If a Bubble Bubble Bursts Off Balance Sheet, Will Anyone Be There to Hear It? Pt 4 - Wells Fargo
Before I delve into specifically what makes Wells Fargo an ongoing Doo Doo list member, I urge those who do no normally follow me to read the precursors to this article:
- If a Bubble Bubble Bursts Off Balance Sheet, Will Anyone Be There to Hear It?
- If a Bubble Bubble Bursts Off Balance Sheet, Will Anyone Be There to Hear It?: Pt 2 - JP Morgan
- If a Bubble Bubble Bursts Off Balance Sheet, Will Anyone Be There to Hear It?: Pt 3 - Bank of America
- And the next AIG is... (Public Edition)
After reading through Wells Fargo's numbers below, I want some of you guys (and gals) with calculators and spreadsheets to review "I'm going to try not to say I told you so..." and let me know the chances of the FDIC's absorbing a behemoth such as the CDO trading, CDS writing, off balance sheet VIE having, QSPE bulging, California and Florida Zero recovery 2nd lien sporting Wells Fargo in the case some of its arcane and non-performing assets really hit the fan. I am getting ahead of myself though. Let's take this from the beginning.
When the ticker WFC came up as a short list finalist in one of our scans last year, I was able to hear the cackling of those name brand groupies and CNBC junkies literally leaping from my keyboard. This is an excerpt from a free piece that I released on them exactly a year and a half ago, before the days of TARP:
"Well, the first bank on the drill down list will also be 2nd of the banks that I will deliver a forensic analysis on (the first was PNC Bank). That bank is,,, (drum roll in the background, crescendo.... I know some of you hate it when I do this........) Wells Fargo! I can hear a few of you naysayers cackling behind your computer screens as I type this. Wells Fargo is a big name brand bank (cackle, cackle)! Wells Fargo has Warren Buffet as its largest investor (cackle, cackle)! Wells Fargo this and that and blah, blah and (cackle, cackle).... All I can say is, beware of name brands (I actually felt compelled to address this in earlier posts). I have made more than a couple of dollars benefiting from name brand hubris and smaller investors who would rather be told what to do than read a balance sheet! Time will tell if I am right or not on Wells Fargo, just be forewarned - several of the banks on the Doo-Doo 32 (32 banks in deep doo-doo) list have already taken a trip to the confessional!"
Well, fast forward a year and a half and we see who was right. I urge those who do not subscribe to my blog to reference "Doo-Doo bank drill down, part 1 - Wells Fargo". Wells Fargo was actually one of the original Doo Doo 32 banks (32 banks in deep doo-doo), a list of institutions quite likely to hit the fan from an investor's perspective. I welcome all to track the well being of the banks on that list from that period to date. As for Wells Fargo, even despite extreme efforts by the government to prop it up, it appears as if I was on to something back then. Although many pundits STILL believe that I am wrong, the more I dig into the innards of this bank, the more cracks I see in its armor.
The risks posed by the housing crisis and arcane financing vehicles are drastically under-appreciated by the sell side...
Wells Fargo's high risk from its exposure to some of the hardest hit regions like California and Florida was further enlarged through the acquisition of Wachovia's ailing portfolio. The surge in NPAs pushed up the Texas ratio of the Bank to 29.9% as of June 2009 from 19.1% in December, 2008. Wells Fargo Eyles Test exceeded the allowance for loan losses by $3.7 billion or 6.3% of the tangible equity as of June 30, 2009 as against the excess allowance for loan losses over ET of $3.4 billion or 7.5% of the tangible equity in Dec 2008. As the rise in NPAs is far from subsiding, the Bank is expected to feel additional the pressure from high charge offs and provisions (see the latest news on the housing front and proposed FDIC charges whose charges have already [within a month] seen the need to be modified, see "I'm going to try not to say I told you so...").
Further, Wells Fargo acquired Wachovia's impaired loan portfolio valued at $56 billion (as of June 2009) at a discount of 36.2% from principal balance outstanding. These loans are classified as SOP 03-3 loans and are not included in the non performing category since they were acquired at substantial discount and the bank expects to recover the fair value. Consequently, the related provisions for loan losses and charge offs on these loans are very low. However, Wells Fargo runs the risk of further deterioration in this portfolio which will necessitate increase in charge offs and provisions for these loans. This has been the case with JP Morgan's highly discounted purchase of WaMu's troubled loan portfolio, which is already in the negative only midway or so in the housing cycle decline, despite aggressive discounting. See:
- JPM Public Excerpt of Forensic Analysis Subscription 2009-09-18 00:56:22 488.64 Kb
- JPM Forensic Report (092209) Final- Retail 2009-09-24 03:12:17 130.93 Kb
- JPM Report (092209) Final - Professional 2009-09-24 03:13:31 550.72 Kb
Write downs on investment securities along with other assets like MSR (Mortgage servicing rights) and mortgages held for sale will further erode the shareholder's wealth.
Wells Fargo carries about $43 billion of highly vulnerable privately issued mortgage backed securities (both RMBS and CMBS), out of which $34 billion are level 2 assets and $9 billion are level 3 assets (highly illiquid). Further, the Bank carries about $28 billion of other debt based assets consisting of asset backed securities collateralized by auto leases, corporate debt and collaterized debt obligations. Out of $28 billion, about $19 billion are level 3 assets while the remaining are level 2 assets. While the Bank values the level 2 assets using the relative value of similar securities or assets in the market, the fair valuation of level 3 assets is completely based on valuation models built through management's own assumptions and outlook. Based on credit losses likely to be realized on these mortgage and asset backed securities, we expect significant write downs. Additionally, Wells Fargo carries $16 billion of MSR (Mortgage servicing rights or the retained interests in its loan securitization arrangements) and $40 billion of mortgages held for sale. While MSR completely falls under level 3 assets category, of the $40 billion of mortgages held for sale, about $4 billion are level 3 assets while the remaining are level 2 assets. We expect additional write downs on these assets as well.
We expect total write downs of about $11.0 billion till 2010 under our base case which amounts to about 19.0% of the tangible equity as of June 30, 2009.
Risk emanating from the massive derivative exposure.
Wells Fargo's huge derivative exposure further adds to the credit risk of Wells Fargo. The notional value of the derivative contracts of Wells Fargo as of June 30, 2009 was $3.7 trillion and the bank is exposed to the counterparty risk emanating from these contracts. As of June 30, 2009, the notional value of the credit protection sold was $105 billion with the fair value of these contracts pegged at $14 billion (carried in the balance sheet). Out of this credit protection sold, about $46 billion of the contracts have underlying entities of below investment grade and have high risk of default. To hedge the credit risk, the bank has purchased credit protection on identical underlying entities of $34 billion (notional value) along with $74 billion of other credit protection purchased. Just in case the point has been lost amidst all of these words - it appears as if Wells Fargo is doing the AIG thing as well. Maybe not to the extent of AIG or even Bank of America, but they are not adequately protected from my perspective. This is even more telling, for this activity is corroborated by reports from the grass roots level. See Wells Fargo's Ticking Time Bomb: Credit Default Swaps On ...
It appears that Wachovia wrote credit default swaps on the junior tranches of commercial mortgage backed securities it was selling, which means that it is on the hook for losses in the riskiest CMBS tranches it sold. Wells itself might not even know the size of its exposure, Buhl reports.
According to sources currently working out these loans at Wells Fargo when selling tranches of commercial mortgage-backed securities below the super senior tranche, Wachovia promised to pay the buyer's risk premium by writing credit default swap contracts against these subordinate bonds. Should the junior tranches eventually default, then the bank is on the hook. Dan Alpert of Westwood Capital says these were practices that he saw going on in the market at large.
Alpert says in reference to how he saw CMBS trades get done, "These guys would say 'We'll just take back that silly credit risk you're worried about.' Of course that was a nice increase to earnings when they got the security sold. The bank made money at the time."
Buhl points out that investors might be caught off-guard if Wells has to start paying out on the swaps it sold. Wells, like most banks, almost certainly holds the credit default swap liabilities off balance sheet and most likely does not recognize them as a loss until they actually have to pay, Buhl writes. Wells says it carefully monitors its derivatives exposure. "We have provided extensive transparent disclosures on our derivatives in our 2008 annual report beginning on page 132," Wells says.
Here's Wells own calculation of its derivatives exposure as of the day it closed the Wachovia deal.
But it seems fair to wonder if Wells really understood all of the derivatives exposure it took on when it acquired Wachovia. Buhl wonders if Wells really has enough capital set aside to handle the derivatives liability.
...So could Wells really have enough capital to handle the liability of credit derivatives that will likely come due within the year? As we watch more and more of the junior tranches of commercial mortgage back securities Wachovia sold become worthless, how will Wells Fargo afford to pay for the risk premiums Wachovia promised they'd cover of if the loans blew up? From all indications, the bank cannot meet these obligations unless it raises more capital, sells good assets for a loss, or puts more of that TARP money to use instead of sending it back to taxpayers, as CEO John Stumpf has promised. So much for "earning our way out" of the financial crisis.
The losses from the credit default swaps might hit even earlier than Buhl expects.
One of the lessons from AIG is that a company can be brought down by collateral demands even before the swaps are triggered by defaults. If the buyers of the swaps have the right to demand additional collateral as CMBS tranches are downgraded--a very likely scenario--Wells could find itself having to scramble for liquidity even though the underlying credits haven't yet triggered the credit default swap payments. This, recall, is exactly what killed AIG.
I looked into this and Wells Fargo is indeed exposed to the risk of credit losses from the credit protection sold as well as the risk of collateral calls from the Credit Default Swaps, particularly those written under the Wachovia securitizations.
Assuming the unhedged proportion for the non-investment grade portfolio to be same as the unhedged proportion of the overall portfolio, we expect to see collateral calls. See our subscription content (WFC Research Note Sep 2009 2009-09-30 13:01:30 281.29 Kb) for what we see and how much under base, optimistic and pessimistic cases over the next 4 years.
Wells Fargo and What May Lie Off Balance Sheet
Wells Fargo uses Special Purpose Entities (SPE) for various securitization activities wherein financial assets are transferred to an SPE and repackaged as securities and sold to investors. As of June 30, 2009 the carrying value of Qualified SPE's (QSPE) in the company's balance sheet stood at $37 bn (64% of tangible equity) while carrying value of unconsolidated variable interest entity (VIE) and consolidated VIE exposure stood at $4 bn and $1.8 bn, respectively. In aggregate, carrying value emulating from QSPE and VIE exposure stood at $80 bn, or 137% of tangible equity as of June 30, 2009. It should be noted that WFC's acquisition of Wachovia brought with it a brokerage arm, not to mention a bevy of poorly performing assets. True commercial banks with investment, trading and brokerage arms are ones that I look to to have hidden skeleton's in the closets in the form of off balance sheet liabilities and hidden contingencies. Wells Fargo has apparently not proven me wrong.
Transactions with QSPEs
Wells Fargo uses QSPEs to securitize consumer and commercial real estate loans and other types of financial assets, including student loans, auto loans and municipal bonds. The Company typically retains the servicing rights from these sales and may continue to hold other beneficial interests in QSPEs. Through these securitizations the company may also be exposed to liability under limited amounts of recourse as well as standard representations and warranties made to purchasers and issuers. As of June 30, 2009 Wells Fargo had carrying value of $37 bn from its QSPEs transaction while maximum loss exposure stood at $43 bn, or 74% of tangible equity. Maximum loss exposure from debt and equity interest, and servicing assets was at $21.6 bn and $15.9 bn, respectively. Maximum loss exposure is defined as the carrying value of off-balance sheet QSPEs exposure plus remaining undrawn liquidity and lending commitments, notional amount of net written derivative contracts, and notional amount of other commitments and guarantees.
As of June 30, 2009 Wells Fargo's reported loan exposure was at $821 bn. In addition, the company had securitized loans of $1,169 bn and held for sale of $47 bn. Total loans owned and securitized by Wells Fargo was $2,038 bn as of June 30, 2009 while delinquent loan exposure was at $29.6 bn, or 50.6% of tangible equity.
Transactions with VIEs
Transactions with VIEs include securitization involving collateralized debt obligations (CDOs) backed by asset-backed and commercial real estate securities, collateralized loan obligations (CLOs) backed by corporate loans or bonds, and other types of structured financing. Total assets from unconsolidated vehicles as of June 30, 2009 stood at $273.4 bn while the carrying value on firm's balance sheet was $40.5 bn. Maximum loss exposure (as defined above) from these VIE's as of June 30, 2009 was $55.0 bn, or 94% of tangible equity - practically all of the companies available equity! Notice how you never here this on CNBC!!!
Wells Fargo also administers a multi-seller asset-backed commercial paper (ABCP) conduit (included in above VIE exposure with maximum loss exposure of $7.8 bn) which was acquired from Wachovia merger (that's right, the Wachovia merger looks to come back to haunt, again!). The conduit makes loans to, or purchases certificated interests from SPEs established by WFC's clients and are secured by pools of financial assets. The conduit funds through issuance of highly rated (or so they say) commercial paper to third party investors. The primary source of repayment of the commercial paper is the cash flows from the conduit's assets or the re-issuance of commercial paper upon maturity. The conduit's assets are primarily backed by commercial loans (48%) followed by auto loans (24%) and equipment loans (15%). The asset quality of the conduit acquired from Wachovia can easily be described as deplorable with 42.2% categorized as BBB and below - or roughly half junk or borderline so.
Off Balance Sheet Asset/Liability Mismatch, Expected Loss from QSPE/VIE and Relevant Impact on Previously Calculated Valuation
Subscribers looking for my estimates of expected losses and the effects on our calculated valuations can download WFC Off Balance Sheet Exposure 2009-10-19 04:11:50 259.25 Kb as an addendum to the following subscription materials:
WFC Research Note Sep 2009 2009-09-30 13:01:30 281.29 Kb - The complete off balance sheet review
I query, why do the smaller, healthier banks continue to agree to fund the likes of the humongous risk behemoths such as Wells Fargo, Bank of America, et. al.? Is it a death of comparable lobbying power? If so, simply pass this series of off balance sheet bank articles to your local representatives AND their constituents. I am sure that can serve to get the discussion started! See "Big Bank (and the Treasury) vs. Little Bank: Whose risking your tax dollars?" for a quick glance at the disproportionate distribution of risk.
Next up: an update and refresher on the Market Neutral Option Strategy Analysis that I use in conjunction with my research , a peek into my opinion of a well known investors REIT short recommendation, and then we snatch some more of the covers off of PNC Bank!