Macro Tsimmis

intelligently hedged investment

SELL SHORT Wachovia Corporation (WB)—same barrel, more fish

Posted by intelledgement on Mon, 12 Nov 07

It ain’t just shoes dropping.

We got flip flops, we got sneakers, we got pumps, we got high heels, we got hiking boots, we got galoshes…we talked about the collapse of the housing market in our recommendation to short Beazer Homes (BZH) a couple of months back. Well, duh…the destruction of subprime mortgages—which become worthless when the underlying value of the house falls below the value of the debt owed on the mortgage and the lender defaults—is hurting anyone holding mortgage-backed securities—many of which are complex derivatives and not so easy to price even when things are going well. When things are going badly, no one can say what a lot of these arcane securities are worth for sure…but it is a sure bet that the value is a lot less than the bank paid for them, and even with all the writeoffs to date, we think it is a good bet that the value is less than the banks are telling us.

Again, most of what you need to know about the banks in general—and Wachovia in particular—is visible in this chart of bank stock prices over the last 18 months. Included in this chart are Bank of America, BB&T, Citibank, SuntTrust, Wachovia, and Wells Fargo. Wells Fargo, one of the best-run financial institutions on the planet, has seen their stock decline 8% in the last eighteen months…and all the others have fared worse, with declines ranging from 12% to 34% (for Citibank). Wachovia’s stock (WB) is the second worst of the lot, down 28%.

The steady drumbeat of decline has been fed by a pattern of negative surprizes—or, as the Wall Street cliché of choice goes, shoes dropping—as each quarter, the update of how badly the banks’ portfolios of securities has deteriorated produces worse—and, generally, worse-than-expected—news. Just last Friday, Wachovia became the latest bank to announce a significant writeoff: last Friday, they announced a $1.1B decline in the value of their subprime mortgage-backed securities just in the month of October.

And it is not just mortgage-backed securities that are providing the negative momentum. Many financial institutions have other complex derivative securities on their books whose performance tends to amplify volatility in dimly understood but potentially scary ways. Pricing these in a sharply declining market is both difficult and depressing (both of one’s net worth and mood).

And guess what: a whole new category of designer shoes are hanging up there along the power line, poised like cute little pair daggers of Damocles threatening to rain down at any moment: credit debt defaults as the consumer spending well runs dry. Hasn’t happened yet, but with the combined effects of the decline in real estate values and the decline of the dollar as the Fed pumps liquidity into the economy and lowers interest rates are bringing us closer and closer to the part of the road the power lines cross.

We could easily go with Citibank for our short position here, but are passing them over in favor of the hometown favorite, Charlotte-based Wachovia.

Wachovia is one of the top-five banks in the USA, with assets as of the end of FY06 of over $700B. Founded in 1879, the bank provides just about every financial service imaginable exclusive of insurance: personal and commercial banking, investing and investment management, personal and commercial loans, credit cards, investment banking, and international trade services. The bank is profitable, with earnings of $7.7B in 2006 amounting to 16.6% of revenues, down slightly from 18.5% of revenues in 2005.

Sounds good, but in addition to their own portfolio of problem loans, in May of 2006, Wachovia management made a bad mistake, agreeing to pay top dollar ($25.5B) to acquire Golden West Financial (GDW). The merger extended Wachovia’s customer base in Texas, Florida, and California…markets that were just about to be hit hard, harder, and hardest by the bursting of the housing bubble. And you guessed it: turns out GDW was one of the most aggressive purveyors of option ARMs, and had mucho soon-to-be problematic loans on their books.

And who knows what their derivatives exposure (exclusive of mortgage-backed securities) is? For sure they have significant exposure to potentially bad loans beyond real estate—commercial paper and consumer debt come to mind.

It’s a tough situation to be in: when you’ve just shot yourself in the foot, just about the last thing you need is to have it be raining shoes. We are looking for a 40% decline here on waves of “unexpected” bad news; when and if we get there, we will reconnoiter and decide where to go next.

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