Back in mid-January, at the height of the first real sell-off we’ve seen in this bear market, I offered that there were only three big financial companies worth buying: American Express (AXP), Wells Fargo (WFC), and US Bancorp (USB). I liked those two banks because they have great, conservative management teams that promote good underwriting practices, and weren’t booking short-term profits during the boom years with alphabet soup assets and NINJA loans that were set to implode. You can’t say that much about a lot of other banks, which is why I think it’s irresponsible to speculate in the lower quality financial names.

What was unusual about the last several months is that short interest in banks has soared across the board (the new SEC proposal to limit the shorting of financials is of questionable design at best, but that’s another article). I can understand Washington Mutual (WM) seeing short interest triple since the start of the year, but both Wells Fargo and US Bank saw their short interest double over that period, as well.

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I’m sure short covering has a lot to do with the big rally we’ve seen since Wells’ earnings; WFC is up 35% and USB is up 21% since the report on exceptionally high volume. Given how oversold everything has been – something I’ve pointed out at various times – the quickness of the snapback rally is to be expected. Still, the lesser financial institutions – your Wachovias (WB) and WaMus – haven’t proven they know what they’re doing in this environment.

It’s been a rocky 2008, but Wells Fargo and USB established that they are the two best-managed banks out there. Wachovia and WaMu have shown they are particularly effective at destroying shareholder value. How so?

The biggest differences between the wheat and the chaff are loan quality, loss provisioning and capital positioning. Looking at the delinquent loan ratios from USB, one can easily make out that 59 bps of their loans are non-performing, and including delinquencies this rises to a flat 1%. The rates at Wells Fargo are higher at 1% non-performing and 1.46% including delinquencies. From the spring, Wachovia’s nonperforming assets, including delinquencies, was 1.91%, and if current trends hold that rate should rise to about 2.4% for the quarter they are waiting to report.

Despite being in a hole already because their assets are doing roughly twice as bad as the better banks, Wachovia is in no hurry to increase its loss provisions. While investors might favor conservatism in general, but especially in times like these, Wells and US Bancorp continue to take much higher loss provisions (and still turn a profit). So as US Bank has allowances for 1.6% of total loans and 270% of non-performing loans, Wells Fargo has allowances for 1.88% of total loans and 184% of non-performing loans, Wachovia takes relatively small allowances of 1.37% of total loans and just 84% of non-performing loans. Truing up, by my count, would require another $1.25 billion against…

An already strained capital base. Wachovia was very slow to cut their dividend, a painful but necessary step because they entered a poor lending environment with less Tier One capital than, to pick two random companies, Wells Fargo and US Bancorp. It also doesn’t help that Wachovia’s net interest margin is highly inferior to that of either of those companies; in fact, Wells Fargo does well enough from their core banking business that they can raise their dividend 10% in times like this because of a Tier One capital build – not that Wachovia happened to raise (and subsequentially chew through) a $3.5 billion capital offering earlier in the year. And, although I think Wells’ dividend raise is a fairly aggressive move for a bank that got where it is through conservative management, I’ll submit that part of the logic behind distributing capital to shareholders now is to give Wells more flexibility should they be called on by the government to take over a failing bank. This is counterintuitive at first – wouldn’t more capital be better? But having less excess capital will let Wells be choosy as to what offers they go after, and it will help them get a better price should they decide to make an acquisition.

Mercifully, we’re still a few days away from hearing just how bad things are at Wachovia and WaMu, such that this financial-led rally might go on a bit longer. But when the gruesome financial two-some of Wachovia and Washington Mutual report on Tuesday, July 22nd, it will be a roulette spin as to the reaction. I don’t think it’s speculating to place my chips on Wachovia needing to take another huge loss provision because their existing ones are too low, and loan quality will continue to deteriorate, but the reaction is what counts… and I think that is simply too difficult to game. The winners are being telegraphed here; no purpose in trying to pick the fifth horse to finish the race.

Disclosure: None

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James Cullen

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