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USB and WFC on track


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I did a little work on future earnings power for both of these banks yesterday using pre-tax, pre-provision profit (PTPP).  I went back over the last 10 years and saw that, on average, both of these banks earn (after tax and after provisions) about 50% of PTPP.  Ranging from 40% to 60%. 


Last year, WFC earned 12% of PTPP and this year it will come in somewhere in the 25% range.  USB earned 41% of PTPP in 2008 and will come in around 20% this year.  WFC is running at a rate of almost $9/sh in PTPP.  USB is running at just over $4.50/sh.


Assuming an eventual return to normal (i.e. 50% EPS/PTPP ratio), WFC's eps should find its way to $4.50/sh and USB to $2.25/sh.  At $29/sh and $25/sh stock prices, respectively, WFC looks seriously undervalued but USB doesn't.


None of this includes future growth projections, but to add a little more umph, WFC has grown its PTPP at a 16% per annum rate since 1998, while USB's PTPP has grown at just over 6% per year.

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USB is growing through acquisitions but it is not making first page headline grabbing acquisitions. I think it is in a very strong position mainly because it has paid back the TARP money. WFC is yet to pay it back - although the execs have said they dont want to dilute the existing shareholders, no one knows for sure till it is done. If they dont dilute, the upside is good.

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WFC would have to double its share count to arrive at the same valuation as USB, based on PTPP.


In the 3rd quarter, WFC had $16.4 billion in short-term earning assets (average balance for the quarter) earning well less than 1%.  They had mortgages held for sale of $5 billion earning less than 3%.  So, they appear to have resources available to pay off the preferreds that are presently earning well below the after-tax 5% they owe the govt. 


On a valuation parity basis, using USB's EPS/PTPP valuation as a benchmark, WFC is worth $46/sh.

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If things work out reasonably well for WFC, I think it remains ridiculously cheap.  If you start with 2000 and go through 2007, there have only been two years where net charge-offs exceeded even 1% of average loans -- those years were 2001 and 2007, where net charge-offs were 1.09% and 1.03%, respectively.  All the other years had net charge-offs were below 1% of average total loans.


Average total loans are now roughly $800 billion for WFC.  Assuming loan balances don't decline forever, one can model appoximately $8 billion in net charge offs for a full year.


In just Q3 of 2009, net charge-offs were over $5 billion and the provison for losses was around $6 billion (thus about $1 billion was added to the allowance in Q3).  These are relatively massive charges.


I figure that WFC should earn around $24 billion after tax when loan losses normalize.  It doesn't take much (a 13.5x multiple) to close in on $70 a share for WFC.  One can argue that things will get worse...but that's a risky dance if you assume that they will ultimately get better.


As soon as net charge-offs start to drop precipitously, the stock should take off. 


I agree that WFC looks to be cheaper than USB...though USB has traditionally had even lower net charge-offs than as a percentage of loans than WFC....Wells had traditionally had the higher net interest margin.  Still, Buffett paid about $31 a share for a billion of USB in 2006...like Wells, they are able to grow earnings a very decent clip while paying out a very large percentage of their earnings in dividends....both companies are extremely profitable when you look at the growth against retained earnings. 


And, as has been pointed out before, both USB and WFC have been able to post large portions of their profits via non-interest income and this is a stabilizing force for both and, I think, allows both to avoid reaching for yield by making poor loans (but still having good ROA's and ROE's).


My 2 cents

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While I like WFC and hold it ( along with USB ), I think WFC carries more risk right now than USB. While it is likely that it will play out fine, the risks I see are:


1. TARP related regulation

2. Break up of large banks. ( it is unlikely it will happen but Volcker has recommended it )

3. TARP not paid thus exposing the company to TARP related regulation


Some others I found:





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Don't forget, though, that there are currently over $2 billion in non-cash amortization charges related to amortizing the value of the acquired deposits from Wachovia.  These reduce GAAP rearnings but are entirely non-cash and in fact exceed the total of the preferred dividends.  


With all due respect to seeking alpha and others, I think almost all of these articles are nonsense.  


Some months ago, the issue was tangible equity.  Now, Wells has produced over $20 billion against the SCAP requirement of $13 billion and change (that includes the $8 billion capital raise...which they clearly didn't need and which Kovacevich was so pissed about)....in just a few quarters.  


Now, the anti-Wells contingent has moved on to Mortgage Servicing Rights.  There is nothing new here.  Wells has made it clear that the change in value of the servicing rights is inversely correlated with new originations and they have always said this (as long as I've been following them).


The supplemental package put out this quarter says that things are going better than they expected on all fronts.  The merger will cost less than planned, the merger savings will be as planned, the pick-a-pay portfolio is working out better than planned, etc., etc.



To put it it nicely, I'm highly suspicious of the comments I saw from Dick Bove recently.  They are non-sensical.


My feeling is that Wells is in the driver's seat with regard to the government.  I believe the goverment actors are posturing for regulatory power.  Wells is one of the only banks left that doesn't need help from the gov't.  Though they are profiting from the massive Net Interest Margin from low short rates, that is the only thing keeping the rest of the banking industry close to solvent.  If the gov't takes that away, they'll bankrupt everyone.  


Wells is doing much better than it seems, in my opinion.  I'm curious to see what the anti-WFC people will come up with once Wells pays back the TARP -- which I think hasn't happened yet because of the gov't.


The supplement to the Q3 release it worth a review for those interested.



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sorry, I don't understand your point on the MSR. I am not specially anti Wells Fargo but try to understand.

each quart Wells earns about 1/1,5 billions with Msr hedges covering more than dEpreciation of the Msr. this gain is not reccurent. Could you explain if you think the contrary? thanks




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Your thoughts are refreshingly rational.  I too have trouble understanding the negative bias toward WFC.  WFC appears to me to be in a class by itself. 


At the risk of countering the crowd, I have even been suspicious of USB's lack of write-offs historically.  I often wondered why they did not provision more for a rainy day.  Now, as WFC's provisions as a percentage of PTPP decline, USB's have accelerated.

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ok for the critisism of Rick Bove and the praise of Buffett .

more interesting is to explain why he is wrong on the MSR.

is the gain on the depreciation /hedge due to the yield curve, is this gain automatic when origination is low and vice versa, but why?

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ok for the critisism of Rick Bove and the praise of Buffett . more interesting is to explain why he is wrong on the MSR.


I think Bove was confused with his claim that WFC made $3.6B due to a hedging profit on the mortgage servicing portfolio.


Yes WFC booked a $3.6B gain from their MSR hedges but that gain has to be looked at as an offset to their $2.1B decrease in the value of their MSRs.  So there was a gain, but it was a net gain of only $1.5B gain -- not $3.6B as Bove claimed.  You need to look at both halves together as WFC hedges their MSRs primarily against changes in interest rates.




$1.5 billion combined market-related valuation changes to mortgage servicing rights (MSRs) and economic hedges (consisting of a $2.1 billion decrease in the fair value of the MSRs more than offset by a $3.6 billion economic hedge gain in the quarter), largely due to hedge-carry income reflecting the current low short-term interest rate environment, which is expected to continue into the fourth quarter;


In the context of a quarter where PPPT was $10.8B, you have to put that $1.5B in context.





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Its not recurring income -- the MSR fair value goes up and down depending on interest rates, prepayment speeds, etc. As stated WFC hedges some of that (primarily with interest rate swaps/caps).   You can find the last 5 quarters data on p. 42 of their earnings release.




For the latest four quarters the net change in market-related valuation changes to the MSRs + economic hedges was:








So roughly $3B on a rolling 4 quarters basis.  MSR accounting is tricky because the value of the fees that WFC receives as servicer are capitalized over the life of the mortgage.  A lot of assumptions go into deriving that value.


One thing I look at is the run rate of actual servicing fees (from the same table I referred to above) which in WFC's case for the last 4 quarters is $3.9B.   The total value of the MSR at the end of the Q was $14.5B -- so the avg life of these mortgages is assumed to be 14.5/3.8 = 3.7 years duration which seems ok to me.


The other way I look at it is to factor out the non-service fee portion and look at what all of these valuation changes/hedges/other accounting adjustments/amortization are worth.   Total rolling 4 quarter servicing income, net for WFC was $3.429 B -- that includes all of the fair value/hedging/amortization adjustments.   Compare that to actual 4-quarter servicing income of $3.897 B -- that means all of the accounting for fair value/hedging/etc was a negative $468m to PPPT.   $468m on a total PPPT of $40B isn't worth worrying about.


That's not to say the adjustments aren't something to think about.  If rates rise and originations fall, then its likely WFC will see losses from its hedges -- but then prepayments will slow, avg duration of mortgages will stretch out and the accounting value of the MSRs will go up.


Still overall, I don't think there's any mischief here in the MSR accounting.



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Other than loss provisions being historically lower at USB than at WFC, another big difference between the two is employee compensation.  I get average employee comp at USB of just over USD 63,000 per annum.  At WFC, it is 50% higher, at around USD 95,000.  That is a large difference, affecting their respective efficiency ratios.


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another interesting situation is pnc.  its in between usb and wfc in terms of risk, but as cheap as wfc on earnings a few years out.  the deposit franchise is lower quality than wfc (but still good), but they have much better fee businesses and a large stake in blackrock.  once the credit cycle goes back to normal they will be able to earn 8 or 9 and wfc will earn 4 or 5.  assuming the low end and a 14x multiple and pnc is a $112 stock and wfc is a $56 stock.

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