This is the forensic continutation of the summary overview of Wells Fargo (Doo-Doo bank drill down, part 1 - Wells Fargo), as well as part 18 of Reggie Middleton on the Asset Securitization Crisis. The other published parts are as follows...

The Asset Securitization Crisis Analysis road-map to date:

1. Intro: The great housing bull run - creation of asset bubble, Declining lending standards, lax underwriting activities increased the bubble - A comparison with the same during the S&L crisis
2. Securitization - dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble - declining home prices and rising foreclosure
3. Counterparty risk analyses - counter-party failure will open up another Pandora's box (must read for anyone who is not a CDS specialist)
4. The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue
5. Municipal bond market and the securitization crisis - part I
6. Municipal bond market and the securitization crisis - part 2 (should be read by whoever is not a muni expert - this newsbyte may be worth reading as well)
7. An overview of my personal Regional Bank short prospects Part I: PNC Bank - risky loans skating on razor thin capital, PNC addendum Posts One and Two
8. Reggie Middleton says don't believe Paulson: S&L crisis 2.0, bank failure redux
9. More on the banking backdrop, we've never had so many loans!
10. As I see it, these 32 banks and thrifts are in deep doo-doo!
11. A little more on HELOCs, 2nd lien loans and rose colored glasses
12. Will Countywide cause the next shoe to drop?
13. Capital, Leverage and Loss in the Banking System
14. Doo-Doo bank drill down, part 1 - Wells Fargo
15. Doo-Doo Bank 32 drill down: Part 2 - Popular
16. Doo-Doo Bank 32 drill down: Part 3 - SunTrust Bank
17. The Anatomy of a Sick Bank!

Significant exposure to real estate, construction and home equity loans - Wells Fargo's loan portfolio has significant exposure to the distressed real estate, construction and home equity loans. With rising defaults and foreclosures, due to declining prices, the bank's US$18.8-billion real estate construction loan portfolio and US$83-billion home equity portfolio will likely be under severe pressure, resulting in higher NPAs. In addition, Wells Fargo has huge exposure to the troubled housing markets of California and Florida that have been at the forefront of the current housing slump. These two states account for 20.3% of the bank's real estate and construction loan portfolios, one of the highest for a major financial institution in the US.

Slowing housing market, worsening macroeconomic conditions to result in higher defaults - The sluggishness in the US housing market, declining prices, rising foreclosures and inventory pile up are likely to have a negative impact on the bank's loan portfolio. Higher deliniquencies in the US mortgage market could increase losses. In addition, the rising unemployment rate and higher inflation would further restrict consumer spending in the US. These developments are likely to increase defaults across all asset catergories.

Problems in home equity portfolio to resurface as maximum exposure is in most troubled markets - Despite avoiding riskier loans, such as ARMs, Wells Fargo's home equity portfolio continues to deteriorate. The bank segregated US$11.5 billion of home equity loans into a liquidating portfolio, representing approximately 3% of total loans outstanding in 1Q 08. In addition, nearly 45% of the US$72.1-billion core home equity portfolio, representing nearly 70% of the bank's shareholders' equity in 1Q 08, was in the states of California (accounted for 36% of the portfolio), Florida (4%) and Arizona (5%) - the most affected real estate markets in the US.

Higher NPAs and charge-offs - The bank's non-performing assets (NPAs) have been rising consistently, up 22% q-o-q to US$3.3 billion in 1Q 08. On a y-o-y basis, the NPAs increased 86%. NPAs as a percentage of total loans rose from 0.54% in 1Q 07 to 0.84% in 1Q 08 due to deteriorating real estate construction and home equity portfolios.

Provisions for losses likely to increase in coming quarters - The bank's provisions for losses have not kept pace with the growth in its loan portfolio. Wells Fargo's allowance as a percentage of loans declined from 2.86% in FY 1998 to 1.18% in FY 2006. The bank's loans increased at a CAGR of 14.3% to US$382 billion in the last nine years, while the provision for losses expanded at a CAGR of 5.5% to US$5.3 billion. Higher provisioning is likely to have a severe impact on its bottom-line in the coming quarters.

We value Wells Fargo at US$16.02 per share, 37% lower than the current market price - To value Wells Fargo, we have used the Discounted Cash Flow (DCF), Price-to-Adjusted Book Value (P/ABV), Price-to-Sales (P/S), and Price-to-Earnings (P/E) multiple methods. Based on our weighted average valuation, we arrived at a fair value of US$16.02, which represents a 37% downside from the current level of US$25.27 per share.

Investment Summary

Wells Fargo & Company (WFC) is one of the largest US banks with significant exposure to the troubled residential and commercial real estate markets, primarily through its home equity loan portfolios that continue to deteriorate at a brisk pace. Wells Fargo's substantial engagement in real estate construction lending activities, which expose it to significant losses and is the primary reason behind its higher charge-offs thus far. The ongoing credit crisis, sparked by the US subprime mortgage meltdown, is more a function of lax underwriting practices followed by banks and the asset securitization fiasco. The increase in bankruptcies infiasco, thus it is safe to assume that we will see a cascading domino effect ripple through WFC's suspect lending portfolio, expanding beyond subprime mortgages and residential lending. The rising defaults in the subprime mortgage markets and rising foreclosures in the housing market marked the beginning of the crisis. Wells Fargo has more than a significant exposure toward the real estate and housing sector as a majority of its lending activities are confined to these sectors. With the current asset securitization crisis showing no signs of abating, the bank will be forced to keep these noxious creations on its books and will assuredly have to take heftyfurther, and more significant charge-offs on its loan portfolio, going forward.

The decline in housing prices, rising foreclosures and inventories along with the slowdown in demand are leading to defaults in the housing market. Moreover, the impact is likely to be felt more strongly in Wells Fargo's case compared to other commercial banks in the US, since it has concentrated exposure to the most troubled housing markets of California and Florida that have been at the forefront of the current housing slump. These two states account for 20.3% of the bank's total real estate and construction loan portfolio, one of the highest for a major financial institution in the US. In addition, nearly US$12 billion of the bank's home equity portfolio, worth US$12 billion, (15%) has been put on liquidation. This liquidation, is also likely to result in huge losses in the coming quarters. The bank will likely be required to increase provisions in the next few quarters as losses unfold in its loan portfolio, which will increase downward pressure on earnings. The bank's net interest income is anticipated to remain stable as long as the recent interest rate cuts by the US Federal Reserve likely to bringremain intact, thus bringing down the borrowing cost. Unfortunately for WFC, as well as many other banks who have marginally profitable operations, the loose monetary policy of the recent past has stoked inflationary fires across the globe and has caused a worldwide push to urge the US to strengthen the dollar, which will inevitably result in higher interest rate targets from the Federal Reserve Bank. In addition, non-interest income is expected to come under pressure as income from the credit card and mortgage banking businesses is likely to decline, as macroeconomic conditions and the consumer balance sheet and confidence continue to worsen.

Key Investment Points

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 distressed real estate, construction and home equity loans. The bank's total loan portfolio, valued on its books at US$386 billion, is comprised of commercial real estate loans of US$156 billion, consumer loans of US$222 billion and US$7 billion of foreign loans. The bank has US$18.8 billion of exposure to real estate construction and development loans that have expanded at a CAGR of 27.8% over the last three years. Wells Fargo's exposure to the real estate construction sector is the fourth-largest among all US banks, in absolute amount terms.

The bank's real estate construction loans are expected to come under severe stress as the slump in housing demand and the decline in housing prices continue to exert significant pressure on the real estate sector. Housing demand has been steadily decreasing while supply is riding the upward wave from builders attempting to monetize depreciating assets, banks flipping REOs back on to the street at highly discounted prices, and existing homeowners cling to last year's pricing - as we see it, housing prices will continue to remain in the ‘correction' mode until affordability reaches pre-boom levels. The US annual housing starts declined almost 25% in 2007, following the 13% fall in 2006. In addition, home prices continue to drop quarter after quarter. The Office of Federal Housing Enterprise Oversight (OFHEO)'s home price index recorded the largest y-o-y decline in the last 17 years, plunging 3.1% in 1Q 08. The states of California, Nevada and Florida reported the steepest y-o-y drop in home prices. Wells Fargo, with large construction loans exposure in all of those regions, is highly likely to be negatively impacted.

Wells Fargo's Loan Portfolio

Source: Company data

The bank's real estate construction loans are under considerable stress -- the non-performing assets (NPAs) to loan ratio stood at 2.32% in 1Q 08. NPAs in real estate construction loans increased to US$438 million in 1Q 08 from US$82 million in 1Q 07 and US$293 million in 4Q 07. California accounted for nearly 32.1% of the total real estate construction loans, while Arizona and Florida accounted for 6.7% and 4.8%, respectively. In addition, the bank has US$38 billion of other real estate loans under the commercial and commercial real estate loans; nearly US$13.9 billion other real estate loans are concentrated in the state of California. Housing prices in California have declined significantly and continue to be on a downtrend. According to OFFHEO, housing prices in this state fell 10.6% in 1Q 08, followed by Nevada (10.3%), Florida (8.1%), Arizona (5.5%), and Michigan (3.1%). Considering the bank's large exposure to these troubled markets, its NPAs in the commercial and commercial real estate portfolio are bound to rise, going forward.

Real estate construction loans and NPAs

Source: Company data

Wells Fargo has US$148 billion in 1-4 family mortgages that represent approximately 38% of the total loans. Around US$49 billion of the total loans is in the state of California, US$6 billion in Florida and US$7 billion in Minnesota. The building permits in California, Florida and Minnesota declined 61%, 46.8% and 47.5%, respectively, in 1Q 08. This is likely to exert further pressure on the loan portfolio. Consumer loans consist of US$148 billion single family mortgages, US$18.6 billion in credit card loans and US$55 billion of other revolving credit and installments. In the last few quarters, the bank increased the charge-offs on this portfolio, which is the worst hit after the real estate construction loan portfolio. NPAs in the real estate 1-4 family first mortgages rose to 1.91% in 1Q 08 from 1.25% in 1Q 07 and 1.78% in 4Q 07, due to increased defaults in mortgages and rising delinquencies. The worsening trend of NPAs reflects Wells Fargo's exposure to the troubled markets and the uptrend in defaults across all loan categories.

Wells Fargo's Real Estate 1-4 family lien mortgage

Source: Company data

Slowing housing market to increase Wells Fargo's problems

The decline in the US residential and commercial real estate markets, owing to the slump in demand, has resulted in huge writedowns and credit losses across the banking and financial services sectors. Housing starts have been falling consistently and recorded a decline of 38.7% in 1Q 08. The sluggishness in the housing market is exerting pressure on the valuation of asset-backed and mortgage-backed securities. In addition, the sharp correction in housing prices witnessed across almost all states in the US is aggravating the woes, causing further deterioration. The increase in housing inventories, following the rise in foreclosures, is expected to put more downward pressure on the value of the housing portfolio.

According to the Mortgage Bankers Association (MBA)'s latest National Delinquency Survey, the seasonally adjusted delinquency rate for mortgage loans on 1-4 unit residential properties stood at 6.35% of all loans outstanding at the end of 1Q 08. The figure represents a 53-basis-point increase from the delinquency rate in 4Q 07 and a 151-basis-point rise from that in 1Q 07. The percentage of loans on which foreclosure actions were started during 1Q 08 was 0.99% on a seasonally adjusted basis, 16 basis points higher than that in 4Q 07 and 41 basis points higher than the 1Q 07 levels. The rising delinquencies in mortgage loans are likely to compel the bank to increase its loan loss provisions in the coming quarters. Any such development could dent its bottom line.

Adding to the problems, on the macroeconomic front, the unemployment rate surged to 5.5% in May 2008, the largest monthly rise in more than two decades. The increase in unemployment rate reflects the recessionary situation in the US. It points toward the reluctance of US companies to hire new recruits, as the consumer spending slowdown and soaring oil and raw material costs squeeze profits. The major concern behind a weaker labor market is that consumers will restrict their spending, which is likely to have a negative impact on corporate profits. Consumer spending is the force behind the growth in the US economy. Therefore, a surge in unemployment rate portends lower spending power for consumers in the US and (coincidentally) lower consumer debt service capacity as well as (consequently) lower corporate debt service capacity; resulting in higher defaults for both consumers and corporations.

Net interest income growth to be restricted in coming quarters

The bank's net interest income has been under pressure during the last few quarters due to the poor performance of its loan portfolio that mainly comprises real estate and housing related assets. The bank's net interest margins benefited from the lowering of the benchmark interest rates by the US Federal Reserve in the last few quarters. Wells Fargo's net interest income grew 15.0% y-o-y to US$5760 million in 1Q 08. Going forward, considering Wells Fargo's significant exposure to the home equity and real estate construction sectors in the troubled markets, the bank's loan portfolio will likely be under pressure. This factor could dent growth in its net interest income in the coming quarters. See "The Anatomy of a Sick Bank!" for an overview of net interest margins in "Reggie Middleton's Doo Doo Bank 32" list, of which Wells Fargo is a prominent member.

Net interest income and growth (%)

Source: Company data

Rising defaults in home equity portfolio could result in higher losses

During the housing boom, Wells Fargo expanded its real estate portfolio and avoided making option Adjustable Rate Mortgages (ARMs) or negative amortizing loans. Despite avoiding these riskier loans, Wells Fargo's home equity portfolio is deteriorating due to rising defaults and declining home prices. Consequently, the bank segregated US$11.5 billion of home equity loans into a liquidating portfolio, representing approximately 3% of total loans outstanding in 1Q 08. These home equity loans that are concentrated in the California, Florida and Arizona markets accounted for a significant portion of credit losses. The liquidating loan portfolio is mainly confined to geographic markets that have witnessed the steepest decline in home sales and housing prices. The liquidating portfolio resulted in an annualized loss rate of 5.58% for 1Q 08, compared to 1.56% in the remaining core home equity portfolio.

Wells Fargo's home equity losses are concentrated in the third-party correspondent channel. Approximately 55% of the liquidating home equity portfolio of US$12 billion has a combined loan to value (CLTV) of 90%. Such a high LTV will likely result in major losses for the bank in this liquidating portfolio. The core home equity portfolio was worth US$72.1 billion in 1Q 08. Of this, approximately 45% of the exposure was in the states of California, Florida and Arizona (36%, 4% and 5%, respectively), representing nearly 70% of the bank's shareholders' equity. The worsening housing scenario in these markets as prices continue to tumble and defaults rise, is expected to result in higher losses in the near future.

Home equity portfolio - geographical breakup

Source: Company data

Credit card defaults to rise with increase in annualized charge-off

In the last few years, as the US economy prospered and reported strong GDP growth, Wells Fargo's credit card loan portfolio expanded at a CAGR of 22.3% to US$19 billion. However, the subprime mortgage bubble burst triggered an economic slowdown amid inflationary fears, increasing stress as well as defaults in the consumer finance segment. The charge-offs to loan ratio in Wells Fargo's credit card segment rose to 1.68% in 1Q 08 (annualized 6.7%) from 1.25% in 1Q 07 and this trend is anticipated to worsen, going forward. As outlined above, the deteriorating macroeconomic environment in the US is likely to increase charge-offs in the credit card segment. As US consumers are burdened with higher gasoline and food prices, and as unemployment increases, the default on borrowings is likely to rise. The delinquency rate of the top 100 banks in the credit card business increased to 4.84% in 1Q 08 from 4.06% in 1Q 07.

Wells Fargo's Credit Card Loan and Charge-offs

Source: Company data

Provision for losses to rise as bank has significant exposure to distressed asset class

Wells Fargo has been under provisioning for its credit and loan exposure for almost a decade now. The bank's provisions for losses have not kept pace with the growth in its loan portfolio. Wells Fargo's allowance as a percentage of loans declined from 2.86% in FY 1998 to 1.18% in FY 2006. The bank's loans increased at a CAGR of 14.3% in the last nine years to US$382 billion, while the provision for losses expanded at a CAGR of 5.5% to US$5.3 billion. In the last few quarters, the bank has increased its provisions to counter the rising losses in the home equity and real estate construction portfolios. However, this may not be sufficient to take care of the anticipated rise in losses from real estate, construction as well as consumer lending.

Wells Fargo announced a US$1.4 billion pre-tax special provision in 4Q 07 due to higher loan losses from home equity loans made through certain indirect channels. The bank also added US$0.5 billion of reserves in 1Q 08, in excess of charge-offs, to cover home equity and small business loans. This development indicates that credit problems are now spreading to other businesses. The bank is required to expand its US$1.9 billion reserves built over the last two quarters to address the ongoing decline in the real estate and housing markets.

Charge-offs and allowances as a % of total loans

Source: Company data

Wells Fargo changed its home equity charge-off policy from 120 days to no more than 180 days, or earlier if warranted, from April 1, 2008. Although the bank states that the shift would help in assisting customers, it appears that Wells Fargo is trying to delay the charge-offs from being reflected in its books. The bank claims that in a challenging real estate market, more time is required to work with customers to identify ways to resolve their financial difficulties and keep them in their homes. However, we believe the bank is trying to hide its losses in the home equity portfolio and put off provisioning to a future date, thus smooth earnings and loss rates.

Higher provisions are likely to dent the bank's profitability. As losses on its home equity, commercial and construction loans continue to mount, the provisions are expected to rise in the near future.

Allowance and Loan growth

Source: Company data

NPAs and charge-offs continue to rise

The bank's NPAs increased 22% q-o-q to US$3.3 billion in 1Q 08. On a y-o-y basis, NPAs grew 86%. NPAs as a percentage of total loans rose from 0.54% in 1Q 07 to 0.84% in 1Q 08 due to deteriorating real estate construction and home equity portfolios. The growth in NPAs is driven by declining value and rising defaults in real estate mortgage loans. In 1Q 08, Well Fargo's NPAs (including foreclosed assets) increased to 1.16% of total loans from 1.01% in 4Q 07 and 0.82% in 1Q 07. The bank's total NPAs grew to US$4.5 billion from US$3.9 billion in 4Q 07. The growth in NPAs in real estate construction was exceptional, 49.5% q-o-q and 434% y-o-y to US$438 million.

NPAs in real estate construction loans stood at 2.32%, followed by NPAs in real estate 1-4 family mortgages (1.91%) and lease financing (0.83%). NPAs are anticipated to rise as the bank liquidates its troubled home equity portfolio in view of declining housing prices and rising defaults.

Wells Fargo's net charge-offs totaled US$1.5 billion, representing approximately 1.60% of average loans, significantly higher than 1.28% in 4Q 07 and 0.90% in 1Q 07. Charge-offs in home equity, real estate constructions, other mortgage and credit card loans increased significantly due to rising defaults, declining home value and deteriorating credit conditions. Commercial and commercial real estate charge-offs increased to 0.19% in 1Q 08 from 0.11% in 1Q 07. Expressed as a percentage of consumer loans, charge-offs in consumer loans rose to 0.63% in 1Q 08 from 0.39% in 1Q 07.

Growth in non accrual loans

Source: Company data

Decline in mortgage banking, credit card fees to drag non-interest income down

Non-interest income contributed approximately 56% to the bank's total revenues in 1Q 08. The non-interest income increased 8.4% y-o-y to US$4,803 million in 1Q 08 on account of growth in service charges and credit card fees, and US$636 million gains on debt securities and equity investments. The bank derives 25% of its non-interest income from the mortgage banking and credit card businesses. Income from mortgage banking declined 24% q-o-q and 20% y-o-y to US$631 million in 1Q 08. The fair value of the bank's Mortgage Servicing Rights (MSRs) has been on a downtrend, decreasing to US$14.9 billion in 1Q 08 from US$17.8 billion in 1Q 07. The bank's income from mortgage banking will depend on changes in the fair value of MSRs and whether or not the bank is adequately hedged against such movements. Considering the current state of the housing market, it is highly likely that the bank's income from mortgage banking will be severely impacted in the coming quarters. In addition, the income from credit card business declined 14% q-o-q to US$499 million. Charge-offs in the credit card business grew significantly in 1Q 08, reflecting increased pressure on the credit card business.

Going forward, as macroeconomic conditions worsen, the strength of Wells Fargo's credit card business will be tested. Consequently, we believe the decline in mortgage banking activities and the credit card business will negatively impact the bank's non-interest income.

Growth in non interest income

Source: Company data

Key assumptions

Net interest income to remain flat

We anticipate the bank's net interest margins would remain flat over the period, as Wells Fargo's loan portfolio, considering its significant exposure to the troubled mortgage market, is expected to weaken. Consequently, the interest income earned on this real estate mortgage portfolio would remain under pressure in the near future. However, the 3.25% reduction in the benchmark rate by the US Fed since September 2007 has helped the bank's financials. As the cost of borrowing comes down, we expect the bank to enjoy a higher spread in the near-to-medium term on account of strict lending practices. The mandatory caveat here: the US and world's central banks are under increasing pressure to raise rates due to global dissatisfaction with the weak dollar and sharp spikes in inflationary pressures. Though deposits will likely be mobilized at a lower rate, considering the troubled loan portfolio (high real estate exposure) and lower loan growth, we expect the margins to worsen or remain unchanged, going forward. There is very little, if any, room for any additional improvement in margins, which bodes ill for a company whose balance sheet is rife with depreciating assets swimming in a hazardous macro environment.

Loan growth to slow down as macroeconomic conditions worsen

The deteriorating macroeconomic conditions in the US and the ongoing credit crisis in the financial sector are likely to significantly dampen the growth in the loan books of banks. The rising defaults witnessed across several banking products, such as mortgages, credit cards, auto and student loans, are likely to pull down growth in loans in the near-to-medium term. The adoption of stricter lending practices by banks in the aftermath of the credit crisis would also halt loan growth. Wells Fargo's commercial loans, which consist of 35% of real estate mortgage and construction loans, are likely to take a big hit. The ongoing meltdown in the mortgage market, with its repercussions in the construction and real estate sectors, is expected to decrease the demand for such loans. In addition, growth in consumer loans, which largely comprise 1-4 family first mortgages and 1-4 family junior lien mortgages, is likely to decline in the near term. The increase in the unemployment rate, rise in job cuts and a weakening macro environment are expected to lead to increased defaults in the credit card segment. Therefore, we expect credit card loans to grow at a slower rate in FY 2008 and FY 2009.

The bank's deposits are likely to expand in FY 2008, considering the growth in its retail core deposits in 1Q 08. However, the decline in interest rates would also restrict deposit mobilization activities. Therefore, we expect growth in the bank's deposits to slow down in FY 2009 and pick up thereafter.

Charge-offs, provisions to rise on account of exposure to troubled portfolio

The slump in demand in the housing market and the ongoing price correction would continue to result in higher charge-offs in the commercial and consumer loan segments. Wells Fargo marked approximately US$12 billion of home equity loans into a liquidating portfolio in 4Q 07 but further reduced it to US$11.5 billion in 1Q 08. The liquidating portfolio resulted in net charge-offs of US$163 million in 1Q 08, representing an annualized quarterly loss rate of 5.58%. Problems in the credit card business could also contribute to increased charge-offs in the consumer business.

The bank has been under provisioning for a long time now and may have to increase provisions for credit losses in the light of the mounting losses in its mortgage and home equity portfolios. Despite the strong growth in its loan portfolio and overall asset base, the provisions (and allowances) have not kept pace with the growth in lending. In our opinion, the bank's loan portfolio would come under severe stress, making way for higher provisions.

Valuation

To value Wells Fargo, we have used the Discounted Cash Flow (DCF), Price-to-Book Value (P/BV), Price-to-Earnings (P/E) and Price-to-Revenue (P/S) multiple methods.

Price/Book value based valuation

We estimated Wells Fargo's tangible book value at US$11.6 per share in FY 2009. Based on a P/BV multiple of 1.4x in line with the peer group average, Wells Fargo is valued at US$16.32 per share.

Price/Earning based valuation

We estimated Wells Fargo's earnings per share at US$1.59 in 2009. Based on a P/E multiple of 10.67x in line with the peer group average, Wells Fargo is valued at US$16.98 per share.

Price/Revenue (Sales) based valuation

We estimated Wells Fargo's revenue per share at US$9.49 in 2009. Based on a P/S multiple of 2.5x in line with the peer group average, Wells Fargo is valued at US$23.6 per share.

Based on our weighted average valuation, we arrived at a fair value of US$16.06, which represents a downside of 37% from the current level of US$25.27.