Wells Fargo's Balancing Act

Wells Fargo ( WFC) will have more work to do than its rivals when potentially ugly assets banks have long kept sequestered are required to come onto their balance sheets.

Banks like Wells have used qualified special purpose entities, or QSPEs, for many years to reap benefits from both sides of the process of issuing and packaging debt. They collect fees from issuing all sorts of debt of varying quality, then securitize the assets and offload them into QSPEs. In those vehicles, banks continue to collect fees by servicing the debt without having to hold capital buffers against potential losses.

"If you could book the fees and didn't have to hold it on your balance sheet, you looked like a great earnings-power story," says Matthew Ko, a financial stock analyst at Profit Investment Management.

Ratio of Assets Off-Balance Sheet
vs. On-Balance Sheet
Source: The companies

However, the Financial Accounting Standards Board announced in June that financial companies will have to take all the off-balance sheet assets they hold in special vehicles, and put them back on their books in January. Evidence of troubles ahead has already emerged.

State Street ( STT) posted a $3.7 billion charge to bring asset-backed commercial paper onto its balance sheet in the second quarter. Bank of America ( BAC) forecast a hefty, yet-to-be-determined charge for credit card receivables ahead, which led Moody's Investors Service to put the company on ratings review Thursday.

The change could have a big impact for firms that have a larger swath of troubled assets hidden behind balance-sheet curtains, particularly Wells Fargo. The firm had more assets off-balance sheet than on -- $1.9 trillion vs. $1.29 trillion -- at the end of the first quarter. That's a ratio of 148%, up from 137% at the end of last year, as Wells' off-balance sheet assets and loss exposure increased.

"It's greater than their assets, so, yea, that is atypical," says Rochdale Securities bank analyst Richard Bove. "They're still undercapitalized relative to the stress-test demands and they have this huge thing sitting out there."

Wells wouldn't respond to questions about its off-balance sheet assets, how much of a role they played in the Federal Reserve's recent assessment of its capital needs, and how the firm is planning to handle the rule change.

"At this point, we have nothing to contribute to your story," spokeswoman Janis Smith said.

But for a company haunted by investors' capital concerns, Wells might have some explaining to do.

Off-Balance Exposure

Wells' maximum loss exposure to off-balance sheet items was roughly $100.6 billion as of March 31. Its QSPEs are mostly weighted in residential and commercial mortgages, while other off-balance sheet items called unconsolidated variable interest entities, or VIEs, mostly contain "investment funds" and collateralized debt obligations.

Barclays Capital analyst Jason Goldberg was unfazed by Wells' large amount of off-balance sheet exposure, noting that potential losses would only occur under an "assumed hypothetical circumstance, despite its extremely remote possibility." But there are some indications that Wells may have shakier assets off-balance sheet than on.

What the Fed: Off Balance Sheet Shell Game

In early May, CFO Howard Atkins said at a Barclays Capital conference that toxic Wachovia assets that couldn't be unwound were simply moved off balance sheet. He went on to say that "virtually all of the mortgage business that we originate, we do not keep on the company's balance sheet."

While Atkins characterized the new loans as the safe, "agency-conforming" type, he added that "somebody else is investing. We're just taking the origination business. And with interest rates low, I see no reason why that can't continue."

In a recent Q&A with the Charlotte Observer, Wells CEO John Stumpf seemed to skirt a question about Wells' exposure to bad debt by saying the lender had "originated some subprime that we did not keep on our balance sheet." But he did not say explicitly that it had been sold -- meaning Wells could still have exposure to those assets in QSPEs.

With the QSPE accounting change fast approaching, Wells may be trying harder to get rid of that debt. National Mortgage News reported last week that the firm "quietly" sold $600 million worth of sickly subprime loans for a relatively strong price of 35 cents on the dollar.

The strategy makes sense, given Wells' big capital gap determined by regulators and its aversion to traditional methods of plugging the hole.

The Fed determined that Wells needed to boost Tier 1 capital by at least $13.7 billion, more than any other firm except Bank of America. Some analysts and investors found this surprising, since Wells seemed to have maintained prudent lending standards before the crisis, and had written down Wachovia debt so significantly that it was posting gains on the assets by the first quarter.

But Fed officials included off-balance sheet entities when calculating how much Tier 1 capital firms would have to raise, an important clue to why Wells' sum was so significant.

The firm raised $500 million more than regulators had required, generating $8.6 billion through a stock offering, and the rest internally. Wells has said it will avoid additional stock offerings, preferred-to-common swaps or asset sales for future capital needs, setting up its own challenge for a quick, effective capital injection. While no one expects Wells to crumble from the weight of bad loans off the books - especially after its surprisingly strong second-quarter results on Wednesday - the company may have to raise even more capital to cover them.

Stressed Out

The charges that individual banks will face related to moving off-balance sheet assets onto their books will depend both on asset quality and how the assets had been valued. The amount of capital they will have to add to reserves will depend on what they already have stored up.

While it's difficult to compare QSPE statistics with competitors, because they don't all report items in the same way, even firms that are considered far more troubled than Wells seemed to have less exposure to QSPEs. Competitors still shackled by TARP, like Citigroup ( C) and BofA, have much less exposure to off-balance sheet items and their capital adequacy ratios are higher.

And while many large competitors decreased off-balance sheet assets, at least in proportion to what was on their books, Wells increased QSPEs and VIEs fairly significantly. In fact, the off-balance sheet assets of BofA, Citi, JPMorgan Chase ( JPM), Goldman Sachs ( GS) and Morgan Stanley ( MS) combined are only about $155 billion more than Wells alone.

Bank of America CFO Joe Price said on a conference call last week that his bank will probably need to put $150 billion worth of credit-card, home equity and other types of trusts back onto its balance sheet, and take a one-time charge for the shift during the first quarter.

However, executives on the BofA call assured investors that off-balance sheet items had been largely accounted for in reserves. Wells didn't mention its off-balance sheet exposure in a pre-recorded call.

"Other banks have built up their capital," says Bove. "Wells has not."