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 Wells Fargo reports Q2-09 results today. As I have been preaching for two years now, and as the mainstream financial media and sell side community are finally starting to focus on, credit deterioration trumps one time (or two time) quarterly windfall profits in mortgage refinancing and trading profits. Many banks truly have a large amount of trash on their balance sheets, levered up and collateralized by assets that have dropped nearly 50% in value, and this is off of a valuation base that was grossly exaggerated and overestimated in the first place.

Question: Can extreme purchase accounting wherein Wells Fargo aggressively marks down their Wachovia loan portfolio acquisition overcome the losses that we expect from WFC's loan portfolio in the optimistic and base cases?

Answer: The purchase-accounting rule, known as Statement of Position 03-3, provides banks with an incentive to mark down loans they acquire as aggressively as possible. The advantage of purchase accounting is after you mark down your assets, you accrete them back in. Popular opinion is that those highly discounted transactions such as JPM's purchase of WaMu or Well's purchase of Wachovia should be favorable over the long run.

At first glance, this accounting treatment will in fact have a positive impact on WFC's books. Of the $122 billion in option ARM's, WFC had already marked down these loans by 37% with an estimated cash flows of around $90 billion in due course. However, based on our assumptions on the bank's loan losses (professional subscribers, please refer to the "SCAP" in the WFC forensic analysis - See WFC Investment Note 22 May 09 - Pro), even under the optimistic case scenario, loan losses will be well over $132.4 billion which will create a void (loss) of nearly $40 billion.

Therefore, it remains unlikely that the change in purchase accounting will lead to WFC overcoming the loan losses that we have estimated under the base and optimistic case scenarios.

 

We have applied high LTV ARM loss rate to calculate the losses on HELOCs (which comprises of total 1-4 family junior lien mortgages and line of credit) using the data from the NY Fed and the FDIC contained in the open source mortgage default model (see the open source mortgage default model and other proprietary research - Green Shoots are Being Fertilized by Brown Turds in the Mortgage Markets). The total losses in these loans are expected to skyrocket, as was rightly pointed out by you. 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 spreadsheet for respective states. Then, 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 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 recession. 

Worsening macroeconomic conditions impact Wells Fargo directly

With the economic environment taking a turn for the worse due to the continued decline in housing prices, rising foreclosures and slowdown in loan demand, the probability of further writedowns has increased. Falling housing prices are likely to widen losses in the loan portfolio. Wells Fargo has significant exposure in the California and Florida real state markets that have witnessed housing price decline of nearly 40% since the beginning of 2007, adding to the huge pressure on the company. Going forward, these regions could see further decline in housing prices which may increase the loan losses for Wells Fargo. Additionally, due to the sharp correction in real estate prices, the loan to value (LTV) of impaired loans increased to around 152% in California, while in Florida it rose to 129%. Such a high LTV will likely result in major losses for the bank in case of increased foreclosures. Wells Fargo has a US$9.8 billion home equity portfolio that has been put on liquidation with higher risk of default. The loss rate stands at around 9.27%, much above the core portfolio loss rate of 2.09%. This is expected to increase loan losses in the coming quarters.

Significant exposure to real estate, construction and home equity loans to result in writedowns in coming quarters

Wells Fargo's loan portfolio has significant exposure to the distressed real estate, construction and home equity loans. The company's loan portfolio, worth US$843.6 billion as of March 31, 2009, comprised US$345.4 billion in commercial & commercial real estate loans, US$466.7 billion in consumer loans and US$31.5 billion in foreign loans. Total real estate exposure of US$491.5 billion has made investors bearish toward the stock.

Wells Fargo has US$33.9 billion exposure to real estate construction and development loans that have expanded at a CAGR of 33.3% over the last three years. Besides, majority of this exposure is in states that have witnessed sharp correction in real estate prices, thus severely denting the company's growth. Wells Fargo's net charge-off on real estate construction and development loans increased to 1.2% (annualized) in 1Q 09 from 0.5% in 2008 and 0.1% in 2007. Considering the decline in housing starts and sharp correction in real estate prices, the charge-off on these loans is expected to negatively impact the bottom line of Wells Fargo. The states of California and Florida reported the steepest y-o-y drop in home prices. Wells Fargo, with large construction loan exposure in these regions (around 25% as of December 31, 2008), is likely to be negatively impacted.

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 rates

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 balance

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 Occupied

Non- Owner Occupied

Default rate

Recovery Rate

Loss Rate

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%