Tuesday, March 25, 2008

Wachovia's Balance Sheet Doesn't Fool Mr. Market: Jonathan Weil

(Bloomberg) -- How will we know when it's time to call a bottom to the mortgage mess? Here's one benchmark: As long as Wachovia Corp. hasn't cleaned up its books, there's probably still more to come.

The fourth-largest U.S. bank ended last year with a book value, or assets minus liabilities, of $76.9 billion. By comparison, the company's current market capitalization is $60.9 billion, following a 19 percent decline in its stock price this year to $30.72.

The $16 billion gap shows the market doesn't believe the company's balance sheet is holding up. It's probably right, too.

I started my research for this column with a simple question: Why has the growth in Wachovia's loan-loss allowance not kept pace with the growth in the bank's nonperforming assets? It turns out the company hasn't been using its allowance to stay ahead of bad loans, so much as it has been taking its time in recognizing expenses.

First, a brief primer on loan-loss allowances. These are the reserves lenders are supposed to set up on their balance sheets in anticipation of bad loans. Provisions are the expenses lenders record against earnings to boost their loan-loss allowances. As loans are written down, lenders take charge-offs, reducing their allowances.

A traditional rule of thumb is that when a bank's allowance is less than nonperforming assets, it's a sign the bank might not be setting aside enough reserves. The norm is for banks to bulk up on reserves, rather than run lean, when their forecasts show the economy is worsening.

Problem Loans

Wachovia, based in Charlotte, North Carolina, reported fourth-quarter net income of $51 million, down from $2.3 billion a year earlier. Nonperforming assets soared to $5.4 billion at Dec. 31 from $1.4 billion a year earlier. Yet Wachovia's loan- loss allowance increased only about a third, to $4.5 billion from $3.4 billion.

Put another way, the company's allowance was equivalent to just 84 percent of nonperforming assets at Dec. 31, compared with 246 percent a year earlier and 378 percent at the end of 2005.

How could that allowance be sufficient to cover future charge-offs? When I put that question to Wachovia's chief financial officer, Thomas Wurtz, he responded by giving me a hypothetical example.

Say Wachovia has a $100,000 home loan for a $120,000 house on its books that becomes 90 days delinquent. At that point, Wachovia automatically classifies the loan as nonperforming. The bank will stop accruing interest, back out any interest it has recognized over the previous two months, and establish reserves of, say, 1 percent of the loan's value, Wurtz said.

Waiting Room

Then it waits. If the loan stays delinquent for 180 days, Wurtz said, the bank will recognize it needs to record a charge- off -- $19,000 in the scenario he gave me -- to reflect the decline in the loan's value and the estimated costs of foreclosure and selling the home.

The bank then takes the hit on its income statement, booking the charge-off and a provision to replenish its allowance in one fell swoop. The loan, meanwhile, stays on the books as a nonperforming asset, where it remains until it is liquidated.

``The point is, we take all the pain to our income statement at 180 days,'' Wurtz said, after which ``we don't really need any particularly high level of reserves against the asset.''

Here's the rub. If the vast majority of Wachovia's nonperforming assets were 180 days or more past due, I could see how Wachovia's loan-loss allowance at Dec. 31 might be sufficient, because those loans already had been written down. So I asked: What percentage of Wachovia's nonperforming assets at Dec. 31 had been delinquent for 180 days or longer?

More Needed

While the company wouldn't give me an exact figure, a spokeswoman, Christy Phillips-Brown, said most of Wachovia's $5.4 billion of nonperforming assets were in the 90-to-179-day category. Wachovia hasn't disclosed this in its filings.

That indicates a lot more provisions and charge-offs may be needed, as more loans hit the 180-day mark. Wachovia recorded $1.5 billion in provisions last quarter, almost four times what it took during the third quarter. Net charge-offs more than doubled to $461 million from the previous quarter, while nonperforming assets rose 84 percent.

Donn Vickrey, editor-in-chief at Gradient Analytics Inc., an investment-research firm in Scottsdale, Arizona, says he'd be more comfortable with Wachovia's allowance had it been around $6 billion to $8 billion at Dec. 31, rather than $4.5 billion.

``It's basically a charge-as-you-go method,'' Vickrey says. ``You're supposed to account for loan losses as a contingent liability, meaning you accrue a reserve ahead of the actual loss.''

Being Patient

Reserves aren't the only example of Wachovia's patient approach. As of Dec. 31, the intangible asset known as goodwill represented $43.1 billion, or 56 percent, of Wachovia's book value. That included $14.9 billion from Wachovia's $24.3 billion purchase of mortgage lender Golden West Financial Corp. in October 2006. Newsflash: Golden West sold near the housing market's peak and wouldn't fetch as much today.

Add it up, and a $16 billion discount to book value for Wachovia doesn't look so out of whack. The market isn't waiting around for Wachovia to take a machete to its balance sheet. It's telling the company to start catching up.

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