Inside the Head of a Bank CEO

In covering the hearing of the nine bank chief executives on Capitol Hill, it didn't take long for me to see that Wells Fargo CEO John Stumpf was having a hard time of it, valiant effort though he did make to defend his bank's lending practices.

Because to look inside Wells Fargo, you will find the worst of the mortgage lenders housed in this bank, Wachovia, which Wells Fargo bought last fall for $15.4 bn, and housed within Wachovia is Golden West Financial, which Wachovia bought for a stupefying $25 bn, Golden West, the purveyor of some of the worst junk mortgages in the country.

Wachovia Corp.'s disastrous $25.5 bn acquisition of Golden West Financial in May 2006, two months before the peak of the housing bubble (see blog "Dumb Bubble Deals"), is a portrait of the housing crisis in miniature.

At bottom you will find a revealing--and impenetrably absurd--transcript of a presentation given by Wachovia management defending the Golden West deal at an analyst-investor conference a week after Wachovia made this disastrous acquisition in May 2006.

The transcript provides a roadmap for why this country is facing the worst housing and banking crisis since the Great Depression. And watch how obsequious Wall Street analysts behave, the smartest guys in the room who are supposed to catch the fire engine red flags. Kudos to footnoted.org for catching this one, the best footnote digging site in the country.

Golden West was a mom and pop shop that went berserk rubberstamping reckless loans for the worst of California's borrowers, as the country's biggest purveyor of the option ARM, which lets borrowers set which payments they want to make, in many cases, interest-only payments on no-doc loans.

These ARMs are the worst of the lot, and they are now adjusting to higher rates, providing an economic effect that is the equivalent of the levees breaking in New Orleans. Option ARMs, indeed, are the most radioactive of loans, and they will drag down the economy this year and next, analysts note.

Herbert and Marion Sandler, who built Golden West into a mortgage mill, made off with $2.4 bn in the deal.

The Golden West deal caused the collapse of Wachovia Corp. In its last quarterly report prior to its acquisition by Wells Fargo, Wachovia booked a huge third-quarter loss 2008 of $23.9 bn--$18.7 bn of which was a colossal golden goose egg writedown of goodwill, meaning Wachovia won the prize for the country's biggest overpayment of a mortgage lender, Golden West.

Wachovia had already lost $33 bn in the two quarters prior to the deal. It's estimated that Wells Fargo could face future loan losses from Wachovia that could reach a total of $74 bn. Wachovia's board pushed its chief executive, G. Kennedy "Ken" Thompson, out the door in June 2008.

Ken Thompson Speaks

Ken Thompson, Wachovia, CEO, President: Our General Bank is nothing if not a sales machine ...In 2005, we exceeded our goal of $180 million in net new revenue, and we believe that we are on track...to reach a run rate of $750 mn+ of new revenue from this strategy in 2007....Golden West, as I said, accelerates our retail momentum...Golden West focused on the West Coast; Wachovia focused on the East Coast.

And again, by adding Golden West's option ARM product, the Wachovia mortgage channel will deepen and enhance its relationships with brokers, realtors, home builders and our branch and brokerage customers.

Matt O'Connor, UBS: Golden West has obviously done an amazing job managing credit risk. I was a little surprised that their FICO scores were, I think, in the 680, 690 range. Is it just that they are so good at what they do and it's a different kind of customer base, or maybe FICO is not going to be as...?

Ken Thompson, Wachovia, CEO, President: Well, let me tell you how they do it. First of all, Herb and Marion Sandler would say if you are relying on FICO scores, you may be missing the boat.

And their FICO scores average about 690. Ours would be 720 to 730. But they actually underwrite without a black box.

So they don't use a lot of black box kinds of things like FICO scores.

Oh, Really?

Thompson continues: They have underwriters in the geography on the ground who are actually looking at the credit application. They have their own appraisers; they've got about 1000 appraisers. So they have conservative appraisals that they are underwriting to.

And then they underwrite to an indexed rate, not to the start rate on their mortgages. And as a result, they've ended up with about a 68% loan-to-value ratio, and that is on the price of the house at the time of the financing. You know, if you factor in the growth in housing prices, it is, I'm sure, lower than that. And then they touch the customer constantly in their servicing process.

So that is why if you go back to 1994, which was a housing depression in California, and look at Golden West's track record, they simply had 18 basis points of charge-offs.

And we feel very, very comfortable - number one, we're not going to change anything about their process; we are going to adopt it. And we feel very comfortable that credit quality won't be an issue at Golden West going forward. Even if housing prices drop fairly dramatically, there is plenty of room in their loan-to-value ratio. Yes.

A Smart Question

Unidentified Audience Member: Ken, the amount of negative amortization in the Golden West portfolio has grown a fair amount in the last number of quarters. It's still a low number relative to their portfolio, but it is growing rapidly off a low base, creating what some people think is a quality of earnings issue.

Could you comment on why you are not concerned or do you have some element of concern about that?

Ken Thompson, Wachovia, CEO, President: I'm really not concerned. And I'm not concerned because of the conservative underwriting standards that the company has. They are not underwriting to start rates; they are underwriting to a fully-indexed rate. And as I say, they produce their own appraisals and they are not using a black box to underwrite.

So if you think about it - and these are going to be rough numbers - but in the last year, their deferred amortization has increased about $600 million. We think over the next several years, it could increase another to $2 billion to $3 billion. If it does that, that will take the loan-to-value ratio on their underwriting from about 68% to 71%.

Still incredibly conservative, still able to withstand significant drops in home values. And we're looking at an unemployment rate that is very low and I think will continue to stay very low.

So if you are underwriting to the start rate and if you are using a black box to do it, then deferred amortization would be threatening. But with the way Golden West does it, I'm just, I'm really not concerned. That would fall way down the list of things that I think are important in that acquisition.