The Bank Nationalization Hysteria

Let me start out by saying I'm about as bearish as anyone on Morningstar's equity analysis staff. I wrote a piece in January 2008 titled "The Bear Market Ahead" and another one a few months later titled "The Death of Leverage". I've been short dozens and dozens of financial institutions over the past 18 months, some of them all the way down to zero. I think  Citigroup (C) and  Bank of America (BAC) will visit the giant ATM machine in the sky. My personal brokerage account is still very much short equities.

All that said, I purchased  Wells Fargo (WFC) common stock this morning. The nationalization meme that has spread like wildfire in recent weeks has erupted into full-blown hysteria. "Is it a bank? Sell, sell, sell! The government is going to nationalize everything!" This seems to be the extent of Mr. Market's analysis this week. Yes, the global economy is in a world of trouble with the massive overhang of bad debt, but barring a return to the Stone Age, there are some banks that will make it through this mess. I'm willing to put a stake into the ground at these prices and say that banks like Wells Fargo have gotten too cheap.

Warren Buffett's  Berkshire Hathaway (BRK.B) is a major holder of Wells Fargo. Let's go back to see what Buffett had to say when he first purchased Berkshire's Wells Fargo stock. From Buffett's 1990 letter to shareholders:

"Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled--often on the heels of managerial assurances that all was well--investors understandably concluded that no bank's numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.�

"Consider some mathematics: Wells Fargo currently earns well over $1 billion pretax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank's loans--not just its real estate loans--were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even."

Before I start my burn down analysis of Wells Fargo, I'll note that the stock now trades for 1.5 times estimated 2009 pre-prevision pretax income (PPTI). Buffett was happy to purchase Berkshire's shares for 3 times pretax earnings.

Burning Down the House
The purpose of a "burn down" analysis is to estimate how much capital a bank may need to maintain capital ratios given a level of lifetime loan losses. We're essentially "burning down" the balance sheet. The table below shows a two-year burn down of Wells Fargo.

WFC Two-Year Burn Down
Net Loans	$843,817.00
Provisions for Loan Losses	$58,213.00
Gross Loans	$902,030.00
Burn Down Percentage	15.00%
Lifetime Losses	$135,304.50
Two Years Pre-Provision Pretax Income	$61,000.00
Provisions for Loan Losses	$58,213.00
Capital Hit	$16,091.50
Tax Benefit (35%)	$5,632.03
Aftertax Capital Hit	$10,459.48
Feb. 9 Closing Price	$19.06
15% "Modest Discount"	$2.86
Convertible Strike Price	$16.20
Convertible Required	$10,459.48
Convertible Strike Price	$16.20
New Share Dilution from Convertible	646
Share Count	4,229
Dilution Percentage	15.4%
Diluted Share Count	4,875
Shareholder Common Equity (ex-Preferred Stock)	$67,736.00
Book Value	$16.02
Diluted Book Value	$13.90
Data as of year-end 2008. All figures in millions except per-share numbers.

There are a lot of numbers, so let's walk through the analysis. At the end of 2008, Wells Fargo held loans in the gross amount of $902 billion. Let's assume that over the life of these loans, 15% of the total value is burned down. This is a loss of $135 billion over the life of the loan book, but the loss is completely taken in the next two years. In 1990, Buffett assumed a 3% burn down of Wells Fargo's loans (10% default rate with a 30% loss).

The next crucial estimate is Wells Fargo's earnings power. Beneath all the bad headlines, the major banks are hugely profitable right now as net interest margins have expanded nicely. We think Wells Fargo can earn roughly $61 billion in PPTI over the next two years. That is some serious earnings power and this income will help to offset loan losses. We also have to account for the $58 billion Wells Fargo has already reserved for loan losses. When we subtract these items from the $135 billion in losses, we are left with a hit to capital of $16 billion. Wells Fargo can deduct this loss from its taxes, so the aftertax hit to capital is $10 billion.

Yes, $10 billion is a lot of money, but does it make sense to nationalize a banking franchise that can earn $30 billion of pretax income this year because of a $10 billion capital hit? I can think of a certain major shareholder in Omaha who would likely be willing to kick Wells Fargo $10 billion.

Even if Wells Fargo cannot raise private capital, the plan outlined by Treasury Secretary Timothy Geithner a few weeks ago is available to fill the $10 billion hole. Under the terms of that plan, the Treasury will purchase a convertible preferred security with a strike price that is a "modest discount" to the closing price on Feb. 2, 2009. Wells Fargo closed at $19 per share on Feb. 2, which means 646 million new shares will be issued to the Treasury in exchange for $10 billion of new capital. On Wells Fargo's existing share base of 4.2 billion, that is roughly 15% dilution.

Dilution isn't great, but 15% is hardly life-threatening for Wells Fargo. The company's common equity per share is about $16; with the dilution from additional Treasury funds, that figure falls to $14. Compare that with a stock price hovering around $10 per share as I type this.

Stocks can always get cheaper, especially in the pessimism of a brutal bear market. Government action has also been very unpredictable, and perhaps all the banks in United States will get nationalized this weekend. Anything is possible. However, it strikes me as an unlikely scenario for Wells Fargo. If we start nationalizing banking franchises that can easily earn their way out of this mess, then I am left speechless at the financial illiteracy of our elected leaders.

Disclosure: Toan Tran owns shares of Wells Fargo.