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Saturday, October 4, 2008

Is Buffett on a buying spree?

In the last fortnight, Buffett seems to have started buying more assets in the US. There's the $5 Billion Constellation Energy Group deal, then, followed by another $5 Billion (+ another $5 Billion) Goldman Sachs deal, then, a $3 Billion General Electric deal, and now, it seems Well Fargo (where Berkshire is by far the largest shareholder with 9% outstanding shares compared to the next institutional investor at 3.6%) now plans to bid approximately $15 Billion (Wachovia shareholders will receive 0.1991 shares of Wells Fargo for every Wachovia share, valuing Wachovia at about $7 per share based on Wells Fargo share price of approximately $35) for Wachovia (at one stage, 4th largest bank in the U.S. last year) and scuttles with Citi's earlier bid which had goverment backing. Wells Fargo Chairman Dick Kovacevich claims that he did not discuss the proposed bid with Buffett (despite Buffett being the major shareholder). Wells Fargo's latest bid is higher (Citi originally proposed to pay just a paltry $2.2 Billion plus partial government guarantees on $312 billion of Wachovia's mortgages), although it does not carry the same extent of government guarantee as Citi's, and Wells Fargo is still exposed to what appears to be very large risks.

It appears the major risks for Wells Fargo is that it will be acquiring $122 billion of "option pay" mortgages, where borrowers can choose every month whether to only pay interest on their mortgages, pay down some portion of their loan, and sometimes to pay less than the interest due. In a plummeting housing market, such assets are seen as highly toxic, and Wells Fargo said it expects to write the assets down by $32 billion over time. Given Wells Fargo's proven history of managing risks successfully with its prudent banking practices (the bank thrived the last year when its peers are going bust), my guess is that the $32 Billion contains elements of prudence. Note that $32 Billion is approximately 30%, suggesting that Well Fargo themselves probably think there is still more downside to the U.S. Housing markets. If one is optimistic, perhaps another 15%-20% more downside to go, suggesting that we are still not quite bottom yet, although it could be time to start nibbling (not gobbling) US assets.

The bank estimates the total assets it is taking on will have to be written down by $74 billion in the years following the deal. Wells Fargo will issue up to $20 billion of securities, likely mostly common equity, to help offset those losses. These are big numbers for Wells Fargo, whose net worth as a company as measured by balance sheet shareholders' equity, was about $48 billion at the end of June. In other words, there is still - according to Wells Fargo - the risk of going bust, although obviously, the bank does not expect to go bust from this deal, when it appears to outbid Citi for Wachovia.

Given the huge risk, why is Wells Fargo doing it? According to analysts, the strategic benefits to Wells Fargo are "compelling". Wachovia has a strong branch presence on the East Coast, patching a major gap in Wells Fargo's network. U.S. banks have been scrambling to build or buy branches, which allow them to raise money from depositors. In a credit crunch, deposit funding can be cheap compared to borrowing in bond markets. The Wachovia bid, if successful, would help bolster Wells Fargo's network of U.S. branches from 3,400 to 6,700. Naturally, this bid would be a huge loss to Citi, whose own network of U.S. branches is only 1,000 at the moment, notwitstanding the much lower bid. Furthermore, Wells Fargo's deal will keep Wachovia's retail brokerage operations (14,600 brokers) intact unlike Citi's deal which intended to only acquire the banking operations.

US markets cheered Wells Fargo's bid very loudly, by sending Wachovia's stock price up by a whopping 59% last night, and penalized Citi's price down substantially by 18%. At the time of writing, Wells Fargo's capitalization ($114B at $34.56) is now larger than Citi ($100B at $18.35). To say Citi is pissed off is under-stating it, and they will take this to court, since this deal was apparently in the bag with "exclusivity agreement" (whatever this means - http://www.independent.co.uk/news/business/news/citi-threatens-legal-action-as-wells-fargo-swoops-on-wachovia-950874.html) before Wells Fargo's entry, even though Wells Fargo's bid is a much better deal for Wachovia's shareholders. The powerful Federal Deposit Insurance Corp., Sheila Bair, said her agency "stands behind its previously announced agreement with Citigroup." It's not exactly clear to me what FIDC statement means, since Wachovia's shareholders would eventually need to approve deals like this, so, it's a no brainer that unless Citi sweetens the deal substantially (the previous Citi's deal would only value Wachovia's shares at around $2 apparently taking into account the entirity of the deal), then, Wachovia's shareholders will not turn down a $7 offer, and Mr Market seemed to understand this very well by bidding Wells Fargo share price up by 59% last night to $6.21. My guess is that the FIDC - which was previously a part of Citi's bid to provide insurance - is merely stating that IF Citi's bid was successful, then, FIDC will honor its earlier obligations, since Wells Fargo's latest bid does not require FIDC involvement. Wells Fargo also issued this press statement "From what we have learned to date, the transaction is in the best interests of shareholders, creditors, the deposit insurance fund, other stakeholders and taxpayers." (http://www.marketwatch.com/news/story/statement-major-shareholders-wachovia-corporation/story.aspx?guid=%7B38E3EDA1-F7CF-45A7-A74D-9CD9A72FA25B%7D&dist=hppr)

Wachovia's employees were apparently happy with this latest bid by Wells Fargo. At Wachovia's headquarters in Charlotte, N.C., where 20,000 employees had anticipated draconian cuts, there was elation in the hallways. "Even in bull markets, I've never seen people this happy," said one Wachovia employee. (http://online.wsj.com/article/SB122303190029501925.html) :-)

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