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By thelegendoftomvu
April 28, 2009

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Wells Fargo will have 40 billion in annual pre-provision income in a very short period of time. The main worry is that regulators decide to make Wells build a lot of tangible common equity in an even shorter period of time.

At present rates, even with the merger with Wachovia, it would take Wells about a year to build up 10 billion Tangible Common equity through retaining earnings.

If the regulators said, " you have six months (that is the time period they are throwing around) to generate an additional 50 billion dollars in tangible common equity, Wells shareholders would be in a really bad spot.

1. They would try to turn to the capital markets at a very bad time for generating capital. The share price would likely plummet just as investors feared the worst case dilution of share-holder value. This scenario would become a self-fulfilling cycle of plummeting share-price and dilution of value. Instead of six months, Wells would have about 6 seconds to generate the capital it needs in private markets.

2. Most likely Wells would need to turn to the government for all or part of the capital. This would be some kind of combination of converting preferred shares to common stock and of flat-out selling new common shares to the government (more TARP money). It is interesting/scary to note that if the treasury department were trying to make the most money from their Tarp investments they would take as much of the Wells franchise as possible. Meaning, they would scare the ... out of common holders with a huge demand in terms of tangible common equity, then they'd convert preferreds to common stock and buy as much stock as possible at low prices with Tarp money. Not only is it possible that they could do this, there is a scenario where we could see the the psychological motivation for them to do this. At a time when the Treasury is getting toasted for putting good money after bad at AIG, why not force the (partial) take over of a perfectly wonderful bank like Wells Fargo at a low price? They would undoubtedly make a ton of money by doing that. Of course, there could be a political backlash at a time when the prevailing counter-politics is charged with rhetoric about socialism, not to mention the fact that most politicians are too stupid to understand that the government would be getting a terrific deal by screwing over the Wells shareholders... The Obama politicians might not want to do that. Who knows? But it scares me.

The other side of this is that tangible common equity is crap. Wells has been and remains above the minimum requirements by law. Tangible common equity has become a fad as of recently in the banking sector. If someone were to come to me and ask if I wanted to buy the Coca Cola company, the whole damn thing, but without any tangible common equity. I'd ask, "how much?" If the person then snickered and told me that the tangible common equity was worth 0 dollars, but they sell it to me for 1 million dollars, I'd say deal and instantly hit my bank account for the best investment purchase since Seward's folly.

Right now Wells common stock holders hold a piece of a business that is worth massive sums of money based on its ability to generate 40 billion pre-provision income in the not to distant future. It is not at all crazy to think this company is worth $50 a share in underlying intrinsic value. If the US government halved the shareholder's claim to this underlying value through a huge dilution, it would still be worth 25 dollars a share in my opinion, so there is some safety, even in that scenario.

So this is the game we are currently playing. We (Wells common stock holders) currently own something worth much more than the market is willing to pay for it. The only thing that could change that fact is if the government forces Wells to do a cataclysmic share offering. If they don't, if the forced TCE raise is small or if it is non-existent (aka Wells is allowed to earn its increased ratio), then we will be sitting pretty. I think the share price will rocket up. Even if it does not rocket up immediately, it eventually will as Wells business performs well in the coming three years and we suffer no further dilution. The return will easily be 30% annualized to common shareholders. This fact, I believe, is holding the price somewhat steady, despite the considerable uncertainty about what the government will do.

A few last thoughts. Coach K has every right to be mad. The obsession over this new metric of tangible common equity in concert with government "stress tests" has really put tremendous pressure on his common holders. In my last post I referred to the fact that I don't like his personality. The truth is I don't know him at all. I have never even observed him outside of canned speeches. For all I know he is a really nice guy. I was simply referring to the fact that dogs who howl have usually been hit. It is often true, but not always.

If I read headlines about him saying the stress tests are "asinine", which indeed they are, I don't like it. It is out of his hands and he can be stoic or not. In my past experience, however, those who make a lot of noise and get real mad are lacking in other departments. I can remember Skilling calling an analyst a "... idiot" who asked him about Enron's off-balance sheet transactions. It was not that Skilling's ego was hurt, it was that the analyst had hit his weak point and the expletive was a sign that party was about to end.

Coach K has every right to be mad about this situation, because his common shareholders have been forced to become speculators by virtue of the fact that the government could force them to any result. Even Warren Buffett is a speculator at this point because he is hoping that the US government will let Wells earn its way to a higher ratio. And there is some evidence it will. The government has indicated they will consider the ability to generate revenue, as well as the level of current reserves to non-performing assets, when they decide how much more capital will be required. But it is still speculation, even for Buffett. One of Buffett's admitted mistakes last year was in two Irish Banks. I don't think Wells can go that wrong over the long haul, but I do think that if the government forces a huge dilution, we could be at $25 a share in 5 years rather than $60 a share.

I am obviously speculating here and hoping for the best for common stock holder, but at the end of the day, the US government is the same government that once forced Eskimos in the region where I used to teach high school to eat cereal covered in radiation. The US government can be ... crazy because it represents us, and sometimes we are crazy. It might do the right thing. It might do the wrong thing. Or it might do something that makes no sense at all. We'll see.

Good luck.