WFC Lays Bear Trap on Wall St.

Today's Wall Street darling is a little old bank from the left coast, Wells Fargo.  The transcontinental horse-back messenger service bank, largely expected to begin an arduous write-off period, surprised analysts by beating their ever sage estimates guesses by $.03 (.53 v .50 est).  The stock bounced 30% on the news.  Unfortunately, WFC's earnings are actually a mine field waiting to blow the legs off some unwitting retail investor.

Most notably, Wells Fargo changed their charge-off policy this quarter for home equity mortgages.  Traditionally they recognized losses after 120 days; now it's 180 days.  Oh, and did I mention they did it to protect homeowners?  From page 4 of their 8-K:

“...the Home Equity charge-off policy changed in the second quarter from 120 days to no more than 180 days to provide more time to work with customers to solve their credit problems and keep them in their homes. The Company has helped nearly 900 customers, and approximately $90 million of Home Equity loans have been modified due to this change."

I know what you must should be asking yourself: what effect did this have on their earnings.  Curiously you have to turn to the next page for that information, divided into two paragraphs, which surely was for clarity obfuscation.

"The policy change had the effect of deferring an estimated $265 million of charge-offs from the second quarter…”

Remember how they beat analyst expectations by $.03, well $265m / 3.2b shares = $.08/share.  Suddenly today's WSJ headline reads:  "Concerns About Financial Sector Grow as Wells Fargo Misses Estimates".

To be fair, WFC did indeed publicly announce this change of accounting during the quarter, and I am in no way accusing the firm of fraud.  By all accounts, Wells Fargo is a very well run company.

That said, deferring charge-offs generally portends bad things ahead.  Much as when firms use accrual accounting (the booking of expected revenues upon the sale/purchase of an item like a bond instead of booking the cash flows as they occur) the intertemporal shift of losses is rarely a good sign.  It becomes especially troublesome as the firm essentially builds a backlog of un-charged, but unrecoverable cash that must be recognized at some point.  It is important to stress, their accounting practices are well within GAAP tolerances, but it is changing mothodology always worries me. Indeed, as they 8-K continues (two pages later):

“Although losses declined, the portfolio continued to deteriorate as property values search for a bottom,” said Loughlin. “Given the continued decline in home prices, we had more accounts move into the higher combined loan-to-value segments, which directly impacts loss levels.” Approximately 38 percent of our $73 billion core Home Equity portfolio and 71 percent of our $11 billion liquidating Home Equity portfolio had combined loan-to-value ratios above 90 percent as of June 30, 2008. The property values are primarily based on a combination of March 2008 automated value models and May 2008 home price indices.”

Wells Fargo currently has $35.5b in outstanding loans with little or no equity cushion.  And, as they noted, we probably aren't even close to the bottom yet, so expect that number to rise even higher.  When they reach 100% you can expect the "jingle mail" to flood their inboxes like Thanksgiving Day sale notices. Instead of beginning to recognize the losses they already have they shifted current liabilities into a much larger chunk to be realized "at a later date".  This money isn't coming back, so why wait?  They claim it's because "accounting rules for them to treat the loans as non-performing, even if they believe a work-out can be reached".  It's always those pesky rules about losing money that get in the way of good business, isn't it? IMHO they wanted to maintain a positive posture as they audaciously raised their dividend $.03.  Either they are brilliant managers/fiduciaries, or this is a company on the verge of crumbling.

There were quite a few other notables and quotables in the 8-K:

• Credit card fees were up 14% YoY, and 22% QoQ due to continued growth in new accounts and greater card activity (consumer's getting pinched);
• The Visa IPO added ~$300m to their income in the quarter (non-recurring income);
• Net unreallized losses on securities available for sale were $2.1b compared with $589m in 1Q08, and securities available for sale increased 64% YoY (unable to unload assets) 

Furthermore, this delayed recognition of charge-offs is one of many curious aspects of their report.  I will let the analysts at GS some up some of the others:

"[T]here are a number of things that are hard to explain at first glance within the numbers, most notably: (a) a 10% dividend increase in an environment when capital is extremely scarce, new business and M&A opportunities are abundant, and Wells Fargo’s stock is already yielding 6%, (b) mortgage banking fees equaling $1.2 bn which was 2X our forecast, and (c) Wells Fargo is one of the only banks that has been able to sustain a net interest margin near 5% (up 23 bp linked quarter to 4.92%), aided in part by a securities portfolio that is growing nearly 50% annualized and has a 6% yield. At the same time, the unrealized losses on securities grew 3.5X to $2.1 bn as a result of higher rates. Adjusting for the home equity policy change, charge offs would have been 1.82% which keeps reserve coverage of charge-offs flat at 1X."

Or, perhaps my buddy's email (which he sent while I was writing this) said it best:

Current book value: $48BB

Budget for additional writedowns: ($15BB) = $4BB home loans + $3BB MBS + $8BB Misc

  =Net Book value: $33BB

Historical Return on Equity: 16 – 17%

Projected Return on Equity: 20 - 22% due to being one of last healthy banks standing and can take advantage of better lending terms

Projected Stabilized Net Income: $7BB (=21% ROE * Book Value)

Target Return on Investment= 10% (i.e. 10 P/E ratio)

  =Value: $70BB

Current Value: $89BB

Verdict: wait until price goes back down to $21.20

No matter what, even if WFC has managed to walk through this period relatively unscathed, I do not think this helps the case for the financials as a whole and would absolutely be a seller (if only I could!) of any rally.  I'm going on record: this is a bear trap.

UPDATE: Apparently the WSJ agrees, or plagiarized.

(Note: This is not a recommendation or investment advice.  1-2 does not have a position in any of the securities mentioned.)

Comments

[Stupid Equity Guy]

Ahhh nice reading, while I seek out some medical attention for me burnt shorts...

Nothing like being in the air traveling as the big reverse hits...

Days like today live in infamy...

~SEG

Someone cue up the Rocky tune....