Tax Break May Protect Wells Fargo

Wells Fargo is being stress-tested by the government and may need more capital to bolster its troubled balance sheet, federal regulators have told the bank.

It may need $50 bn in new capital due to looming writedowns, says Keefe Bruyette & Woods, which did its own stress test of the bank's balance sheet.

But then again, thanks to a sweet tax break, maybe Wells won't need any capital at all.

Wells is among the 19 companies that went through the government tests, and may have heard about the results Tuesday, reports indicate.

Banks were given preliminary results of the stress tests last month, and the final results were originally scheduled for release Monday, but the Fed postponed their release to tomorrow after several banks objected to the findings, reports indicate.

While the exact number of banks needing more capital remains in dispute, Wall Street analysts now doing their own stress tests of bank balance sheets say the following companies may need to raise more capital: Citigroup, Bank of America, Wells Fargo, PNC Financial Services Group, SunTrust Banks, Capital One Financial Corp, BB&T Corp, Regions Financial Corp, Fifth Third Bancorp, KeyCorp and GMAC.

Why Wells?

Look inside Wells Fargo, and you will find one of the worst mortgage shops 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 breathtaking $25 bn two months before the peak of the bubble in May 2006, a bank which numbers among the worst purveyors of junk mortgages in the country (see blog "Dumb Bubble Deals").

When the housing market collapsed, Wachovia was left with hundreds of billions of dollars in souring loans, much of it picked up in the Golden West acquisition.

Federal banking regulators feared that Wachovia's problems were so deep it might collapse, forcing the FDIC to provide insurance guarantees to its depositors.

Golden West was a mom and pop shop that went berserk rubberstamping reckless loans for the worst of California's borrowers. It was 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-documentation loans.

Pick-Alot-of-Nonsense

These "pick a payment" or option ARMs are the worst of the lot, as the loans made at the height of the bubble are now adjusting based on their five year term adjustments 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.

Meanwhile, 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. and helped push out the door its former chief executive, G. Kennedy "Ken" Thompson, in June 2008.

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 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.

Wells Fargo's Balance Sheet Problems

It's now got:

*$55.6 bn in level 3 assets

*$1.8 tn in off balance sheet assets, including mortgage loan, commercial mortgage, student loan and auto loan securitizations, as well as derivatives such as collateralized debt obligations.

*Its provision for credit losses rose to $15.97 bn at year end 2008, up from $4.9 bn at year-end 2007.

*Net interest income, the lifeblood of banks, was nearly flat at $25 bn for the year, up slightly from $21 bn year end '07.

Tax Break Helps Wells Fargo

Wells Fargo chairman Richard Kovacevich has called the government's stress tests "asinine." 

But what is not so asinine to Wells Fargo is the sweet tax break the bank used last fall to buy Wachovia. The tax change let Wells, as well as other banks, use losses picked up in acquisitions to reduce taxable income.

Last fall, the US Treasury Dept. under then Treasury Secretary Henry Paulson quietly changed US tax law which helped Wells Fargo buy Wachovia out from under the nose of  Citigroup. Citi had desperately wanted Wachovia's deposit base to plug its own balance sheet holes.   

The tax law change was coincidentally made within days of Wachovia agreeing to sell itself to Citigroup. Wells Fargo eventually bought Wachovia for about $15.4 bn, more than seven times the sum Citigroup offered, $2.2 bn.

In the Citi deal, the government would have had to provide a whopping $312 bn backstop to Wachovia's bad balance sheet, an insurance wrap whereby the FDIC would have to take onto its balance sheet these potentially rotten assets.

"This agreement won't require even a penny from the FDIC," Wells Fargo chairman Richard Kovacevich said at the time.

But it did require lots of pennies from the US taxpayer.

According to Wells Fargo's financial disclosures, the bank could avoid having to pay taxes on up to $74 bn in profits. The bank has said it did not lobby for the change.

Federal regulators thought Wells Fargo was ready to buy the bank last fall, but the company walked away from the table Sunday afternoon, saying it could not afford to absorb the losses on Wachovia's loan portfolio, reports indicate.

At the time, Citigroup only wanted to buy Wachovia's deposit branches, not its brokerage or asset management business. These other businesses have created the hundreds of billions of dollars in off-balance sheet assets and problematic derivatives.

The FDIC had said it would provide guarantees to Citigroup if it bought Wells Fargo. Specifically, it said it would help limit losses on a $312 bn portfolio of Wachovia's worst loans. In that deal, Citigroup would have had to take the first $42 bn hit on these losses, with the government taking the remainder. In exchange, the government would have also plowed $12 bn in TARP money into Citigroup.

With the tax change, Wells Fargo and other banks now get to shelter unlimited amounts of income by deducting the losses they pick up in acquisitions. That meant Wells Fargo could write down $74 bn in losses from Wachovia's loan portfolio against income for as long as 20 years. It would, of course, have to post a profit to take advantage of this rule change. Which so far it is doing.

The question for Wall Street is: "For how long?"  

A Telling Exchange

To see the problems Wells faces, read this telling exchange last year between a top bank analyst, Matt O'Connor, and Wachovia's then chief executive, Ken Thompson. Here you'll see that Golden West didn't use FICO scores to approve borrowers:

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.

O'Connor: Oh, Really?

Thompson continued: 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...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...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 mn. We think over the next several years, it could increase another to $2 bn to $3 bn. 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.