Lenders are reporting profits. Washington is finally dealing with banks' toxic assets. Stocks have rallied somewhat. Is the worst over for big banks?
One of the industry's healthiest players, Wells Fargo (WFC), isn't celebrating just yet. Chief Executive John G. Stumpf's main worries: the recession and unemployment. Stumpf is bolstering the bank's books and making fresh loans. But a deep, prolonged downturn with double-digit unemployment could derail his plan to modify troubled mortgages and absorb Wachovia, the bank that Wells purchased for $15 billion in January. "This downturn is different," says the 55-year-old banker. "It will define a generation."
The economy remains a giant unknown for the entire industry. The government's own "stress tests" for banks use 10% unemployment as the worst-case scenario. But a growing number of economists are predicting that the jobless figure could easily blow past that level in the next year. As unemployment rises, more borrowers run into trouble, leaving lenders to cope with the losses.
Wells, the No. 2 mortgage lender, has weathered the financial crisis better than most. The San Francisco lender's credit rating is among the highest for any U.S. bank, even after a downgrade by Moody's Investors Service (MCO) on Mar. 25. Last year profits fell 71%, to $2.4 billion. But that compares with an 83% drop for Bank of America (BAC) and a $28 billion loss for Citigroup (C).
The Wachovia acquisition is a big source of Wells' concern. Stumpf, who was promoted to CEO in 2007, inherited $446 billion in consumer and commercial loans in the deal. The portfolio includes $95 billion of risky adjustable-rate mortgages called option ARMs, which allow borrowers to defer principal and interest. "They can't change the fact that they bought a bunch of crap and the economy is sinking like a lead anvil," says Martin D. Weiss of researcher Weiss Group.
Stumpf knows all about bad debt. At his first bank job, he reviewed delinquent car loans by day and repossessed the vehicles by night. He also dealt with dicey deals in the wake of the savings and loan crisis in the early 1990s. Stumpf was the point man for Norwest Bank (Wells' predecessor) on its $5.5 billion purchase of United Banks of Colorado, which was buried in bad debt. Later, he handled 30 acquisitions of troubled Texas banks.
Before the Wachovia deal closed, Stumpf boosted Wells' reserves for bad loans by $5.6 billion and took a $37.2 billion writedown on Wachovia. In essence, that assumes roughly half of the borrowers with option ARMs will default. By taking a huge hit up front, Wells is less likely to surprise investors with acquisition-related losses—as rivals have done after big deals. "It's a pretty draconian estimate regardless of how toxic the assets," says Doug Rao, portfolio manager at Marsico Capital Management, a Wells shareholder. "They can generate strong returns if they successfully modify those loans."
Stumpf set up a separate division to rework the toxic mortgages in January. The group initially is focusing on customers in Florida and California, where foreclosures are severe. Wells sent out letters to 30,000 borrowers, offering to lower interest rates and extend mortgage terms. The bank also plans to cut principal on some loans—a costly move that few lenders have been willing to make even though it has proven more successful than other measures. Some 22,500 of those customers are working with Wells to change their loans.
But all of this hard work could be for naught if the economy substantially worsens. "Who knows where the country goes from here? A year from now, excessive amounts of unemployment and all these attempts to stabilize the market might not work," says Michael J. Heid, who is overseeing the loan modification work for Wells. Says Stumpf: "We didn't get into this overnight, and we won't get out overnight."