I have not written for a long time - roughly a month - as the market has turned me into a hermit. I am afraid of the people in my industry, recommending or buying stocks based on what the person next to them just bought. My service, ChangeWave Shorts, only recommends puts so short term momentum can kill a fundamentally sound position. That being said, I sense the beginnings of a turn to rationality - a light turn, a hesitant turn, but a turn - and the first place the market should and will get rational is the banks. They led us into the mess, they led us out, and they will lead us to stagnation and decline as reality sets in.
And the bank I really don't understand - excuse me, the bank stock I don't understand - is Wells Fargo (WFC), an $8-$10 stock masquerading as a $28 plus stock and trading at a multiple well beyond the rest of the banking segment. It isn't that Wells should be valued alongside the segment; it should be valued lower than the segment due to current and future problems in its business, led by its balance sheet.
I have spent weeks pulling apart their balance sheet and reading other analysts' deciphering of their financial Esperanto - a universal language no one understands. And what I present below may include mistakes but they are not of my own making - they are due to what at best can be considered willful obfuscation - a time honored practice in most financial reports - of extremely complex financial statements. But I gave it a shot using my fourth grade math and common sense.
First, let's look at the garbage - excuse me, am I being too negative? - on the balance sheet as it is written as of March 31 according to the TARP oversight folks. The garbage bin is called Level III assets, their dodgiest class of assets (the Brits know how to coin a phrase, don't they?) which according to recently and frantically revised accounting rules, is an asset without a market, leaving management free to assess and declare its value based on a model. Wells had, as of March 31 (and I am using these numbers because they have been blessed by regulators), $61.7 billion in Level III assets. What are they really worth? Who knows - but even if it is 50%, which I believe would be very high, that is 23% of the company's market cap.
Second, they are using arcane - and perfectly legal - rules of purchase accounting to mask loan losses. A Wall Street Journal article (September 21) had a nice discussion of these rules. Under the rules of purchase accounting, and these came into effect when Wells purchased Wachovia, losses must be accounted for in the purchase price and subsequent paper write off and cannot be incurred after an acquisition, with the loans on the books now set at a new and lower value to reflect the write-off at the time of the Wachovia acquisition. They must have been busy with Christmas because this year they have adjusted these write offs and increased them by $7.1 billion in the first half of 2009 - write-offs that do not hit current earnings. This wonderful accounting chicanery can continue for one year after the merger date, so they have until New Year's eve to "discover" new losses.
It gets better. The company acquired $110 billion in what it calls Pick and Pay and everyone else calls option ARM mortgages with the purchase of Wachovia. These were valued at $90 billion and change when the deal was closed. Wells shoved a big chunk under the umbrella of purchase accounting and using these rules then got rid of $20 billion in losses. Remember that write downs under these rules do not hit your current books. Some percentage of the remainder, $38.9 billion, can still be adjusted retroactively under purchase accounting - I think, I am not sure, don't quote me - and ain't life grand? Of the option ARM mortgages still held by the company, the loan to value ratio based on quarterly adjustments is 87.2% but with home prices still falling I am willing to bet - as is Meredith Whitney, who is predicting another sharp drop in nationwide home values -- this is 100% in a year. And that means owners have no incentive to stay in their homes as mortgages reset. More importantly, while the company assumes future losses on these mortgages in a manner I literally cannot fathom (but I think they are assuming a 31%-35% default rate), analysts from Goldman Sachs (GS) see almost 61% of option ARMs originated in 2007 will fall into default. The Goldman guys assumed a 10% decline in home prices, and, over time, these same analysts estimate more than half of all option ARMs ever issued will eventually default. If Goldman is correct, or close, that is 25% of, well, what? They can write off a lot of this stuff via purchase accounting. But let's be kind to me and my hard work and say it will cost them $5 billion more than they are assuming.
Third, proposed accounting rule changes would force banks, including WFC, to put off balance sheet assets on their balance sheet. WFC has more than $2.0 trillion of this off balance sheet nonsense - using the same acronyms, I might add, used by Enron (and that other great bank, Citigroup (C)). Some healthy percentage of these assets can be assumed to be headed to the balance sheet if the FDIC says they agree with the FASB rules and insist banks live by them. In theory, and based on history, WFC would then have to raise enormous amounts of capital or dump assets to stay within regulatory guidelines. They cannot dump assets - they would have done so if they could have - which means pounds of new shares and shareholder dilutions. Of course, the FDIC is free to ignore GAAP rules when creating regulatory requirements and it is possible they will do so again. But the cat (let's say the cat's name is transparency), will be out of the bag and lazy investors who have yet to consider Wells' off balance sheet follies will now get a closer look at them.
The off balance sheet assets are almost impossible to decipher let alone explain. The company claims, in its second quarter financial statements, that only $155 billion - or maybe 7% - of off balance sheet assets will be forced onto their balance sheet. Games and more games, mainly due to the ability to loosely interpret the proposed FASB guidelines. They have concluded, and I quote their earnings statements, that "$1.1 trillion of conforming residential mortgage loans involved in securitizations are not subject to consolidation under FAS 166 and FAS 167." They do not say why--just because these are insured mortgages and they, according to someone's interpretation of the new rules, do not have to hit the balance sheet (I was unable to locate an FDIC or FASB opinion on this). I spoke with someone on the staff of the Senate Banking Committee - in relation to the off balance sheet assets held by Citi - and the first thing I heard was government guarantees, which shut down the conversation, so it is possible this rule, when and if implemented, will be faked, like the stress tests. But investors will have a much better idea about WFC's real exposure to the real world. If $155 billion hit the balance sheet, that would be 12% of current assets and 19% of their current loan portfolio - to my mind that means the capital base would have to increase 12%.
The company does provide a caveat to what I view as their generous analysis of the new FASB regulations. Again, I quote their second quarter 10Q: "FAS 166 and 167 are principles based and limited interpretive guidance is currently available. We will continue to evaluate QSPE and VIE structures applicable to us, monitor interpretive guidance, and work with our external auditors and other appropriate interested parties to properly implement these standards. Accordingly, the amount of assets that actually become consolidated on our financial statements upon implementation of these standards on January 1, 2010, may differ materially from our preliminary analysis..."
What about the rest of their business? They hold $330 billion plus in commercial and commercial real estate loans - one third in California and Florida - and $450 billion plus in consumer loans, including more than $117 billion in home equity lines that are second tier to primary mortgage holders and end up in the junk bin after a foreclosure. And 37% of these home equity line are in California and Florida. Need I say more?
I do not want to go through their balance sheet and earnings statement ad nauseum so let's leave it at this - their loan loss reserves are, to my mind, completely out of whack with the reality facing these portfolios, as are consensus earnings estimates. I quote that second quarter 10Q again. "We believe our balance sheet is well positioned given the current economic environment. Our allowance for credit losses was $23.5 billion at June 30, 2009, compared with $21.7 billion at December 31, 2008. Our allowance covers expected consumer loan losses for approximately the next 12 months and inherent commercial and commercial real estate loan losses expected to emerge over approximately the next 24 months." Translation - on more than $800 billion in balance sheet assets, two trillion in off balance sheet assets and in the face of 10% unemployment and contracting GDP, an all time high for mortgage defaults, credit card defaults, home equity defaults, not to mention commercial real estate problems that are beginning to accelerate, they increased net reserves less than $2 billion.
Let's go on - I may be wrong because reading their SEC filings could give a dead man a migraine, they had $3 billion in non-performing loans in Q2 that they had yet to reserve against (see what these reports do to my grammar?). To simplify, let me quote one of the only clearly written parts of their report. "The ratio of the allowance for credit losses to total nonaccrual loans was 149% and 319% at June 30, 2009, and December 31, 2008, respectively...." They saw an increase of non-accrual loans - busted loans - of $5 billion in Q2 alone, which they blamed, perversely, on purchase accounting. True, but not of the real world. And Wells had $16.6 billion (with a b) in loans more than 90 days past due - more than $10 billion without guarantees by the taxpayers. So let's say the dearth of reserves is worth another $12 billion they need to raise this year or soon.
And what about operating earnings going forward to compensate for the probable need for far more reserves? It is hard to imagine they will duplicate the $3 billion in mortgage origination fees they had in 2Q - and even if they pull it off in Q3 it should not happen in Q4. Meredith Whitney said as much the day she turned the market around with her call on Goldman Sachs, the same market that missed the last half of her statements on CNBC saying bank earnings this year would not be matched next year. Stumpf recently pounded the table, calling out Uncle Sam for messing things up and saying they were going to pay Uncle Sam back and oh, by the way, can you have Freddie (FRE) and Fannie (FNM) buy jumbos so we can make more mortgage origination fees.
Wells was one of the companies told to raise capital after the fake stress test results showed you can only fake something so much. They claim they can raise that capital by the end of Q3 by internally generated means - including, in Q2, $2.7 billion in deferred tax liabilities, the same accounting gimmick that bit Fannie Mae big time.
Do they think we are stupid? Yes - and they are pretty much right. Maybe it is Buffett - but remember he values businesses based on cash and cashflow and brand, and Wells is a great consumer bank, arguably the best in the country and has no problem with cash or cashflow. Maybe it is the bellicose statements by CEO Stumpf - maybe it is their legendary customer service - maybe it is fear - but no one is calling them out. Line up ten thousand more readers and maybe we can start the hue and cry.
What will we cry out?
You need more capital.
To write off more Level III assets, someday - maybe as much as $30 billion.
To support off balance sheet assets coming on - maybe as much as $15 billion.
For greater loan loss reserves - maybe as much as $12 billion.
For more option ARM losses - maybe as much as $5 billion.
To pay back Uncle Sam - no maybes, $25 billion.
Total: $87 billion. (Maybe)
I use the word maybe because this analysis is based on financial statements that make Vladimir Putin's inner soul seem transparent. November and beyond may provide some market support for this skeptic's view of their balance sheet as FDIC guarantees of bank bonds goes away and Wells will eventually go to short term capital markets and raise money based on what people know about Wells.
The bottom line: subtract current reserves of $23 billion and you get $64 billion in new capital of some sort. Sure, I am mixing apples and oranges but in the bars around the world where real analysts do their best work, this is how calculations are done and decisions made. Slightly less than half their market cap. Cut the stock in half and you get $15 and change. Bring the multiple down to the rest of the segment and voila - $8-$10.
Simple math - works for me.
No comments:
Post a Comment