Reader Scott pointed out this BankImplode story, “Exclusive – Wells Fargo’s Commercial Portfolio is a ticking time bomb.” I can’t verify it, but it sounded plausible and contained some juicy details:
Wachovia, which Wells purchased last fall as it teetered on the brink of collapse, was so desperate to increase revenue in the last few years of its existence that it underwrote loans with extremely shoddy standards and paid traders to take them off their books.
According to sources currently working out these loans at Wells Fargo, when selling tranches of commercial mortgage-backed securities below the super senior tranche, Wachovia promised to pay the buyer’s risk premium by writing credit default swap contracts against these subordinate bonds. Dan Alpert of Westwood Capital says these were practices that he saw going on in the market at large.
Now I am not familiar with credit default swaps practices in CMBS, and informed readers are encouraged to correct me. My understanding prior to the credit contraction, CDS for subprime, and I’d assume commercial real estate bonds, were incredibly cheap (in fact, this applied across the credit spectrum). An investor could enter into a so-called negative basis trade on a raft of bonds and structured credit tranches. A “negative basis trade” occurs when the market yield on an instrument is greater than the cost of hedging it. That means you still had a positive yield if you bought an instrument even after you paid for a CDS against it. And that was lovely for a whole host of reasons. A lot of investment banks would treat the two positions as offsetting and let the investor lever his brains out against it (ignoring the new risk that had been introduced, that of counterparty risk). Eurobanks could and did treat the resulting position (if the original position was an AAA instrument and then hedged with an AAA counterparty) as requiring NO capital; some US investment banks were close to being that aggressive.
So that is a short way of saying these trades were pretty popular.
In most deals, the super-senior tranche was at most the top 4%. So what was the true economics of these trades?
The risk of loss sat with Wachovia. It held the super senior and retained the rest of the risk by writing CDS on its OWN deals, meaning it kept the downside exposure (well save on the equity layer, which was unrated and hence not CDS-able, but that was only 1% in subprime mortgage securitizations, and I assume no more in CMBS).
It also wound up with WORSE economics. Remember, the negative basis trade meant that the investor got more yield than it was giving up in premium. That puts Wachovia in the converse position, that it was giving up more yield than it got back in CDS premiums.
But it no doubt looked better on a current basis. The securitization probably enabled Wachovia to front load some income via fees, it still continued to show income thank to the CDS premiums received, and any reserving for losses had more favorable optics, at least until the deals really blow up:
Instead of selling the loans, sources inside Wells commercial group told BankImplode that they have been instructed to modify loans for customers in default by adjusting the interest rate, but not change the maturity date. Why? According to Meredith Whitney, founder and CEO of Meredith Whiney Advisory Group, Wells is working an accounting game of “extend and pretend.”
“If the bank doesn’t change a maturity date, then it does not have to take an impairment charge on its books, which would affect earnings,” says Whitney. If the loans don’t look like they are impaired, the rating agencies then do not have to downgrade the billions of CMBS that Wachovia sold to other banks and investors. Moody’s backed out of such a downgrade last month, after it previously warned downgrades were coming on $4.1 billion of Wachovia Bank commercial mortgage securities because it now expects principal and interest payments to continue.
Adds Whitney “We’ve seen Wells Fargo play modification games with its own loans. Why wouldn’t they do it with the loans they took on from Wachovia?” On Tuesday on CNBC, Whitney said again “I don’t know if those commercial modifications are going to work.”….
Unfortunately for investors, banks hold CDS liabilities off balance sheet and do not recognize them as a loss until they actually have to pay it. Wachovia at least disclosed in its third quarter 2008 10-K (on note 15) that credit derivatives are a regular part of how they finance commercial activities, and add that such instruments ‘don’t meet the criteria for designation as an accounting hedge’.
Given that a specific number for CDS exposure is not yet tenable, it’s hard to say how many billions are at risk. Yet most market players who follow this bank said when those CMBS de-lever and the derivatives come due, it will be a problem for which Wells is absolutely not adequately capitalized.
Now the scary bit about this is the throwaway comment from Dan Alpert at the very top, that a lot of banks were engaged in the same basic approach. And if the old Wachovia portfolio is any indicator, this movie will end badly:
One senior member of Wells Fargo’s commercial loan group who deals directly with the quandary, who spoke on the condition of anonymity, said, “One third of this commercial portfolio we took on from Wachovia is impaired and needs to be completely rewritten. I’ve just hired five more guys and we can’t keep up with the volume of defaults. Southeast Florida and Tampa are serious trouble spots.”
The CRE alarmists may yet be proven right, but the delayed reckoning due to CDS accounting means it may take a while for these shoes to start dropping.