About this Bank Plan - It Won't Save the Truly Insolvent Banks!

By: Reggie Middleton | Wed, Feb 11, 2009
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Quite a few people have been emailing me about my opinion on the bank bailout deal. I do not think Obama will go the Bush Route and favor Wall Street over Main Street. It is just not a wise move. Alas, I've been wrong before, but if I am wrong about Obama's politics, I still will not be wrong about bank finances. Exactly how well did all of the other bank (and insurer) bailout plans work? I don't recall any of them resulting in a sustained increase in banking shares. As a matter of fact, I observed just the opposite. I really like Obama (contrary to most finance folk), but the man (and his staff) can't work miracles. Mother Market will have her way one way or another. Let me walk you through an example of how expensive it is to save the banks (this is a continuation of Is JP Morgan Taking Realistic Marks on its WaMu Portfolio Purchase? Doubtful! which itself is a continuation of Re: JP Morgan, when I say insolvent, I really mean insolvent).

Much of the data below came from the Wells Fargo Forensic Analysis that I released exactly 8 months ago, before I started charging for premium content. It appears the report has been quite prescient. There is ample evidence in that report to indicate that WFC is due for a downfall, but strong institutional coverage and media favoritism, plus the brand name effect (see my take on Brand Names and those that follow them), seems to have kept the price elevated for some time. That is alright, though, I have a lot of patience. I would like to make clear, contrary to popular (albeit, probably just current) belief, that I cannot predict the future. I can count my ass off, though, and that's how I find companies that eventually tank, and often tank hard.

Keep in mind this is OLD data from last year, before the employment bust, before the steepening of housing price depreciation, before the other big bank failures, and most importantly - before the assinine acquisition of Wachovia and its poisonous option ARM, HELOC and 2nd lien mortgage portfolio that it shouldn't have been able to GIVE away at cost. The excerpt from the report:

The states of California, Nevada and Florida reported the steepest y-o-y drop in home prices. Wells Fargo, with large construction loans exposure in all of those regions, is highly likely to be negatively impacted.

Wells Fargo's Loan Portfolio

Source: Company data

Rising defaults in home equity portfolio could result in higher losses.

During the housing boom, Wells Fargo expanded its real estate portfolio and avoided making option Adjustable Rate Mortgages (ARMs) or negative amortizing loans. Despite avoiding these riskier loans, Wells Fargo's home equity portfolio is deteriorating due to rising defaults and declining home prices. Consequently, the bank segregated US$11.5 billion of home equity loans into a liquidating portfolio, representing approximately 3% of total loans outstanding in 1Q 08. These home equity loans that are concentrated in the California, Florida and Arizona markets accounted for a significant portion of credit losses. The liquidating loan portfolio is mainly confined to geographic markets that have witnessed the steepest decline in home sales and housing prices. The liquidating portfolio resulted in an annualized loss rate of 5.58% for 1Q 08, compared to 1.56% in the remaining core home equity portfolio.

Wells Fargo's home equity losses are concentrated in the third-party correspondent channel. Approximately 55% of the liquidating home equity portfolio of US$12 billion has a combined loan to value (CLTV) of 90%. Such a high LTV will likely result in major losses for the bank in this liquidating portfolio. The core home equity portfolio was worth US$72.1 billion in 1Q 08. Of this, approximately 45% of the exposure was in the states of California, Florida and Arizona (36%, 4% and 5%, respectively), representing nearly 70% of the bank's shareholders' equity. The worsening housing scenario in these markets as prices continue to tumble and defaults rise, is expected to result in higher losses in the near future.

Home equity portfolio - geographical breakup

Source: Company data

Now, since I had nothing else to do, I decided to sit up for two nights in a row to calculate more realistic marks by hand, using the Case-Shiller index which any who follow me know that I feel this index is much too optimistic when dealing with urban areas (see Is JP Morgan Taking Realistic Marks on its WaMu Portfolio Purchase? Doubtful!). Below you will find various categories of 2nd lien loans with various CLTVs over various LTV primary loans.

Markdown on 0.85 CLTV 2nd lien over an 0.8 LTV primary mortgage  
  Average Markdown, Case-Shiller WFC Inventory Weight Adjusted Markdown
Others ~ Comp 20 -38% 0.44 -17%
Texas 0% 0.04 0%
Minneapolis -55% 0.06 -3%
Florida -67% 0.04 -3%
California -89% 0.37 -33%
Arizona -83% 0.05 -4%
Appropriate Mark -60%
 
Markdown on 0.9 CLTV 2nd lien over an 0.8 LTV primary mortgage  
  Average Markdown, Case-Shiller WFC Inventory Weight Adjusted Markdown
Others ~ Comp 20 -78% 0.44 -34%
Texas 0% 0.04 0%
Minneapolis -96% 0.06 -6%
Florida -79% 0.04 -3%
California -93% 0.37 -34%
Arizona -87% 0.05 -4%
Appropriate Mark -82%
 
Markdown on 0.95 CLTV 2nd lien over an 0.8 LTV primary mortgage  
  Average Markdown, Case-Shiller WFC Inventory Weight Adjusted Markdown
Others ~ Comp 20 -80% 0.44 -35%
Texas 0% 0.04 0%
Minneapolis -100% 0.06 -6%
Florida -80% 0.04 -3%
California -93% 0.37 -35%
Arizona -87% 0.05 -4%
Appropriate Mark -83%
 
Markdown on 0.95 CLTV 2nd lien over an 0.9 LTV primary mortgage  
  Average Markdown, Case-Shiller WFC Inventory Weight Adjusted Markdown
Others ~ Comp 20 -80% 0.44 -35%
Texas 0% 0.04 0%
Minneapolis -100% 0.06 -6%
Florida -80% 0.04 -3%
California -93% 0.37 -35%
Arizona -87% 0.05 -4%
Appropriate Mark -83%
 
Markdown on 1 CLTV 2nd lien over an 0.9 LTV primary mortgage  
  Average Markdown, Case-Shiller WFC Inventory Weight Adjusted Markdown
Others ~ Comp 20 -100% 0.44 -44%
Texas -60% 0.04 -2%
Minneapolis -100% 0.06 -6%
Florida -80% 0.04 -3%
California -100% 0.37 -37%
Arizona -93% 0.05 -5%
Appropriate Mark -97%

No matter which way you slice it, Wells Fargo has to take a significant hit to its equity if these loans are marked any where near market. Mar-08 (dated) shows net tangible assets at $35,011,000,000. The average writedown here is about 81%, times the 19% of loans the OLD WFC had (which is about $500 billion, I haven't looked it up) and you have just about wiped Well's Fargo's tangible equity right off the table. These numbers are not even close now, due to the Wachovia acquisition, but they will be looking a lot worse, not better.

I am going through all this to illustrate a point. Let's suppose the government decides to over pay for the asset by 30%, that still leaves a gaping whole in the equity of this bank, and that is not taking into consideration the massive amounts of other debt that is going bad in the bank. This is just one subclass of residential real estate lending. If you go through the Wells Fargo Forensic Analysis you will see a plethora of other problems that will need to be bought out. Long story short, the US does not have the capital to support these rotting assets. They will fall one way or the other.

Now, let's suppose that the US just prints enough to buy the assets. Well, there is still a loss there. The loss was purchased from the banks and passed to the US taxpayer, who will bear the loss in higher taxes which will come out of that tax payers discretionary consumption which then comes out of industries revenues which dampens demand for bank services (or which there are still too many banks anyway). Again, long story short, there is no way out of this other than to let the truly insolvent banks fail. It's just a matter of whether they fail now, or later - but it will happen.

Unfortunately, I had to write this at 3 am, so I will go back and correct lapses in logic and typos withing 24 hours.

 


 

Reggie Middleton

Author: Reggie Middleton

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