It has been well documented that Warren Buffett is Wells Fargo’s biggest fan – and largest shareholder (through Berkshire Hathaway). In fact, in his annual letter to shareholders he states that WFC is likely to increase its dividend the most among his common stock holdings. Given that WFC cut its dividend after taking TARP money, his prediction should not come as a surprise.
Another interesting comment from the Oracle of Omaha was his take on Black-Scholes. He writes that the model “produces WILDLY inappropriate values when applied to long-dated options” (emphasis mine). Then he wryly states that he “would rather be approximately right than precisely wrong.” While I like the comment (during my days as an analyst, I often questioned the value of the 10th iteration of a 50 page model), I believe this is where misses the point – yes, he may be right in the end, but what if all management teams thought they were “approximately right?” Time to move on, this isn’t an article about Buffet.
The reason I raise the issue is because a well-known and respected bank analyst believes WFC is using this theory with regard to the quality of their loan book. In his report, Chris Whalen writes that he believes the management at WFC is engaging in a practice of “extend and pretend.” By extending repayment periods, management delays the time at which they must confess to investors and the markets the true scope of their losses. In March of 2009, Warren said he believes WFC will “do fine earning their way out” of their current problems. It seems WFC management agrees. I digress, on to the list. Where possible, I compared the results with those in 2008 when the world was a much darker place. As read each point, keep in mind that WFC has Tier 1 common equity of $81 billion.
1. I find it odd that the financials are incorporated by reference to the actual 10K. The other large banks put it all in one place. In the staid world of banking, why stand out from the crowd unless you’ve got something to hide?
2. In a jab to Obamacare, WFC reported an annual effective tax rate of 33.9%, up from 30.3% in 2009 “primarily due to the new health care legislation.”
3. 34% of commercial real estate loans – excluding Purchase Credit Impaired (“PCI”, aka toxic assets) loans – were for properties located in California and Florida. Similarly, 37% of 1-4 Family Mortgage Loans were in those same states. These states, to the best of my knowledge, remain in mired in a housing morass. In fact, today we learned that pending home sales fell 2.8%. Upon closer inspection, you will find the West index fell 5.2% to 0.9% below last year!
4. The Pick-a-Pay portfolio – where the borrower has the option each month to select from among four payment options (1) minimum payment (which may not be enough to cover interest), (2) interest only, (3) fully amortizing 15 year payment, or (4) fully amortizing 30 year payment – in California had an average loan to value (“LTV”) of 81%, while the Florida loans had LTV’s of 100%. 33% of the entire mortgage loan portfolio have LTVs of 100% or more (inclusive of those loans where no LTV was available – exclusive of PCI). 57% of the PCI portfolio had LTVs of 100% or more. Back in 2008, the Florida loans had a LTV of 89% and California was 86% – and that was before the modification machine went into high gear. Together, these states alone total $50 billion. At some point, a person with a loan worth more than the house will stop paying. What would the bank be able to sell these properties in foreclosure?
5. In 2010, WFC completed 27,700 loan modifications. Approximately 49,000 modification offers were proactively sent to its borrowers. As part of the modification process, the loans are re-underwritten, income is documented and the negative amortization feature is eliminated. Most of the modifications result in material payment reduction to the customer. Is this how they generated a better performing loan book?
6. Nonaccrual loans in commercial real-estate mortgage loans jumped 41% to $5.2 billion and non-accrual consumer real-estate first mortgages rose 22% (it should be noted that consumer real estate loans are not moved to non-accrual status until they are 120 days past due). Foreclosed assets also jumped 90% to $6.0 billion. In 2008, foreclosed assets were a mere $2.2 billion (extend and pretend?). The PCI portfolio was similar with 20% of the loans 120 days or more past due. These jumps are alarming for a bank that claims its portfolio is better than its peers.
7. Troubled debt restructurings (TDRs) increased 85% to $15.8 billion in 2010. A reserve allowance of only $3.9 billion was set aside for TDRs in 2010. The bank notes that the majority of TDRs do not receive principal forgiveness, however, when they do, the entire amount is charged off. These TDRs seem to be yet another way to “extend and pretend.”
8. Fed fund repos increased 209% to $24.9 billion. In 2007, that source of funding was $1.7 billion. Thanks Ben.
9. Borrowers with FICO scores below 640 make up 21% or $83.7 billion of the consumer loan portfolio. That number jumps to 25% when borrowers where no FICO score was available are added. The PCI portfolio was much worse with 68% of the loans to borrowers with FICO less than 640. These borrowers are at the low-end of the credit spectrum and are likely living from pay check to pay check – if they are still receiving one. In 2009, management stated that loss rates for loans to borrowers with FICO scores of less than 620 was a full 188 basis points (or 36%) higher than those to borrowers with FICO scores higher than 620 (in the 2010 report, management provides groupings of FICO scores from <600 and 600-639, so much for consistent reporting from one year to the next). A 7% loss on $83.7 billion would be quite a dent in the bank’s Tier 1 equity.
10. The company transferred $20 billion of Mortgages Held for Sale (MHFS) to trading assets. MHFS include commercial and residential mortgages originated for sale and securitization in the secondary market or sale as whole loans. In 2008, only $0.5 billion of MHFS were transferred. In addition, 2010 saw $3 billion of loans transferred to securities available for sale – in 2008, that number was $283 million. This suggests that either the securitization market hasn’t completely thawed and/or the bank has been forced to retain more risk on its books.
I promised 10 things, so I won’t go into the litigation facing the company which has been documented by other sources. From the list above, it is clear that the bank has plenty of issues to earn its way out of. Good luck Mr. Buffett.
Some people will suggest that I short the stock if I’m so sure of my analysis. As John Maynard Keynes famously stated, “markets can remain irrational far longer than you or I can remain solvent.”