Wells Fargo Lays Bear Trap on Wall Street

Today's Wall Street darling is a little old bank from the left coast, Wells Fargo (WFC).  The transcontinental horse-back messenger service bank, largely expected to begin an arduous write-off period, surprised analysts by beating their ever sage estimates guesses by $.03 (.53 v .50 est).  The stock bounced 30% on the news.  Unfortunately, WFC's earnings are actually a mine field waiting to blow the legs off some unwitting retail investor.

Most notably, Wells Fargo changed its charge-off policy this quarter for home equity mortgages.  Traditionally it recognized losses after 120 days; now it's 180 days.  Oh, and did I mention it did it to protect homeowners?  From page 4 of the 8-K:

...the Home Equity charge-off policy changed in the second quarter from 120 days to no more than 180 days to provide more time to work with customers to solve their credit problems and keep them in their homes. The Company has helped nearly 900 customers, and approximately $90 million of Home Equity loans have been modified due to this change.

I know what you must should be asking yourself: what effect did this have on the company's earnings?  Curiously you have to turn to the next page for that information, divided into two paragraphs, which surely was for clarity obfuscation.

The policy change had the effect of deferring an estimated $265 million of charge-offs from the second quarter…

Remember how the company beat analyst expectations by $.03, well $265m / 3.2b shares = $.08/share.  Suddenly yesterday's WSJ headline reads:  "Concerns About Financial Sector Grow as Wells Fargo Misses Estimates."

To be fair, WFC did indeed publicly announce this change of accounting during the quarter, and I am in no way accusing the firm of fraud.  By all accounts, Wells Fargo is a very well run company.

That said, deferring charge-offs generally portends bad things ahead.  Much as when firms use accrual accounting (the booking of expected revenues upon the sale/purchase of an item like a bond instead of booking the cash flows as they occur) the intertemporal shift of losses is rarely a good sign. 

It becomes especially troublesome as the firm essentially builds a backlog of un-charged, but unrecoverable cash that must be recognized at some point.  It is important to stress, their accounting practices are well within GAAP tolerances, but it is changing mothodology always worries me. Indeed, as they 8-K continues (two pages later):

Although losses declined, the portfolio continued to deteriorate as property values search for a bottom,” said Loughlin. “Given the continued decline in home prices, we had more accounts move into the higher combined loan-to-value segments, which directly impacts loss levels.” Approximately 38 percent of our $73 billion core Home Equity portfolio and 71 percent of our $11 billion liquidating Home Equity portfolio had combined loan-to-value ratios above 90 percent as of June 30, 2008. The property values are primarily based on a combination of March 2008 automated value models and May 2008 home price indices.

Wells Fargo currently has $35.5b in outstanding loans with little or no equity cushion.  And, as it noted, we probably aren't even close to the bottom yet, so expect that number to rise even higher.  When they reach 100% you can expect the "jingle mail" to flood their inboxes like Thanksgiving Day sale notices.

Instead of beginning to recognize the losses the company already has shifted current liabilities into a much larger chunk to be realized "at a later date."  This money isn't coming back, so why wait?  It claims it's because "accounting rules for them to treat the loans as non-performing, even if they believe a work-out can be reached."  It's always those pesky rules about losing money that get in the way of good business, isn't it? In my opinion, the company wanted to maintain a positive posture as it audaciously raised its dividend $.03.  Either the company has brilliant managers/fiduciaries, or this is a company on the verge of crumbling.

There were quite a few other notables and quotables in the 8-K:

• Credit card fees were up 14% YoY, and 22% QoQ due to continued growth in new accounts and greater card activity (consumers getting pinched);
• The Visa (V) IPO added ~$300m to income in the quarter (non-recurring income);
• Net unreallized losses on securities available for sale were $2.1b compared with $589m in 1Q08, and securities available for sale increased 64% YoY (unable to unload assets) 

Furthermore, this delayed recognition of charge-offs is one of many curious aspects of their report.  I will let the analysts at GS some up some of the others:

[T]here are a number of things that are hard to explain at first glance within the numbers, most notably: (a) a 10% dividend increase in an environment when capital is extremely scarce, new business and M&A opportunities are abundant, and Wells Fargo’s stock is already yielding 6%, (b) mortgage banking fees equaling $1.2 bn which was 2X our forecast, and (c) Wells Fargo is one of the only banks that has been able to sustain a net interest margin near 5% (up 23 bp linked quarter to 4.92%), aided in part by a securities portfolio that is growing nearly 50% annualized and has a 6% yield. At the same time, the unrealized losses on securities grew 3.5X to $2.1 bn as a result of higher rates. Adjusting for the home equity policy change, charge offs would have been 1.82% which keeps reserve coverage of charge-offs flat at 1X.

Or, perhaps my buddy's email (which he sent while I was writing this) said it best:

Current book value: $48BB

Budget for additional writedowns: ($15BB) = $4BB home loans + $3BB MBS + $8BB Misc

  =Net Book value: $33BB

Historical Return on Equity: 16 – 17%

Projected Return on Equity: 20 - 22% due to being one of last healthy banks standing and can take advantage of better lending terms

Projected Stabilized Net Income: $7BB (=21% ROE * Book Value)

Target Return on Investment= 10% (i.e. 10 P/E ratio)

  =Value: $70BB

Current Value: $89BB

Verdict: wait until price goes back down to $21.20

No matter what, even if WFC has managed to walk through this period relatively unscathed, I do not think this helps the case for the financials as a whole and would absolutely be a seller (if only I could!) of any rally.  I'm going on record: this is a bear trap.

UPDATE: Apparently the WSJ agrees, or plagiarized.

(Note: This is not a recommendation or investment advice.  1-2 does not have a position in any of the securities mentioned.)

Comments

[firstmethod70:]

In general companies don't jack dividends to "prove a point" or "maintain a 21 year track record" or to be audacious they do it because they can. This is doubly true for an 150 YO blue chip widely known to be ultra conservative. I distinctly remember the CFO in the conference call saying "the business is accellerating faster than the write offs". The (anonymous) poster also made no positional disclosure which makes me suspect its histronics from a badly burned short. Regardless WFC will be one of the last banks standing and will be cherrypicking amongst the burned out rubble - additional writeoffs or not.

2008 Jul 18 11:35 AM

[RonB:]

Let's see...should I listen to some emotive blogger with an obvious agenda, or pay attention to Warren Buffett, who has been adding to his substantial $9 billion plus stake in Wells Fargo as the stock declines? Gee, there's a tough choice! This areticle is absurd, but everyone is entitled to their own opinion. Panicky people like this who don't understand banking have created a wonderful opportunity to buy stock in a high quality company at a bargain basement price.

2008 Jul 18 11:57 AM

[rb1253:]

If $265Mil equals .08 /sh, then I guess the reserve BUILD of an additional 1.5 BILLION could have improved their reported results by .45 /share!! No mention of that here though --you can cherry pick anyone's numbers and come up with the story you want -- but go through all of the numbers on WF and you find they are well positioned to separate themselves from the rest of the pack.

2008 Jul 18 12:14 PM

[Stewie:]

"should I listen to some emotive blogger with an obvious agenda, or pay attention to Warren Buffett, who has been adding to his substantial $9 billion"

You have to be kidding, if you bought BRK.A 10 years ago at 80,000 it would now be worth a whopping 116,000, that flat out sucks. That's 3.75% a year, you would have been better off in a Treasury Bond. You deserve to be slaughtered in this market.

2008 Jul 18 12:50 PM

[Financial C...:]

I believe most banks are insolvent or at least close to it. You want to buy banks now? Go for it. I need a good entry point for a short position. If it wasn't for all the accounting manipulation, fraud, and government intervention, most bank stocks would be in single digits or zero by now. DOW 7000 anyone?

2008 Jul 18 01:25 PM

[Small-Investor:]

Seems very lopsided, trying to build a justification after deciding on the conclusion. $265 MM = $0.08 analogy (though it is flawed as also shown by "Bankonit" post) needs to be adjusted for tax... conveniently forgotten. The question also is whether the $1.5 Bn would have remained unchanged if the $265 MM policy change had not occured....if not, then we could have had $265 MM + addnl reserve of $1,235 MM...basically no effect on EPS...see the last line from the earnings call transcript :

Credit Quality
Overall credit quality deteriorated in the second quarter. Net charge-offs in the second quarter were $1.5 billion, or 1.55 percent of average loans annualized. As previously disclosed, beginning in the second quarter we changed our home equity charge-off policy
from 120 days to no more than 180 days, consistent with FFIEC guidelines. The impact of this change deferred approximately $265 million in home equity charge-offs from second quarter, although the change in policy did not reduce second quarter provision expense
which included the deferred charge-offs.

2008 Jul 18 01:48 PM

[riverpirate:]

While the dividend move was questionable, one thing is for sure, Wells is not in the same boat -- not even in the same ocean -- as IndyMac, CFC, and Bear Sterns. Be careful what you shorties focus on was the message, loud and clear. While the apacolypse-wishers focus on the 265m affected by the change to 180 days, the smart money doesn't turn a blind eye to the very high Tier 1 capital they have and the fact that the bank is highly diversified, they aren't a one-trick pony by any means.

Also, they have always been the most vigorous managers of credit quality in their peer group, by a long shot. It's not so hard to believe that they are faring the best (sans USB) out of the banks when the have consistently had the best counterparty rating of any domestic bank, period.

A lot of banks are in serious trouble. Well's trouble isn't THAT serious, and they wanted to let you know that, shortie, very emphatically, so that you wouldn't sully their reputation and ruin their access to capital.

2008 Jul 18 05:18 PM

[ignorant:]

The change in the 120 to 180 write-off period did not change the expense to earninngs. The $265 was charged against earnings although it was not charged against the reserve (balance sheet) as a write-off. I suggest that all the readers of this article read the WFC earnings release to understand this distinction. Either the author of this article does not understand this or is attempting to distort the facts.

I also suggest that readers understand the difference between the terms: charge-off, provision of credit losses (income statement), and allowance for loan losses (balance sheet). WFC hit the income statement with the $265 million in the provision for credit losses expense. It will not charge the $265 million against the reserve until the end of the 180 day period.

2008 Jul 19 09:57 AM

[Relmhill:]

The head should say, "... lays a BULL trap...". You're not trapping bears if future losses lie ahead, you're trapping people who are bullish based on headline news.

2008 Jul 19 11:38 AM

[Ames Tiedeman:]

Was Buffet increasing his stake on the ride down?

2008 Jul 19 01:33 PM

[Urbane Gori...:]

First, at 12% of our GNP, id like to state flatly that it's "Left Coast", and not 'left coast'. It'd be nice if you 'pointy black shoe, green ties with blue shirt, can't wear white till labor day, east-coasties' could get that right. Just kiddin'...

Was listening to an NPR (yeah...liberal channel) interview and it was brought up that one of the indications of a bank in trouble (is there another kind?) was to see if the bank was offering CDs at a higher rate than other local banks. Hmmmmm ....

Nice tap-dancing around the 180 day charge off issue.. ('Blinded me with science!') Wells Fargo can limbo-rock. How low can they go?

Thx jegan ...

2008 Jul 19 02:23 PM

[Skip Olinger:]

Very well written piece compared to most shallow and/or emotional articles written here. I haven't read enough to make an intellengent comment but you made a very good case that I will investigate. Thanks very much

2008 Jul 19 10:45 PM

[Eli55:]

A large position in “Brady Bonds” whose value declined precipitously clobbered Wells Fargo a number of years ago. With patience the bond's price firmed and they became whole (while possibly suffering opportunity costs). Wells is taking a proactive posture on riding out the cyclical housing/mortgage market, working closely with delinquent payers, which was not done in previous cycles. While long term they again may suffer opportunity costs they will lose little or no money on their mortgages.

Their stores (branches) are growing by their clients using more of the stores eight product lines (5+ of 8 for individuals and 6+ of 8 businesses). They are incrementally buying bank companies and increasing sales.

They have no known off the book loans, derivatives, CDOS, CMOS, SIVS or what have you, i.e. Enron, Citigroup. They did not make a market in these instruments, as purportedly did JPM.

Wells Fargo is a well-run money store.

2008 Jul 20 12:18 AM

[najdorf:]

Just want to point out that Stewie is wrong. Ten years ago BRK.A was in the 70s, and you could have gotten it in the 50s or 40s with good timing. Today it's 117, but it has hit 150 this year, so with ideal timing one could have tripled one's money. Even with random timing, one usually could have outperformed the S&P 500. Bonds will outperform the S&P and a lot of major stocks in bad stock market times - that's why some people invest in bonds. However, if you were in treasuries you would have paid taxes every year and you'd be at a peak price right now, whereas with BRK all your profits would be unrealized and continuing to compound, with the price having plenty of room to run from today's valuations.

2008 Jul 20 12:51 AM