Fact, Fiction, Farce and Lies! What happened to the Bank Bears?

By: Reggie Middleton | Thu, Aug 13, 2009
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I have some good news and some bad news. The good news is that that market neutral strategy illustrated through the 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 are 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 whey 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 Zerohedge.com 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 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. Than, 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 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 contrained 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 though our forensic model, incorporating off balance sheet entity risk.

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

Our Analysis

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 majority of these loan value 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
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
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
Non- Owner
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
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
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
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 additional US$25.65 billion as a safeguard against a deeper recession.



Reggie Middleton

Author: Reggie Middleton

Reggie Middleton

Reggie Middleton

Who am I?

Well, I fancy myself the personification of the free thinking maverick, the ultimate non-conformist as it applies to investment and analysis. I am definitively outside the box - not your typical or stereotypical Wall Street investor. I work out of my home, not a Manhattan office. I build my own technology and perform my own research - in lieu of buying it or following the crowd. I create and follow my own macro strategies and am by definition, a contrarian to the nth degree.

Since I use my research as a tool for my own investing to actually put food on my table, I can stand behind it as doing what it is supposed too - educate, illustrate and elucidate. I do not sell advice, I am not a reporter hence do not sell stories, and I do not sell research. I am an entrepreneur who exists just outside of mainstream corporate America and Wall Street. This allows me freedom to do things that many can not. For instance, I pride myself on developing some of the highest quality research available, regardless of price. No conflicts of interest, no corporate politics, no special favors. Just the hard truth as I have found it - and believe me, my team and I do find it! I welcome any and all to peruse my blog, use my custom hacked collaborative social tools, read the articles, download the files, and make a critical comparison of the opinion referencing the situation at hand and the time stamp on the blog post to the reality both at the time of the post and the present. Hopefully, you will be as impressed with the Boom Bust as I am and our constituency.

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So here I am, creating my own research for my own investment activity. What really sets my actions apart is that I offer much of what I produce to the public without charge - free to distribute and redistribute, as long as it is left unaltered and full attribution is given to the author and owner. Why would I do such a thing when others easily charge 5 and 6 digits annually for what some may consider a lesser product? It is akin to open source analysis! My ideas and implementations are actually improved and fine tuned when bounced off of the collective intellect of the many, in lieu of that of the few - no matter how smart those few may believe themselves to be.

Very recently, I have started charging for the forensics portion of my work, which has freed up the resources to develop the site to deliver even more research for free, particularly on the global macro and opinion front. This move has allowed me to serve an more diverse constituency, which now includes the institutional consumer (ie., investment turned consumer banks, hedge funds, pensions, etc,) as well as the newbie individual investor who is just getting started - basically the two polar opposites of the investing spectrum. I am proud to announce major banks as paying clients, and brand new investors who take my book recommendations and opinions on true wealth and success to heart.

So, this is how I use my background and knowledge in new media, distributed computing, risk management, insurance, financial engineering, real estate, corporate valuation and financial analysis to pursue, analyze and capitalize on global macroeconomic opportunities. I have included a more in depth bio at the bottom of the page for those who really, really need to know more about me.

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