"One wonders if it would be cheaper in the long run to have the Treasury underwrite all transactions for real goods in the economy in return for depriving firms of the opportunity to 'hedge' their transactions with derivatives. I think it would cost less. Of course, the rational solution is just to declare derivatives ultra vires for the banking system and unenforceable in the courts as a matter of public policy. Then bankers could do whatever they want with them and would have only shareholders to answer to for their follies."

Walker Todd of AIER on
derivatives reform legislation
October 7, 2009

Today The IRA is traveling back to Indiana State University to give a talk on "Re-Privatizing the US Banking System" and other related topics. We are going to further develop our thesis on the "Alliance of Convenience" between the political class, the primary dealers and the Fed that we discussed last week at AEI. We'll have an annotated text developing this idea next week that will be published by AEI later this month.

Also, please put November 4, 2009, in your calendar for the next full day event hosted by the Washington DC chapter of Professional Risk Managers International Association at the FDIC Seidman Center, entitled "Regulatory Reform: Defining Issues and Tasks to Enhance Systemic Stability." Co-sponsored by the CFA Society of Washington, FDIC Corporate University and the Office of Thrift Supervision, this event features former Bear, Stearns CEO Alan Schwartz, former LTCM general counsel James Rickards, Ernie Patrikis of White & Case, and Achim Duebel of Finpolconsult in Berlin to discuss the events of the past several years and solutions to prevent a repeat of these events. Click here to register or for more information. Note: State and federal financial regulatory personnel may register free of charge by contacting us directly (info@institutionalriskanalytics.com).

In this issue of The IRA, we look at WFC, one of the four zombie banks that were the primary focus of the Great Bank Bailout of 2009. With the backdrop of last week's G-7 meeting in Turkey, where FDIC Chairman Sheila Bair told attendees that, in the future, bank debt should be haircut in the event of insolvency, a discussion of large bank capital is certainly relevant. This is especially true since the Congress is showing no sign of being willing to restrain risk taking by banks via such speculative instruments as OTC derivatives.

The hearings this past week on reform of OTC derivatives before the House Financial Services Committee run by chairman Barney Frank (D-MA) are a bad joke, even if the bill is amended by the proposal from the House Agriculture Committee. Higher bank capital may be the only hope for addressing the public's concerns about systemic stability among financials as a group, especially since the Washington political equation seems to be, as always, rigged by the large NY banks. The willingness of Frank and other members of the Congress to pander to the financial services industry is seemingly without limit, but the shameless display of subservience by the Congress may be cause for remorse come next November.

As the Q3 2009 bank earnings circus is about to begin, we thought we'd look at WFC from the perspective that we use in our commentaries in The IRA Advisory Service. WFC is currently rated "A" by the IRA Bank Monitor, based on a Stress Index score of 1.3 vs. the industry average Stress Index score of 3.1. The factors in the IRA Banking Stress Index for all of the bank units of WFC are shown below along with the industry benchmarks:

IRA Bank Stress Index Rating -- WFC -- Q2 2009

IRA Letter Grade A Overall stress is slightly better than industry average.

Stress Score Overall 1.3 ROE 1.1 Loan Defaults 2.9 Capital 1.0 Lending Capacity 1.0 Efficiency 0.7 Industry Benchmark 3.1 8.6 3.8 0.9 1.0 1.2

Source: FDIC/The IRA Bank Monitor

The first thing to notice about WFC is that it is hyper-efficient at 46% and thus the 0.7 Stress Index score for aggregate efficiency. This is a measure of the cost of acquiring a dollar of revenue. JPMorgan Chase (NYSE:JPM) and Bank of America (NYSE:BAC) are also in this category of efficiency, but Citigroup (NYSE:C) is in the 60s, a key business model difference between these respective zombies.

The strong operating results at WFC are also a function of federal subsidies, including equity injections, repurchase agreements with the Fed, FDIC guaranteed debt and other favors reserved for primary dealers of US government debt. WFC finally agreed to become a primary dealer after reportedly refusing the invitation from the Fed several times. But WFC's trading book risk remains far smaller than that of JPM or C and the bank lacks a first-tier investment banking operation. Some would consider this a blessing, but WFC management has indicated they will be building IB capability.

Of interest, an analyst at Wells Fargo Securities says that they expect to see 7 million foreclosures in the US between now and 2014, this according to Housing Wire , and that loss rates for various flavors of prime ARMs could range from 2-6% while losses on subprime ARMs could reach from the teens into the thirty percent range.

In terms of business model, we measure WFC's risk by calculating Economic Capital or "EC" for each of three operational buckets: lending, trading and investing. The results from The IRA Bank Monitor are shown below as of Q2 2009 in thousands of dollars along with the Tier One Risk Based Capital for WFC, the ratio of EC to T1 RBC, and the Risk Adjusted Return on Capital ("RAROC") that results from comparing EC with nominal income.

Wells Fargo & Co ($000)
Economic Capital -- Q2 2009

Lending $27,670,405
Trading $34,627,113
Investing $85,547,522

TOTAL EC $147,845,040

Key Ratios:

EC to Total Assets Ratio 0.119-to-1
EC to Tangible Assets Ratio 0.125-to-1
EC to Equity Ratio 1.135-to-1
EC to Risk Based Capital 1.126-to-1
EC to Tier 1 1.656-to-1

Reference Data:

Total Assets $1,241,160,147
Tangible Assets $1,180,782,718
Equity $130,257,081
Total Regulatory Risk Based Capital $131,247,309
Tier 1 Risk Based Capital $89,275,612

Source: FDIC/The IRA Bank Monitor

WFC -- Subsidiary FDIC Reporting Units for 2009-06

"A" Wachovia Bank, National Association
301 SOUTH COLLEGE STREET CHARLOTTE, NC
1.0 | 1.3 | 1.2 | 1.1 | 1.0 | 0.7

"B" Wells Fargo Bank, National Association
101 N. PHILLIPS AVENUE SIOUX FALLS, SD
1.6 | 0.8 | 4.5 | 1.0 | 1.0 | 0.7

"A+" Wachovia Mortgage, FSB
6825 ALIANTE PARKWAY NORTH LAS VEGAS, NV
0.8 | 0.8 | 0.9 | 1.0 | 0.9 | 0.4

"A" Wells Fargo Bank South Central, National Association
301 W NORTHERN LIGHTS BLVD. ANCHORAGE, AK
1.4 | 0.7 | 4.0 | 1.0 | 1.0 | 0.3

"A+" Wachovia Bank, FSB
2005 TAYLOR STREET HOUSTON, TX
0.9 | 2.0 | 0.3 | 1.0 | 0.2 | 0.7

"F" Wells Fargo Bank Northwest, National Association
3889 WASHINGTON BOULEVARD OGDEN, UT
22.7 | 100.0 | 10.4 | 1.0 | 2.0 | 0.2

"C" Wachovia Bank of Delaware, National Association
100 WEST 10TH STREET WILMINGTON, DE
4.4 | 15.6 | 4.7 | 0.7 | 0.8 | 0.3

"F" Wachovia Card Services, National Association
171 17TH ST. NW, 100 BLDG ATLANTA, GA
24.0 | 100.0 | 13.1 | 0.2 | 6.4 | 0.1

"C" Wells Fargo Financial National Bank
4455 SPRING MOUNTAIN ROAD LAS VEGAS, NV
4.6 | 1.8 | 12.3 | 0.6 | 7.8 | 0.3

"A+" Wells Fargo HSBC Trade Bank, National Association
1 FRONT STREET, 21ST FLOOR SAN FRANCISCO, CA
0.7 | 0.8 | 0.1 | 0.5 | 1.7 | 0.7

"C" Delaware Trust Company, National Association
505 CARR ROAD 2ND FLOOR WILMINGTON, DE
2.7 | 12.2 | 0.0 | 0.1 | 0.9 | 0.1

As we wrote last week regarding BAC, the one thing you do not yet see reflected in the Bank Monitor financial profile or Stress Index ratings of WFC is the off-balance sheet exposures. While WFC does provide good disclosure on Page 84 of its most recent 10-Q of the $1.5 trillion in consumer and commercial OBS mortgage exposures, the economic cost of making these securitizations money good is not fully appreciated by the markets.

Here's our question for IRA readers: What haircut do we apply to WFC and BAC OBS exposures going into 2010? Current charge-offs for on-balance sheet exposures? Or should we instead look to the secondary market prices for this paper? Remember, we've got trillions in exposure here, so the loss rate assumptions make a big difference for equity and debt investors of both WFC and BAC.

The working assumption in the regulatory community at the time of the Stress Tests was that an economic bounce would save the day at WFC and make the combination with Wachovia workable. Like BAC, WFC still obscures the impending balance sheet reality behind the accounting rule changes of the FASB, even though the economic cost is already apparent in redemption expenses and secondary market prices for this collateral. Even with the rebound in collateral values seen for many MBS, the WFC OBS exposures could, at the end of the day, be the most significant risk factor to WFC, one reason why we do not have a positive outlook on WFC for the IRA Advisory Service.

Comments on Securitization & BAC

We appreciate the comments on our last missive regarding Bank of America (NYSE:BAC), "Bank of America: How Much Should Bond Holders be Haircut to Restore Solvency?," Three items seemed to summarize the flow of questions.

Joe wrote about our view of large zombie banks such as Citigroup (NYSE:C): "We had the stress tests and you're telling people that you have managed to find $200 billion of losses in Citigroup's books while the government's examiners just glossed over them? Please."

The IRA: That's correct Joe. The government stress tests were about restoring confidence, not determining capital adequacy. The movement of financials in the equity markets has little or nothing to do with the fundamentals of the banks. But when the flight to financial instruments reaches its limit and investors recognize that the real economy is still contracting, look out for that snapping rubber band.

Hugh asked whether inflation is coming back.

The IRA: Inflation is already here. So long as regulators and politicians are focused on bailing out the speculative economy at the expense of the real economy, we see deflation as the dominant trend. But inflation is also at workk. One of the ways that you lose money via inflationary monetary and fiscal policies is losses incurred during financial bubbles. Von Mises, Hayek all wrote about this reality. Indeed, it is possible to have both asset deflation and liquidity driven manic bubbles, as in the case of large cap financials (+150%) vs. smaller names (+50-100%) since March. Whatever the bond holders of the zombie banks gained via bailouts they will lose and more via inflation from the debt incurred to fund the subsidies.

A veteran fund manager named Scott wrote to us about BAC, the mechanics of securitization, and our comparison of auto paper with MBS:

"B of A's purchase of countrywide was such a bizarre move because it was obvious at the time that, had they walked away, countrywide would have gone under. Lewis seemed to be in the habit of lending a hand to the government. However, my understanding of the facts of the Helocs and the securitization differs significantly from your comment."

"The repurchase of loan issue is not an issue of a secret side deal - Countrywide/BAC are being asked to repurchase loans that breached loan representations. Every mortgage deal has this requirement. Countrywide happens to have an extremely large number of requests (most coming in the form of big lawsuits). The argument investors are making is that Countrywide abandoned underwriting standards and thus put loans that didn't qualify for the deals into the trusts - they aren't seeking enforcement of a secret side agreement."

Scott continued: "Likewise for the HELOS - as second lien loans, these are typically not foreclosed buy are rather charged off, like credit cards. All second lien lenders have provisions for the loans to be removed upon charge off or when 180 days past due (the typical charge off date, as with cards). This isn't a side deal or a QSPE issue. Countrywide is not supporting the deal. I am enforcing the plainly stated terms. Nearly all second lien deals are done as debt, rather than true sales, so the accounting is different anyway… Countrywide did not and does not cure deals and this was absolutely not a factor in their deals being popular. Rather, for many years they were considered the best quality originator (that's why BAC bought them and why Fannie and Freddie did so much business with them) with the fewest loan defaults and best track record."

The IRA: Our point is as much financial as legal. You will most likely never know whether side agreements exist or not, but reliance on reps and warranties as part of the credit structure is outside the original securitization paradigm. Investors did not purchase structured securities at securitization prices based on the idea of ultimate obligor buybacks via the de facto practice of curing. Securitizations are not yet shown as liabilities of sponsors. The reps and warranties of an MBS are the backstop for the security not performing as per the offering prospectus.

To us, the problem is that what's sauce for the goose is sauce for the gander. If you can let hedge funds and pension funds put the collateral back to the Seller at some price other than intrinsic value, then you can let the Seller do likewise. We hear that Citibank was a master at this. What it means is that there is no structured finance/securitization market, just a Ponzi scheme. But the confusion is perpetuated by the lack of a definitive standard for the term "non-recourse." Ann Rutldge likes to say that "It's the opposite of pornography: you don't know it when you see it."

We also don't understand the point about HELOCs. That they have a different accounting treatment, or that they are difficult to collect in the same way as first liens (a point that was well-known to investors even in the 1990s), doesn't have a bearing on the question of recourse. Cash flow valuation of assets is outside GAAP. FASB admits as much in Appendix B of SFAS 140. So it seems that accounting treatment has no bearing on valuation, at least from where we sit.

As far as its bearing on the notion of recourse, yes it is true that the accountants define recourse as the Seller being able to call back the loans (investor puts are allowed) but the fact is that the law sees it the other way (investor puts define the essence of recourse). So, to our way of thinking, there's no refuge to be had in accounting conventions. In terms of the mechanics of default, well, of course, 180 days is very late to be writing off an insolvent loan, too, but at least the standard for declaring defaults is unambiguous.

The real question is this: Does the Seller recognize the default at 180 days or does the Seller engage in some kind of invisible restructuring so that it never reaches 180 days by the same clock-and if it does reach 180 days, what happens then? Does the Seller write down the balance of the QSPE assets simultaneously with the write off, or wait until the proceeds come in? We all know the answer to that question.

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