Alexandria, VA (July 16, 1998) --Moving to our second finalist, I'll say right off the bat that this one's going to be tough to beat. It's a strong superregional bank that thinks like a consumer products company (because that's what it is, after all) and looks like it will stay focused on servicing consumers as well as doing the traditional commercial banking thang. I'm talking about Norwest (NYSE: NOB), which is in the process of merging with Wells Fargo (NYSE: WFC).
Since we originally wrote about it (Part 1, Part 2, Part 3) immediately after the merger announcement with Wells Fargo, the company has worked to get analysts to understand what the strategy behind the merger is all about. At the time, I said, "I'm not sure how the market is coming along on understanding the strategy of the merger." With the stock up 15% since that time, I think there's a better understanding out there.
The most attractive part of Norwest is its many different channels of distribution. Instead of being just a branch banking company with maybe a website and ATMs, the company is the largest mortgage banker in the U.S. with 727 stores originating mortgages. Over the long-term, the company doesn't hold the mortgages, but sells them to investors in the form of asset-backed securities. It records revenues from this process in a complicated way that makes its financials a little harder to understand than other banks. This had been somewhat of a concern to me before I formed a better grasp on the accounting, but it's still not the easiest set of banking financials in the world to understand. For an explanation of the way accounting for securitizations works, see the appendix below. This is from a Fool that works with this stuff full-time and very generously sent this explanation to me with the offer to re-print it.
Mortgages are commodities today. Holding them isn't the most profitable thing in the world for a bank. Originating the mortgage, packaging it into securities that fit the varied needs of multiple investors, and servicing the mortgage consumes less capital on a perpetual basis and is more profitable. Like any commodity business, the company with the best process and best cost per unit of production will generate the best relative returns. That doesn't mean that over the long-term this is a great business to be in, because even the best producer in a highly commoditized business may not earn sufficient returns on capital. Over the foreseeable future, though, this unit of Norwest looks attractive. In addition, given that $10 billion of Norwest's mortgage loans were originated in California in 1997, Wells Fargo should benefit by being able to cross-market to these customers.
More on that and other things when we wrap up Norwest tomorrow.
Appendix: Securitization Accounting
Assume the Fool Bank makes on Foolish loan (which by definition means its a legit loan to honest people)
Step 1: The Foolish loan is originated.
Comments: There are no MSR entries for originating a loan. Nothing happens until the loan is sold/securitized with the servicing retained by the Fool Bank.
Step 2: 15-45 days later, the Fool loan is securitized.
Entry: Debit: MSR Asset
Credit: MSR Income
Comments: What's capitalized on the books is supposed to be the fair (or market) value of the servicing, which is based in no small part on the expected life of the Fool loan. Hence the importance of prepayment projections.
The income is recorded immediately and the asset amortized into expense over the expected life of the loan. Is that a recipe for trouble for the Wise or what?
Another way to view (and sometimes calculate) the servicing fair value is to determine the net present value of the expected cash flows received from servicing the loan, discounted at an "appropriate" rate.
Step 3a: Each period a portion of the asset is written off into expense in proportion to the expected cash flows.
Entry: Debit: MSR Amortization
Credit: MSR Accumulated Amort (contra)
Comment: Still awake? Here's a example: If I originally capitalized $1500 and estimated that I'll receive $24 net cash flows per month evenly for the next 8 years, then I should amortize $15.63 per month ($1500 x $24 / ($24 x 12 mos x 8 yrs). The expected cash flows should be re-evaluated each period.
Step 3b: Also each period, the fair value of the asset should be re-evaluated based on current conditions. If the current fair value is less than the remaining book value, impairment is created:
Entry if impairment exists: debit: Impairment Expense
credit: Impairment Reserve
That's basically it in a nutshell. Here's the major problems, in no particular order:
* The MSR asset needs to be funded on the balance sheet. It's a capital hog, and for banks that need to watch their capital ratios, it could be an issue.
* Valuing servicing market is not like valuing Treasuries. It's very subjective, with different companies using different assumptions. Liquidity comes and goes, values go up and down, and transaction prices are not publicly posted.
* Prepayment risk comes in three forms -- 1) projections for future prepayments increase disproportionately with interest rate moves, 2) actual prepayments are different than projections and 3) the timing of actual prepayments may not correlate with rate moves.