Philip Gvinter

Tier 1 Capital Ratios of Large U.S. Banks

Tier 1 is also subject to risk weights assigned to assets. As we are clearly seeing during this credit crisis these weights are oftentimes not appropriately set and these risks are not properly measured. The retained earnings are also subject to manipulation. One easy trick is to use a decline in the market value of a bank's debt as income (Morgan Stanley did this at the beginning of the year)

Tier 1 Capital Ratios of Large U.S. Banks

Two problems here.

1. The Tier 1 ratio does not include massive off balance sheet liabilities which can account for as much as 75% of some banks' assets.

2. Tier 1 ratios can be (and in my opinion are) manipulated by including intangible assets such as good will as well as retained earnings to boost said ratios.

A much better measure of bank health is tangible common equity. The banks above have very low TCE ratios.

Rating the Top 12 U.S. Banks - From Hidden Gems to Zombies

$15B - $11B = $4B. $4B + $35B = $39B. So instead of buying WFC at a 40 P/E they pay the low low price of a 2- p/e when industry average is 12. In a good market. They overpaid and will get buried by the losses from the Golden West portfolio as well as WB's home equity and construction loans. Also keep in mind that WFC was one of the biggest buyers of high FICO but otherwise sloppily underwritten Jumbo loans which were really ALT-As. These loans were mostly stated income and done at near conforming rates in 2006 and 2007 way past the peak of property values. I do not think that WFC are anywhere near as conservative as their reputation suggests. They also had a substantial subprime wholesale mortgage operation and there have to be some reps and warrants from those loans leading to some serious losses.


On Feb 20 12:01 PM 360877 wrote:

> You forget that Wells Fargo also got a $11B tax write off. The effect
> on their balance sheet was zero. Wells Fargo will continue to post
> a profit through 2009. Kovasavich and Stumpf run a tight ship and
> are very conservative in their approach. This message runs strong
> throughout the company.
>
>
> On Feb 19 09:31 PM Philip Gvinter wrote:

Rating the Top 12 U.S. Banks - From Hidden Gems to Zombies

Wells paid $15B and agreed to absorb losses. This is a bad deal for Wells if the losses taken are significantly greater than the future revenue that the purchase will generate. For example if they have to take an additional $35B of losses the total purchase price would be $50B. This would mean that they must somehow turn what they bought into more than $50B. This can come from future earnings or the sale of the assets they got as part of the deal. I do not see how Wachovia's operations can be expected to earn anything near what they used to given the demise of the free for all mentality in the securitization markets which drove a large percentage of those earnings. My estimates are that Wachovia's operations are capable of producing the kind of earnings that a bank of similar size was able to produce around 2001 or 2002. That would be about a 50% haircut from the peak achieved in 2005 and 2006. At that rate it would take WFC over 25 years to recoup their investment. To me that represents too low of a yield on the investment.

Rating the Top 12 U.S. Banks - From Hidden Gems to Zombies

I have to disagree strongly on USB. They were a very active subprime lender in the wholesale market and continued to do subprime loans all the way into Q2 2008. At that point there was no secondary market for the subprime loans as the securitization process had locked out subprime during the summer of 2007 and ALT-A by fall 2007. This means that a substantial portion of their subprime originations which were done by third party brokers are in their own loan portfolio. I would also be willing to guess that the same decision making process and lack of appropriate risk management which lead to making subprime portfolio loans also probably lead to other credit policy mistakes. One very telling thing that set the initial red flags off for me was when management repeatedly talked about growth at the expense of weaker competitors during Q1 and Q2 08. This growth was most likely fueled by what turned out to be overly risky deals which looked much better before the reality of what was upon us truly made itself obvious to everyone. To its credit USB has avoided the ill conceived mergers like BAC-CFC, BAC-ML, WB-Golden West, WFC-WB, or even to some degree JPM-WM, JPM-BSC and PNC-NCC. At the same time I have a feeling that their loan portfolio has much more hidden risk than is currently assumed and that management stayed in certain niche lending markets far too long.

Now's the Time to Buy Bank Stocks

I also have to say that transparency is critical here. I am very leery of the overly optimistic and rather opaque numbers reported by JPM, WFC, BBT, and to a lesser degree USB. I feel that the lending standards industry wide were relative cookie cutters for each individual asset class (subprime, alt-a, option arms, prime jumbo, GSE saleable, etc.) and that the real qualitative difference was the level of exposure to the given asset classes and business models. Originate-to-securitiz... is pretty much dead. Option ARMs are the most toxic waste still outstanding but the big players (CFC, WB, WM, DSL, FED, BKUNA, AHM) are either dead (AHM, WM) on life support (DSL, BKUNA, WB) or a great short (FED.) The one thing that I think we can really learn from is the approach that institutions have taken to deal with the issues. Those who have maintained relatively high transparency are absolute steals at these prices as long as they are solven. Those who moved held-for-sale assets into held-for-investment in order to avoid taking writedowns and who seem to have default rates which seem lower than those which should come from their lending program mix look very suspicious and like the next CFC or WB.

Now's the Time to Buy Bank Stocks

I could not disagree more with the author. I have followed the banks closely and feel like the supposed "high quality" banks like USB, BBT, WFC, JPM, ZION, Hudson City and others who are trading near Jan 08 levels are ripe for a short while the heavily discounted but still solvent like SOV, FHN, perhaps NCC and others who are beaten up but who have taken the lumps they have coming to them (ALT-A wirtedowns >35% and done with their subprime) will do well on a relative basis. The problem is its very difficult to tell who is still solvent.

In the case of the "better banks" these valuations are CRAZY. They are trading at a huge premium to the rest of the peer group with no bottom in sight for either the housing market or the economy in general as unemployment continues to increase. Wells and BBT have lots of ALT-A, Prime Jumbo and construction loan exposure. These guys have painted a very optimistic picture by announcing default rates that are still below 1%. This cannot continue and they are being priced as if it can. I am not saying that these well run banks will collapse but simply that they have too high of a price premium relative to their peer group as well as an unrealistic future P/E which does not price in the issues they will inevitably face. In my opinion all of these stock still have anywhere between 25% and 75% downside risk as their earnings see the effect of a 2% to 3% default rate across their loan portfolios.

As for the "bad banks" some have taken aggressive writedowns on their held-for-investment portfolios which will exceed actual losses. Many have also faced the majority of their portfolio stress test on asset classes which are nearing the peak of their impairment or have even moved beyond that point. I believe that C at $15 or lower is a buy for this reason. I also feel that ALT-A loans should be separated into two distinct categories, Option ARMs which are toxic waste and regular ALT-A which will have high but not astronomic default rates and loss severity. The difficulty lies in identifying the banks who are furthers along in their portfolio stress test but who are still fundamentally solvent. SOV in my opinion belongs on this list. I need to gather more data on FHN and NCC but feel that they are strong candidates.