By Dan Wilchins - Analysis
NEW YORK (Reuters) - Wells Fargo & Co (WFC.N) has gotten through the credit crunch so far smelling like a rose, but a skunk may yet cross its path.
Many analysts wonder if the company is setting aside enough money to cover losses as the United States struggles with the worst credit crisis since the Great Depression.
Because of questions about Wells Fargo's readiness for increased credit losses, some fund managers argue that the bank's shares may be overvalued relative to others in the sector.
Wells Fargo posted a $1.64 billion net income for the third quarter on Wednesday, or 49 cents a share, clobbering analyst estimates of 34 cents a share.
But part of that better-than-expected performance came from setting aside just $2.495 billion for loan losses -- about $500 million less than the second quarter.
Setting aside less money for losses is puzzling, because the bank's loan losses increased: the company charged off $1.995 billion for bad loans in the third quarter, or almost $500 million more than the second quarter.
"This should be a time when you set aside more money for losses, but Wells Fargo didn't," said James Ellman, president at Seacliff Capital in San Francisco.
Wrote Richard Staite, analyst at Atlantic Equities in London, "The low reserve build will raise questions."
Wells Fargo believes it has set aside enough money. The company's chief credit officer, Mike Loughlin, said in the company's earnings release, "Over the last 12 months, we have doubled the size of the (credit) allowance to address higher credit losses and support the strength of our balance sheet in these volatile times."
"We believe the allowance was adequate for losses inherent in the portfolio at September 30, 2008," Loughlin added.
Wells Fargo has allowances that are lower than its peers'. For example, the bank has a total of about $8 billion set aside over time to cover loan losses, about 1.6 times as much as its nonperforming loans. JPMorgan Chase & Co, on the other hand, has loan loss reserves equal to more than twice its nonperforming loans, excluding loans gained when it took on some of Washington Mutual's assets and liabilities.
Wells Fargo is clearly highly confident in its capital strength. When Treasury Secretary Hank Paulson, Federal Reserve Chairman Ben Bernanke and other senior government officials met with nine banks to offer them capital on generous terms on Monday, Wells Fargo Chairman Richard Kovacevich asked why the capital was necessary, the Wall Street Journal reported.
But the ferocity of the credit crisis has routinely surprised banks over the last four quarters, and two fund managers that spoke to Reuters under the condition of anonymity believe Wells Fargo will be surprised.
PREMIUM VALUATION
Wells Fargo shares command a premium valuation. In a market where many bank shares trade at about their book value, Wells Fargo's shares are about twice their book value, and about three times their tangible book value.
Even if the bank is a solid underwriter of loans, it may not deserve such a high valuation relative to its peers, the two fund managers said.
The bank is also taking on substantial risk as it acquires Wachovia Corp WB.N in a takeover originally valued at about $15 billion. That acquisition requires the bank to sell $20 billion of shares in a difficult environment for raising equity.
Banks are broadly suffering now as the housing sector weakens and unemployment increases. Credit losses are rising, and are expected to get even worse after the year-long credit crunch reached new intensity in September.
Wells Fargo has done well during this downturn, but the bank still has big risks left on its balance sheet, including about $84 billion of home equity loans, not to mention other types of consumer loans.
"On every front, Wells Fargo and other banks are facing more pressure," said Sean Egan, principal at bond rating agency Egan-Jones Ratings.
(Editing by Gary Hill)
