Buffett and Credit Risk: Wells Fargo

Using some of the concepts laid in my book (search "Asif Rajani" on Amazon), we try to understand the rationality behind the October 1990 purchase of Wells Fargo by Berkshire Hathaway.

The investment was buying 5 million shares out of the 52 million outstanding at an average price of 57.88$:

The big picture here is that earlier in the year, Wells Fargo was trading as high as $86 per share, but then investors began divesting in Californian banks fearing a recession that would cause big amounts of loan losses in the commercial and residential real estate market.

Since Wells Fargo had the most commercial real estate of any California bank, investors sold their stock and short sellers added to the downside pressure.

Looking to the bank fundamentals from a profitability point of view we could see that:

1.??????Return on Assets (RoA):

2.??????Return on Equity (RoE):

Furthermore,

Pretty healthy numbers. As written in my book, the RoE can be decomposed to give a better idea about the drivers of the RoE:

From here you can see that if a bank operates with a Leverage of around 20x, i.e., 5% of equity, then issues with the Profit Margin can quickly escalate into a catastrophe.

Warren Buffet says that banks are good business if they issue loans responsibly and curtailed costs, meaning if they control the two of the most important components of the Profit Margin:

1.??????Control their cost-to-income ratio:

??2.??????Control the cost of risk:

On the cost side it was known that their cost to income was 20 to 30% lower than Bank of America or First Interstate:

On the Cost of Risk side, the the Asset size of Wells Fargo in 1990 was roughly:

Out of which the most pressured by the Californian recession was the Commercial Real Estate (CRE) that accounted for:

So, a potential huge loss could be calculated roughly as:

But because of the strong income generated, the posted earning in 1989 were:

Buffett estimated that even in the case above, with $ 1.44 billion of additional losses, the bank would have some negative results in one year but given the historical of growing business seen above, it would then generate very strong cash-flows from there onwards.

Furthermore, it should be noted the big margin of safety of the investment. Based on:

A quick cash-flow discount calculation constant earnings gave Buffett a discount of around 55% on the price paid, meaning a great margin of safety against potential additional losses:

As Buffett said in one of Berkshire’s annual meetings: “Banking doesn’t have to be a bad business, but it often is, (...) bankers dont has to do stupid things, but they often do.” He describes a high-risk loan as any loan made by a stupid banker. When Buffett purchased Wells Fargo, he bet that Reichardt was not a stupid banker. Berkshire ’s bet paid off hugely and Wells Fargo was one of the most important positions detained by Berkshire till few years ago. I’ll cover the episode and the investment in Bank of America in a separate article.

?Sources:

The Warren Buffett Way, Robert G. Hagstrom, John Wiley & Sons, Inc., 2014.

Credit Risk: The Easy Path. From Rookie to Expert, Asif Rajani, 2022.