Stress Test Results: AQ Chances vs. SCAP Buffers

On Tuesday morning May 5, 2009 I was interviewed by Connell McShane on Fox Business News live about my recent article Stress Testing: What’s Your Bank’s AQ? I spent a lot of time positioning the AQ score and describing how the good banks did. Then Connell asked me this question:

Wells Fargo is, forgive me, on the [Fed’s] naughty list … but Wells Fargo is number two on your [Good Bank] list. Is that right?

My answer to his question was: Yes, the AQ score for Wells Fargo & Company (WFC) was +5. This made it viruatlly certain the company had enough capital in the last quarter of 2008 to absorb future losses if the recession deepened. Connell then asked me to cmpare my AQ scores with the Fed’s stress tests. I said the major difference is that the AQ test is simple and fully transparent.

THE BUFFERED BANK AQ SCORES
Late Thursday afternoon May 7, 2009 the government published its stress tests of the 19 biggest banks. Except for privately held GMAC all of these institutions were included in my Seeking Alpha articles on the AQ index.

So now it’s possible to compare directly my AQ predictions with the SCAP simulations pointing to the nine banks that required a capital buffer to sustain a prolonged worst case scenario. The following table compares results for the nine "buffered" banks shared by both studies.

The SCAP report concluded that all nine banks required a capital buffer. Based on their AQ score the chances these banks were holding a significant proportion of troubled assets on their balance sheet appear in the last column of this table.

Of the nine “buffered” banks, the AQ predicted eight of them correctly. And six of these predictions were virtually certain with chances greater than 0.96. The other two were pretty good bets: 0.74 for Fifth Third Bancorp (FITB) and 0.81 for Morgan Stanley (MS).

Then there’s WFC: its AQ chance of needing capital was virtually zero. This was not a near miss. Its AQ score went off the chart.

I knew the Wachovia acquisition would have an impact on Wells Fargo, but I had no evidence to support the rumor that WFC was on the Fed’s “nasty” list. In the last three quarters of 2008 Wells Fargo’s AQ score got better and better. Topping out at greater than +5. That’s why its chance of having a significant proportion of those troubled assets on its balance sheet was zero. Sudden swings in equity and debt market performance are tricky, especially in the interval between quarterly financial reports during the volatile markets of late 2008 and early 2009.

UPDATED WELLS FARGO AQ SCORE
As soon as Wells Fargo filed its report with the SEC on Saturday May 9, 2009 I downloaded the statements from I*Metrix. Here’s what happened between the company’s September 2008 and its March 2009 filing in which the Wachovia merger results first were reported:

• WFC’s revenues almost doubled to $24 from $13 billion
• The price of its common stock fell more than 50% to $14 from around $38.
• The number of shares outstanding rose by over 30% from 3.3 to 4.4 billion.

These numbers turned the company around – in the wrong direction. Wells Fargo’s share of market capitalization fell from 12% to 6%. And share of revenues jumped from 8% to 15%. The difference between revenue share and value share in the set of 92 banks on my list went from a little over +4 to just under -9. After adjusting the raw score for volatility Well Fargo’s AQ plunged from +5 to -4. Investors in the equity and debt markets declared the merger a bad idea. The Fed agreed.

In the first quarter after completing the merger with Wachovia, the AQ chances that Wells Fargo had a significant proportion of troubled assets on its balance sheet went from zero to near certainty. This not only explains why my earlier prediction was “wrong,” it also validates my assertion that the AQ is both simple and transparent. It might even produce useful information.

Thank you for visiting. As always your comments are welcome.

p.s. Here’s a link to my Fox Business News interview. It begins around 34 minutes into the hour.

Comments

[Sanitychecker:]

You might remember my question to you when you first proposed your AQ approach and the extraordinary health of WFC..

Which Banks Are Holding Those 'Hard-to-Value' Assets? [View article]
How did you account for Wachovia in your analysis of Well Fargo?

Isn't your analysis still something? Shouldn't Wachovia's market capitalization and revenues be included in the analysis enen though you are not necessarily scoring them? At first blush, it would seem to me that would allow for an apples to apples comparison and perhaps push WFC's AQ score back toward 0?

Disclosure: I am long WFC and short WFC calls but not for long!

May 12 04:16 PM

[Victor Cook:]

Sanitychecker,

Yes, of course I remember your comment. Unfortunately, I did not follow up on ways to combine Wachovia’s pre-merger numbers with Wells Fargo’s. I wish I had done as you suggested.

It would have been a simple thing to combine the two if WB were included in my 32 quarter analysis of the 92 public US bank and thrift holding companies with the most deposits. But it wasn’t. That’s because WB was not on the list I got from American Banker. Apparently their data supplier (SNL) removed WB since the merger had gone through when they compiled the list on March 11, 2009. So, rather than redo the analysis I let it ride.

I just checked WB’s 9/30/08 financials. At that time its price had dropped to around $3.50 destroying its market cap, while the merger would have doubled WFC revenues. The combination would have pushed Wells Fargo’s AQ score back far below zero. Then I wouldn’t have been nailed by Connell in my interview! Sigh…

~V

May 13 06:19 PM