Wells Fargo: Whatever Happened to Bank Bears?

I have some good news and some bad news. The good news is that that market neutral strategy illustrated through my blog research is working like a charm (I will be posting some results soon). The market has been on a massive bullish tear, to the dismay of market bears.

Well, the new strategy works and it allows us to profit from both bullish and bearish moves. I have transformed my personal portfolio to the market neutral strategy.

The bad news is that the problems that caused those of us who know how to count to be bearish still abound and have apparently been conspired into the bin of ignorance.

Accounting boards, banks, media and sell side analysts in general appear content to ignore the facts, change the way we count losses (after all, losses are... well... losses. Right???!!!), and generally sweep the banking problems under the rug in anticipation of bubbling our way out of the problem or at least concealing it long enough through accounting shenanigans to allow accounting profits to somehow paper over economic losses.

Good luck with that. Underlying fundamentals are still deteriorating, albeit potentially at a slower pace, as share prices are literally flying through the roof. Those who are in the market and are bullish or not market neutral are, in my opinion, playing with fire. It is gambling to buy stock just because the stocks' prices are going up. I know it feels good when the prices go higher after you buy the stock, but the underlying fundamentals are atrocious and if one were to get caught in a nasty correction, one could not have said it was "impossible to see coming".

This is exactly the same scenario that played out in the dot.com bubble. Bulls were justified because share prices went higher, not because underlying values increased. When reality hit (and it always does hit, that's why they call it reality) folks were literally wiped out.

I will anecdotally illustrate some of that fire investors are playing with in the banking sector. While I was browsing through the extremely interesting, if not controversial, Zero Hedge blog, I came across this video of Elizabeth Warren, who heads the Congressional Oversight Committee's investigation of the banks. I will like my readers to listen to it then continue reading this post.

Wells Fargo (WFC) and over $100 billion of economic losses????

In the case of Wells Fargo, we have applied high LTV ARM loss rates to calculate the losses on HELOCs (which comprises of total 1-4 family junior lien mortgages and line of credit) since the direct HELOC data was not available for WFC. The total losses in these loans are expected to skyrocket as can be seen from the raw, and unbiased NY Fed and FDIC call sheet data (see The Re-Release of the Open Source Mortgage Default Model and Green Shoots are Being Fertilized by Brown Turds in the Mortgage Markets).

It is a small wonder why the Treasury failed to use this government data to run the bank stress tests, for if they did the outcome would have been far different, and decidedly much more negative. We have taken a conservative approach in valuing the loan losses due to which the total loan losses in the HELOCs alone would be 56.4% or US$62.1 billion.

We have segregated the total HELOC loans as owner occupied and non-owner occupied based on the proportion mentioned in the FDIC data derived spreadsheet for each respective states. Then, applying the default rate assumption made in this sheet for High Risk ARM (owner occupied - 65% & non-owner occupied - 95%) we calculated the total default rate for each state.

Further, we applied the recovery rate based on the current LTV to arrive at the total charge-off in the next two years.

The total losses are expected to jump to US$187.4 billion in the adverse case in the coming two years. Wells Fargo's current Tangible Common Equity (TCE) stands at 3.28%, which is significantly lower than the prescribed limit of 4%. According to our estimate, the bank's TCE would fall to 1.56% at the end of 2010 after adjusting for accounting and economic losses.

Considering the massive anticipated losses in the next two years, Wells Fargo's capital would fall short by US$34.3 billion and not US$13.7 billion as shown by the SCAP result (see America, You have been outright lied to! Bamboozled! Swindled! Hoodwinked! The Worst Case Scenario, Welcome to the Big Bank Bamboozle!, and The Real Stress Test Results) to maintain a TCE ratio of 4% in the pessimistic case.

As Wells Fargo has raised US$8.6 billion capital it would still be required to raise an additional US$25.65 billion as a safeguard against a deeper economic downturn or a recovery marred by another negative dip, OR a recovery hampered by lingering unemployment OR a recovery constrained by floundering property sector OR a recovery pulled down by mediocre growth.

Here is the Wells Fargo Eyles test, Texas Ratio and Tangible Equity trends using FDIC and NY Fed data as fed through our forensic model, incorporating off balance sheet entity risk.

click graphics to enlarge

Wells' share price is up nearly 400% since March while nearly every compreshensive credit metric (if calculated using real, unbiased data in a real, unbiased fashion) forecasts a very, very different outcome.

Federal Reserve vs. Our Computation - Loan Loss Estimates

Methodology to compute loan loss rate: Real estate 1-4 family mortgage loans

Real estate 1-4 family mortgage loans comprise prime loans and Alt-A loans. Since the complete breakdown of loans into prime and Alt-A is not known for Wells Fargo, we have assumed the default rate of Alt-A loans in the US. Thereafter, we adjusted this default rate to factor in the prime real estate 1-4 family mortgage loans.

We computed the net loss rate for two years (2009 and 2010) based on the Alt-A default rate to arrive at the overall default rate. We then applied the recovery rates, based on the decline in the housing prices and LTV, to calculate the total loss rate. We assumed the loss rate to be 20% lower than the loss rate of the Alt-A loan in each state as some proportion of the loans could be prime loans.

The S&P Case-Shiller Index has declined around 18.9%, 29.3% and 29.2% since 2005, 2006 and 2007, respectively, as the majority of these loan values have been wiped out completely due to the severe correction in prices while the LTV still remains very high.

Based on the current LTV, we have assumed the recovery rate to derive the loss rate for 2009 and 2010.

The total impaired loans would thus have a loss rate of 31.2% in the coming two years while loss rate in the real estate 1-4 family first mortgage would be 20.1%. The Federal Reserve loss rate of 7-8.5% is far too optimistic to give a true picture.

Real estate 1-4 family first mortgage
Impaired Loans	Current LTV	Overall Defaults rates	Recovery rate: Case-Shiller - LTV	Loss rate for 2009 and 2010
California	128%	34.8%	12.0%	30.6%
Florida	124%	38.6%	12.0%	34.0%
New Jersey	108%	36.6%	21.4%	28.8%
Arizona	146%	36.5%	12.0%	32.1%
Other	112%	40.2%	19.4%	32.4%
Total Impaired Loans				31.2%
All other loans
California	125%	22.4%	12.0%	15.8%
Florida	122%	29.2%	12.0%	20.6%
New Jersey	105%	23.3%	21.4%	14.7%
Virginia	110%	25.7%	16.7%	17.1%
New York	87%	22.6%	35.0%	11.8%
Pennsylvania	111%	27.0%	16.7%	18.0%
North Carolina	85%	31.8%	35.0%	16.5%
Texas	91%	31.5%	28.2%	18.1%
Georgia	104%	30.4%	21.4%	19.1%
Arizona	139%	28.6%	12.0%	20.2%
Other	110%	28.6%	12.0%	20.2%
Real estate 1-4 family first mortgage				20.1%

Wells Fargo acquired home equity loans from Wachovia, which carries the highest default risk as its portfolio largely comprises second lien mortgages. The value of the home equity portfolio is US$128.9 billion.

Home equity portfolio	US$ mn
Core portfolio
California	31,784
Florida	12,067
New Jersey	8,086
Virginia	5,653
Pennsylvania	5,129
Other	56,342
Total core portfolio	119,061
Liquidating Portfolio
California	3,835
Florida	492
Arizona	233
Texas	179
Minnesota	122
Other	5,001
Total liquidating portfolio	9,862
Total core and liquidating portfolios	128,923

The value of Wells Fargo's pick-a-pay portfolio (home loans) is US$93.2 billion of which US$39.7 billion or 42.6% is impaired loans. The principal balance of the impaired loans is US$61.6 billion. This loan has the highest probability of risk and could result in complete writedown. Currently, the LTV in majority of the states is above 100%, with California and Arizona having the highest - 161% and 152%, respectively. Despite writing down US$21.9 billion, the carrying value at these two states hovered around 100%, implying high risk.

Pick-a-pay-portfolio		Impaired loans
	Unpaid principal balance	Current LTV %	Carrying value	Carrying value to current value
California	42,216	152.0%	26,907	98.0%
Florida	6,260	129.0%	3,779	79.0%
New Jersey	1,750	101.0%	1,271	74.0%
Texas	475	76.0%	336	54.0%
Arizona	1,642	161.0%	987	99.0%
Other states	9,306	110.0%	6,397	77.0%
Total	61,649		39,677

Methodology to compute loan loss rate: Real estate 1-4 family junior lien mortgage

Real estate 1-4 family junior lien mortgage comprises home equity line of credit (HELOC) and second/junior lien mortgage. Home equity carries a very high risk of default due to high LTV and being second lien mortgage. We segregated the loans into owner occupied and non-owner occupied based on the state-wise proportion published by FDIC. Thereafter, applying the respective default rate of each category we arrived at the weighted average default rate.

To determine net charge-offs, we have considered the recovery rate based on historical recovery rates applied in conjunction with the current LTV. The table below gives the recovery rates used to determine net charge-offs.

	Current LTV	Recovery rate	Basis
Greater than	120%	12.0%	(recovery rates during 1990-1991, lowest since 1976)
Greater than	110%	16.7%
Greater than	100%	21.4%	(average recovery rate since 1976)
Greater than	90%	28.2%
Less than	<90%	35.0%	(highest recovery rate since 1976)

Source: FDIC and BoomBustBlog.com analysis

We estimated the current LTV for home equity loans based on the housing price decline calculated using the Case-Shiller Index of each state and LTV at origination to determine the current LTV. Impaired loans have a two-year loss rate of 67.5%, while other loans have a loss rate of 56.4%.

We have assumed impaired loans to have a 0% recovery rate in each of the states. The non-impaired home equity loans would have a loss rate of 56.4% for 2009 and 2010, while the Federal Reserve's estimated loss rate is 21-28% for the same period.

Real estate 1-4 family junior lien mortgage		High Risk Subprime ARM Loans (Low FICO and high LTV)
	Current LTV	Owner Occupied	Non- Owner Occupied	Default rate	Recovery Rate	Loss Rate
Impaired Loans		65.0%	95.0%
California	128%	93.7%	6.3%	66.9%	0%	66.9%
Florida	124%	88.7%	11.3%	68.4%	0%	68.4%
New Jersey	108%	91.5%	8.5%	67.6%	0%	67.6%
Arizona	146%	91.9%	8.1%	67.4%	0%	67.4%
Other	112%	91.0%	9.0%	67.7%	0%	67.7%
Total Impaired Loans						67.5%
All other loans:
California	128%	93.7%	6.3%	66.9%	12%	58.9%
Florida	124%	88.7%	11.3%	68.4%	12%	60.2%
New Jersey	108%	91.5%	8.5%	67.6%	21%	53.1%
Virginia	111%	91.1%	8.9%	67.7%	17%	56.4%
New York	90%	92.0%	8.0%	67.4%	28%	48.4%
Pennsylvania	111%	90.0%	10.0%	68.0%	17%	56.6%
North Carolina	86%	88.3%	11.7%	68.5%	35%	44.5%
Texas	89%	91.6%	8.4%	67.5%	35%	43.9%
Georgia	105%	88.5%	11.5%	68.5%	21%	53.8%
Arizona	146%	91.9%	8.1%	67.4%	12%	59.3%
Other	112%	91.0%	9.0%	67.7%	17%	56.4%
Home equity portfolio						56.4%

Loan Charge-off in 2009	Pessimistic Case	Base Case	Optimistic Case	Assumptions
Commercial	2.44%	2.14%	1.84%	In the US, commercial and industrial loan charge-off was 1.76% in December 2008. The Federal Reserve has pegged this charge-off between 2.5% and 4%.
Other real estate mortgage	2.20%	1.80%	1.40%	Total real estate charge-off stood at 1.75% in Dec 2008.
Real estate construction	5.62%	5.12%	4.62%	Construction and land development charge-off stood at 5.12% in the US in 4Q 08.
Lease financing	0.89%	0.74%	0.47%	In the US, lease financing charge-off was 0.62% in 4Q 08.
Real estate 1-4 family first mortgage	12.03%	10.13%	11.03%	Computed based on state-wise loan rate.
Real estate 1-4 family junior lien mortgage	16.19%	28.18%	15.19%	Computed based on state-wise loan rate.
Credit card	15.47%	14.00%	12.28%	Wells Fargo charge-off on credit card stood at 10.13% in 1Q 09. Furthermore, Federal Reserve assumptions for the same stood at 9%-10%.
Other revolving credit and installment	4.00%	3.50%	3.00%	Wells Fargo's charge-off on revolving credit and installment stood at 3.1% in 1Q 09.
Foreign	0.68%	0.58%	0.48%	Our assumption is based on regression analysis. The charge-off on foreign loan stood at 0.4% at the end of 4Q 08.

Total losses based on the 1Q 2009 outstanding loan balance:

Pessimistic Case
Loan Portfolio (US$ million)	Outstanding Balance 1Q 2009	Loan losses in 2009 and 2010
Commercial and commercial real estate:
Commercial	191,711	9,355
Other real estate mortgage	104,934	4,617
Real estate construction	33,912	3,812
Lease financing	14,792	264
Total commercial and commercial real estate	345,349	18,049
Consumer:
Real estate 1-4 family first mortgage	242,947	51,643
Real estate 1-4 family junior lien mortgage	109,748	62,958
Credit card	22,815	7,059
Other revolving credit and installment	91,252	7,300
Total consumer	466,762	128,960
Foreign	31,468	926
Total Loans	843,579	147,934
Securities	1Q 2009	Total
Available for Sale	223,581	13,652
Trading Account	46,497
VIEs & QSPEs exposure as on December 31, 2008	1,902,631	25,800
Total Loan Losses		187,386

Federal Reserve loan loss computation:

Federal Reserve Computation (US$ billion)	Loan losses in 2009 and 2010	As % of loans
First Lien Mortgages	32.4	11.9%
Second/Junior Lien Mortgages	14.7	13.2%
Commercial and Industrial Loans	9	4.8%
Commercial Real Estate Loans	8.4	5.9%
Credit Card Loans	6.1	26.0%
Securities (AFS and HTM)	4.2	NA
Trading & Counterparty	NA	NA
Other	11.3	NA
Total Loan Losses	86.1
Capital to be raised	13.7

Capital to be raised - Impact on TCE:

Capital to be raised US$ million
Min Tangible Equity Capital Ratio	Pessimistic Case	Base Case	Optimistic Case
2.25%	10,635	9,461	8,250
2.50%	14,009	12,865	11,684
2.75%	17,383	16,270	15,119
3.00%	20,757	19,674	18,553
3.25%	24,131	23,078	21,988
3.50%	27,505	26,482	25,422
3.75%	30,879	29,886	28,857
4.00%	34,253	33,290	32,291
4.25%	37,627	36,694	35,726
4.50%	41,001	40,098	39,160
4.75%	44,375	43,502	42,595
5.00%	47,749	46,906	46,029

Wells Fargo's current Tangible Common Equity (TCE) stands at 3.28%, which is significantly lower than the prescribed limit of 4%.

According to our projection, the bank's TCE would fall to 1.56% at the end of 2010 after adjusting for accounting and economic losses of US$187.4 billion in the adverse case. (According to the Federal Reserve stress test, losses in the next two years would total US$86.1 billion, which is much lower than our assumption). Furthermore, resources other than capital available to absorb losses totaled US$60.4 billion, marginally higher than the Federal Reserve estimate of US$60.0 billion.

Though the Federal Reserve resources available to absorb losses are similar, the loan losses estimate does not match. This is mainly due to Wells Fargo's huge off-balance sheet exposure of US$1.9 trillion in 1Q 08, up from US$1.79 trillion in 4Q 08, and home equity loan exposure of US$128.9 billion. Considering the massive anticipated losses in the next two years, Wells Fargo's capital would fall short by US$34.3 billion and not US$13.7 billion as shown by the SCAP result to maintain a TCE ratio of 4% in the pessimistic case.

To increase the TCE to 4% in the optimistic case, Wells Fargo would have to raise US$32.9 billion to endure the recessionary pressure.

According to the press release, on May 9, 2009, Wells Fargo raised US$8.6 billion capital by issuing 392.15 million shares at US$22 per share. This diluted the earnings by around 8.4%. However, in the pessimistic case scenario, the bank would still be required to raise an additional US$25.65 billion as a safeguard against a deeper recession.

Disclosure: I am bearish on and short WFC

Comments

[fatcat:]

Reggie,apparently you and I are the only remaining bank bears.

Only a fool would fail to see that the banks are years away from shedding their massive problems..

Aug 13 11:01 AM

[Joe H.:]

Negatory on your intry.Make that three roaring polar bears!

Aug 13 11:29 AM

[Joseph L. S...:]

It's "Night of the Living Dead," updated for 2009. Banks like Wells Fargo and Capital One are walking upright, bumping into things, and making gutteral sounds every now and again as they try to claw us into their grasp.

The sad thing is, at least the original zombies knew they were dead. The bankers have deluded themselves into believing they are still viable.

Aug 13 11:56 AM

[Roger Knights:]

What this means to me is that when reality sinks in, the market won't just decline, but crash, because it's risen so high. Pop goes the weasel.

Aug 13 12:11 PM

[AndrewBaker:]

Add me to the bank bears but one who is currently long the banks: though I am close to bailing out. Maybe the best way to make up for previous short losses is to wait and short again. They are due for a big fall, but timing is of the essence and the way things are right now, that is just about impossible to read. I may just leave it and stay with some boring commodities like gold and sugar. Interesting mix anyway.

Aug 13 02:20 PM

[peterfk:]

What's truly amazing is that the stock is almost at pre crisis levels. It's just begging to be shorted. I think people have too much faith in Buffett.

Aug 13 03:39 PM

[Tropean:]

Been building a short position in regional and community banks for a little more than a week.

Aug 13 06:08 PM

[BullnBear:]

I believe that the fed window is doing a great deal right now to give the perception of strength to the banking sector as a whole; don't you wish you could borrow at zero?

In the case of WFC I can't help but believe that Buffet does a great deal in terms of perception and strength and I also believe that we have something else in the form of government assistance on the way.

I've played the FAS and FAZ game this year and quite frankly I had enough of the whipsaw for the time being. I don't believe in the banking sector from a fundamental standpoint at all but larger forces seem to be bent on keeping the market inflated.

Great data collection!

Aug 13 07:41 PM

[Fighting Yoda:]

Market is back into the irrational exuberance zone. Of course our Fed is the leader of the pack in trying to inflate the next bubble. As long as the economic model of our country remains 'Bubbles R US' - we will have bubbles, and of course the resulting bursts too. But till then, for now it is a bubble.

Aug 13 08:54 PM

[ETFdesk.com:]

Track Reggie's call over time .... tinyurl.com/r8fkys

Aug 13 10:03 PM

[Jeez:]

After all this data and research, at least you did decide to short WFC. How about all the philosophy of "market neutral". I was waiting to see that trick with your extreme pessimistic view.

However, remember you (and no one) can or should fight the fed - and they have made up their mind to prosper all these banks.

Aug 13 10:33 PM

[a fat panda:]

You are bearish on their fundamentals . But fundamentals have nothing to do with the rebound in banking stocks. The bank stocks have rebounded because the government is channeling capital to them. Whether it is the fed buying bad assets, or TARP loans, or TAF, or the unwinding of AIGs CDOs at 100 cents on the dollar; the federal government is intent on making banks good on their investments.

I don't know what the government will do next. One day we bail-out the equity interests and the next we are letting debt holders get nailed. The government will step up and save one company but let the next go away. Shorting that kind of unpredictability seems unwise when there are so many other places to play.

Aug 13 11:28 PM

[Joe Shareho...:]

If we hit 9600 again, then it's time to get back into FAZ to recoup some losses. They pulled that 10 to one reverse split and it's lost half its value since then. I got smoked. However, what goes up must come down in this market. Benny Boy has a lot of persuasion and has manipulated this rally, but ultimately fundamentals ALWAYS win.

Aug 13 11:36 PM

[expat in China:]

Dear Mr Buffet!

Is WFC the high quality corporation that Berkshires desires for the buy and hold strategy, I do expect them to survive and may pay a dividend some day? Can you tell us what was stated when "Obama went to the banks"

The billions you just made from the stock prices really belongs to the American tax payer and we want it back.

You are to big to hide!

Aug 13 11:52 PM

[Vladimir Se...:]

On Aug 13 11:36 PM Joe Shareholder wrote:

> If we hit 9600 again, then it's time to get back into FAZ to recoup
> some losses. They pulled that 10 to one reverse split and it's lost
> half its value since then. I got smoked. However, what goes up
> must come down in this market. Benny Boy has a lot of persuasion
> and has manipulated this rally, but ultimately fundamentals ALWAYS
> win.

fundamentals eventually win but FAZ isn't an instrument that allows you time to wait for that eventuality.
unless your play is extremely short term you're likely to get smoked again with FAZ.

Aug 13 11:53 PM

[expat in China:]

what strategy would buy over 10,000 Oct 30 CALLS!

yesterday seems like large buy side volume?

Aug 14 01:17 AM

[TradingHelp...:]

"Whatever Happened to the Bank Bears"?

Most of last quarters bank bears are this quarters bulls. The herd instinct is strong.

Few analysts and commentators stick with the same story whilst the trend of risk appetite turns against them.

Aug 14 04:32 AM

[TGals:]

The current version is called the Bernanke Geithner Wealth Transfer Strategy.

It goes like this:

1) Create large amounts of money (TARP)
2) Distribute to banksters who go on buying spree (emphasis on bank stocks)
3) Step up rhetoric expounding how resilient the economy is (Pump)
4) Squeeze shorts until they cry 'Uncle!', lure unsuspecting masses back into the water.
5) Leave unsuspecting masses holding the bag (Dump).

Rinse, repeat.


On Aug 14 01:17 AM expat in China wrote:

> what strategy would buy over 10,000 Oct 30 CALLS!
>
> yesterday seems like large buy side volume?

Aug 14 07:27 AM

[Schweizer:]

Thanks for a great article, Reg. My prediction is that Ben wants out of the job and he'll let the next fool go down with the ship. I nominate Larry Summers as I know he can't swim.

The people are not going to stand for more bank bailouts, so watch the dollar soar as banks scramble to raise capital, causing equities, especially theirs, to crater just like last time, but this time it will be final!

Then we will ask Timmy what did the taxpayers get for that $700B we borrowed to save the banks. The answer is nada ...

Aug 14 09:14 AM

[ain't no fo...:]

Bank shorts R.I.P.

Cause of death: Total lack of balls.

And I guess that includes me.

Aug 14 04:05 PM