let's split the difference and say it is 53% of $95 billion. That is roughly $50 billion - or $20 billion dollars more than their internal models are projecting.

Those projections have prompted them to reserve $23 billion for future losses - in everything, not just option ARMs. The bank also held $118 billion in home equity lines and $138 billion in commercial real estate loans at year end 2008. Simply put, WFC has a great many more write downs coming and their shareholders will be significantly diluted as they raise more capital either from Uncle Sam - most probably the case - or the private sector, although I don't see Warren Buffett stepping to the plate with more dough, do you?

Agreed, their write downs will come over time as they hold these mortgages and these only have to be written down as they are truly impaired. That means shareholders face many more quarters of greater than anticipated write downs.

Bottom line: I believe WFC is blowing some serious smoke here. The operating earnings they discussed are real -- but the possibility they will need more capital never made it into their press announcement. Stay away - and when the market stabilizes a bit, put WFC on your short list of short prospects.

Comments

[Pygmalion:]

With $37B in annual PPI ($9.2B in 1Q x 4) WFC can withstand a lot of bad loans before they need to raise any more capital. Plus, this PPI is bound to grow as they gain business from weaker players with their now larger footprint, and cost synergies from the merger. While it is unlikely that the earning over the next few quarters will be as good as 1Q; it is hard to imagine that they can't write off thier bad loans over time and maintain solvency without raising additional equity.

The case to short WFC is not clear at all. In fact, this stock has a habit of disapppointing short sellers everytime they announce earnings.

Apr 14 08:20 PM

[Alan Young:]

Good article! Thanks for putting some solid numbers into the discussion.
The stock is doomed, but so is the short: the Street seems to have ways to squeeze the shorts out periodically, even though there's no real improvement in the fundamentals.

Apr 14 10:59 PM

[Russ Krull:]

"..so, let's split the difference and say it is 53% of $95 billion. That is roughly $50 billion"

I don't believe you can apply the default rate directly to the value of the loans to get a write-off value. Even in default, a mortgage is worth more than zero since the property securing the loan has some value.

Lets assume the average defaulted loan balance is 150% of the underlying property value. That puts the average loss on a loan default at 1/3 of the asset value. That would put the loan losses from your 53% default rate at $16.8 billion.

Disclosure - long WFC.

Apr 14 11:04 PM

[User 187593:]

The author is confusing default rate with loss rate. Wells Fargo did not project a 29% default rate. The projection was a 29% loss rate. I'm tired of bloggers who do not know what they are talking about.

Apr 14 11:37 PM

[spanish moss:]

Good point, and let's remember Richard Bove's recent commentary that in spite of all the doom and gloom, 97% Home Equity loans are paying as agreed, 98% are paying something. Those borrowers have to live somewhere, not only is it incorrect to assume a complete loss on any given loan, it is wrong to assume a homeowner defaults just because their home's price is currently depressed. WFC loss projections on the Golden West paper were sober and their expanded earnings power will make up any short fall. Remember, these are they guys who didn't offer Option (PIK a Pay) ARMs, they were afraid of them. I reason that WFC's eschewing govt support in their counter offer for WB made them all the more sober. (An aside if I may: What if Citi had gotten WB, the FDIC would probably be broke by now. WFC used it TARP funds, Goldman Sachs sat on theirs and now says they can repay the paultry $10B they got in TARP... what about the $500B+/_ they got in AIG CDS relief??? Good Grief, Goldfinger, stop preening!)


On Apr 14 11:04 PM Russ Krull wrote:

> "..so, let's split the difference and say it is 53% of $95 billion.
> That is roughly $50 billion"
>
> I don't believe you can apply the default rate directly to the value
> of the loans to get a write-off value. Even in default, a mortgage
> is worth more than zero since the property securing the loan has
> some value.
>
> Lets assume the average defaulted loan balance is 150% of the underlying
> property value. That puts the average loss on a loan default at 1/3
> of the asset value. That would put the loan losses from your 53%
> default rate at $16.8 billion.
>
> Disclosure - long WFC.

Apr 15 08:27 AM

[MGA_1:]

I didn't know wells had that many option arms in their portfolio - well, they'll be back to govt handout window in no time soon I guess.

Apr 15 08:44 AM

[Jonathan Ch...:]

Many of the banks now have permission to "Print Money". The ones that are careful in their purchase of "Toxic Assets" read "extremely undervalued real estate mortgages" will do very well.

Remember that though CMO's were selling at less than 30 cents on the dollar, over 90% of the mortgages were performing. Even if those homes in default sold for 50 cents on the dollar, since they only paid 3o cents for that 50 cents, the profit is there. Do the math. Assume an average of 6% interest, mortgage life of 6 years, 10% default, and a loss of 50% of face value on foreclosed homes. RESULT: MUCHO PROFIT.

Apr 15 08:53 AM

[john s. gordon:]

wachovia just had to have golden west @ an excessively high price & poisoned their system thereby. now the poison is in WFC.
> jack

Apr 15 08:55 AM

[AndrewBaker:]

Whatever the real situation ... it is worse than what has been disclosed. There are some serious losses coming on financial stocks, and even though the shorts do seem to be getting squeezed out by irrational rallies in these stocks, the day of reckoning can't be put off for ever.

Apr 15 03:04 PM

[Lee Eugene ...:]

Ok, while I have a few issues with this piece in terms of ratios, the general idea is spot on. Just because a stock goes up doesn't mean it has any value. The CEO himself said last week the accounting rules allowed some pumped up numbers.

Apr 15 03:29 PM

[T. Marc Sch...:]

Yeah, this is interesting. I am curious to see how their earnings do the rest of this year.

Apr 15 03:31 PM

[Maklo:]

The author makes some serious analytical mistakes and uses numbers out of context. I almost stopped reading after the author made a comment on WFC's "incredibly complex financial documents" - WFC's financials are the simplest out of the big banks. The author cites a "$24 billion [write-down]" against a portfolio "between $90 and $100 billion. Let's say $95 billion". The actual numbers, which are not at all difficult to find (are 10Ks hard to find?), are a $37.2 billion discount against a $93.9 billion portfolio. The $24.3 billion cited by the author is only against the $59.8 million Pick-a-Pay Mortage portfolio, which I will elaborate on below:

Prior to closing, WFC wrote off $24.3 billion against Wachovia's (formerly Golden West's) option ARM portfolio that had current face value of ~$59.8 billion, or a 41% discount. As of closing on 12/31/2008 these particular loans were carried in a separate liquidation portfolio. For WFC to "use up" the $24.3 billion reserve, they would need a foreclosure rate of around 75% with losses of around 50%+ per foreclosed loan. In real world terms, 50% losses means that ...

... loans were originated at an average 80% LTV, ALL at the peak with no assumption of paydown
... housing prices have fallen 46% peak to trough and WFC unloads these properties only at trough pricing.
... an additional 10% foreclosure charge to cover rehabilitation, agent fees etc.

Remember, WFC bought Wachovia in December 2008, not July 2007. Given their track record, and at that particular point in time, there is very low probability in my mind that they would have under-estimated the coming wave of Option ARM resets, which people had started to wail about in 2006.

Apr 15 03:37 PM

[Snort1962:]

WFC took a $40B+ charge against WB in connection with the acquisition. How do you compare TCE at WFC versus other banks? Likewise, although this is not in the loan loss provision, it gives them a significant ability to afford the loan losses associated with WB.

Apr 15 04:05 PM

[Minlita:]

No surprises here!
- FED provided the banks with fresh cheap funds and quantitative easing and this lend at healthy rates on credit cards, auto loans and even mortgages.
- It doens't take a good CEO to borrow at 3% or 2% and lend at 5% making a profit.
- Banks (GS is taking the lead) now want to pay TARP funds and free themselves of federal restrictions on compensation (most big clients don´t like banks depending of FED).
- Wells originated mortgages that it knew could be shipped on over to the government’s coffers for a handsome fee, and refinancing bank loans can’t be considered a sustainable

Apr 15 06:27 PM

[samfarkus:]

agreed balance sheet worse than they say but.. with time and more funny money fed programs, that could stabilize. And you cant ignore the massive money machine churning away in the meantime. However, I think a capital raising announcement will be what turns the tide on this stock. I'll buy in after it succeeds. Still a great bank.

Apr 16 04:06 AM

[bodie7:]

How many of the Option ARMS will be refinanced to fixed rate loans so the upcoming future ARMS reset will not be an issue. Fixed rates now are so low, as long as the mortgage holder can qualify for a refinance, they probably will. After all, that was probably the orginal homeowner plan before the housing crisis hit. If the homeowners refinance with Wells, then that should be increased refinancing profits for the bank.

Apr 18 10:35 PM

[blasted:]

The only way Wells stays standing is a Facist Banking system. All these profits writing even more mortgages at super low intrest rates. The mortgages they wrote this quarter are sub prime by old school underwriting standards. Wells does all their own appraisals and over the past 10 years hired only the cheapest, fastest and bigest liars. I would have thought they would be one of the first players to belly up.

Apr 20 09:47 AM

[Joe Bruin:]

We will find out really soon if Michael Shulman is right or wrong. Either Shulman is right or Warren Buffet is right. Mr. Buffet is a large Wells Fargo share holder. The great thing about blogs is that users can visit any time to read and the author is accountable for his writing.

For those who don't know their history, Wells Fargo got hurt in the real estate melt down in the 1990s. They were will prepared for this melt down and purchased distressed asset when they thought it was prudent. Did they over pay? We will find out on April 22.

Apr 21 01:15 AM

[tim leary:]

It seems you are all talking about only what they are telling you. Here is what they are not telling you. BAC and WFC hold 50% of all commercial real estate loans among the top 10 banks. WFC has about 90 billion of these loans and most reset within the next 2 -3 years. 29% are already under water. Do you reckon they will get a refi? Dont look back, look forward....the next shoe is about to fall.

Apr 24 05:01 AM

[hard money ...:]

WFC default rates for residential 1-4 properties is astounding:

www.thehardmoneypros.c...

Its also interesting looking at their REO bank owned home inventory

www.thehardmoneypros.c...

Jun 12 12:52 PM