Surprise, Wells is America’s most-stressed bank

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Colleague Steve Gandel wrote a great story. So I asked if he’d be up for blogging about how it came to be. He agreed. Steve writes:

I have a story up on the website today and in the magazine next week about how the government could go about stress testing the banks and what they would find if they did. I got interested in doing the story because a private equity guy I talk to who knows banks told me that the bank of his envelope said that none of the big four would pass. That sparked my interest particularly because while I was talking to the guy last week I was at the same time watching all the CEOs of the major banks, except Citi’s Vikram Pandit, tell Congress won’t need any more of the government’s money. Some even said they would like to give it back. So I decided to try a stress test myself and see what I found out.

I was surprised by the results. The perception of the public and I think most business journalists is that Wells Fargo is the strongest among the banks. So I expected Wells Fargo to come out on top, and every other bank to fail. If you have read the story, you know that what our stress test found, it was quite the opposite. Wells Fargo came out on the bottom, and JP Morgan was the only bank to pass our stress test.

I was actually so surprised by the results that I immediately called up the folks at Wells Fargo to get their reaction. Here’s what I got:

Our  Tier 1 capital ratio was 7.9 percent at year-end, which is well above  regulatory minimums for a well-capitalized bank, and Wells Fargo Bank, N.A. has the highest credit rating  currently given to U.S. banks by Moody’s Investors Service, “Aa1,” and  Standard & Poor’s Ratings Services, “AA+.” As is our longstanding practice, we can’t comment on  your model or calculations; however, we would like to refer you to our 4Q 2008  earnings release where we state: “Tier 1 capital was $86.4 billion at December  31, 2008, after the impact of de-risking the balance sheet for credit  impairment of loans and write-down of negative cumulative other comprehensive  income at Wachovia, which, in the aggregate, reduced the Tier 1 capital ratio  by approximately 230 basis points to 7.9 percent at year  end.”

Regarding de-risking, we also stated in  Q4 that our principal action was to identify and segregate  $93.9 billion of higher risk loans on Wachovia’s balance sheet and ‘impair’  those loans through purchase accounting adjustments at close for $37.2 billion  of estimated life of loan losses.  As an example, as part of the $37.2  billion  action , we  already reduced the Pick-a-Pay  portfolio   by approximately 20%, or $24.3 billion, as of year-end 2008.  Such   de-risking is an important distinction when comparing year-end bank  portfolios under stress scenarios.

The bold text is their emphasis not mine. The first argument is that we looked at the wrong type of capital-total, not Tier 1. I’m not sure who is right about that one. But CreditSights ran their own stress test, and found that even under a conservative loan loss scenario Wells Fargo ended up with the lowest Tier 1 capital ratio of all the big banks.

The more important argument Wells is making is this: They took a big write down for bad loans when they acquired Wachovia, and so it should be assumed that they will have fewer losses in their lending business than their competitors because they have already removed the problem loans.

The problem is this not a new argument. For a long time banks have been saying, “Back off regulators, we know how much risk is on our books so we know how much capital we need to have.” Of course, this was a self-serving argument because the lower capital they held, the more profits they could announce, at least in the short run. Well it turns out the loans were much riskier than the banks thought, so indeed they needed more capital they said they needed. And undercapitalization is the reason so many banks are in trouble.

That’s why Wells Fargo’s argument is hard to swallow at this point. The Wachovia acquisition, which was just completed at the end of the year, added some $400 billion in loans to Wells books, and seriously depleted Well’s capital position. That’s what is showing up on our stress test.

Yet, Wells is already saying they know this loan portfolio and know how much capital they need to have. It’s admirable they have tried to size up their losses, and taken a big hit–$37 billion—for doing so. But if they are wrong about the loans they have acquired—and indeed NYU’s Nouriel Roubini would argue that losses on Pick-A-Pay loans should be 25%, not 20%–Wells could soon replace Citi as Tim Geithner’s biggest headache.