For Wells, Relief Over Pick-a-Pay Portfolio

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Wells Fargo & Co. executives will be cross-examined about their loan book next week in a way they haven't been in awhile.

Abandoning its long-standing practice of issuing prerecorded comments on quarterly earnings, Wells executives on Wednesday will present fourth-quarter results live and engage in a give-and-take with analysts.

The questioning is likely to dwell more on where the bank is losing money than where it's earning it, and a great deal of short-term focus will be on the $2 billion blow to Wells' quarterly results from repurchasing preferred stock issued under the Troubled Asset Relief Program. But when it comes to a major area of prior concern — the biggest portfolio Wells acquired in its 2008 purchase of Wachovia Corp. — the news is getting better.

For the past year, Wells has grappled with the $119 billion portfolio of Pick-a-Pay loans it inherited from Wachovia. Amid grim news about option adjustable-rate mortgages in general, investors and analysts worried that losses on the portfolio would overwhelm even the $26.5 billion of reserves set aside at the time of the deal. While Pick-a-Pay was far from the only troubled asset that felled Wachovia, it was hard to estimate the extent of the portfolio's damage at the beginning of 2009, when the housing market was still in free fall.

A year later, the portfolio is still widely reviled, but analysts and other observers predict the worst of the danger from Pick-a-Pay has passed.

"I think the product stinks," said Nancy Bush of NAB Research LLC. "And Wells Fargo thinks the product stinks. But compared to the other option ARMs, [Pick-a-Pays] were pretty well underwritten, by and large."

Over the past few months, Wells has been relatively upbeat about the portfolio. Chairman and Chief Executive John Stumpf said at a Goldman Sachs conference last month that it has been performing better than expected.

"I don't think they would have made the statements they did unless you saw continued improvement," said Joe Morford, an analyst at RBC Capital Markets.

Much of this optimism is a function of the banking sector's gradually improving expectations for consumer credit losses. Wells now expects them to peak before midyear.

That would allow the bank to take some accounting gains on the impaired portion of a major portfolio.

After writedowns, modifications and repayments, the Pick-a-Pay portfolio's carrying value is down to $88 billion. And negative amortization, the bete noire of the portfolio, has been dropping.

In Wells' prerecorded third-quarter earnings call in October, Howard Atkins, Wells' chief financial officer, raised the prospect that, beginning in the fourth quarter, Wells could begin "recapturing a portion of the life-of-loan purchase accounting marks" it took on the impaired portfolio.

Bush and other analysts said this quarter is likely too soon for Wells to "declare victory" on Pick-a-Pay — because of both macro concerns about the housing market and the difficulty of predicting how the $50 billion unimpaired portion of the portfolio will perform.

While those loans are still performing according to plan, she said, "If they're over-reserved, they're going to stay over-reserved over the next couple quarters."

Given Wells' credit issues on other fronts, however, taking out much of the uncertainty over Pick-a-Pay should be welcome news.

At the beginning of the quarter, commercial real estate loans from the Wachovia legacy portfolio were deteriorating at a significantly increasing rate, with Wells having already run through $3.9 billion of $10.4 billion of reserves that, at the time of the acquisition, were intended to cover 24 months of writedowns.

While the Wachovia assets have accounted for most of the deterioration of late — Wells' legacy commercial losses held virtually steady from the second quarter to the third — the cumulative totals render Wells more exposed to the commercial real estate than the other big banks, analysts said.

Bush expects more commercial pain in this quarter and several more to come.

"The old Wells got fairly conservative on commercial real estate about two years before some of their peers did," Bush said.

"But with many of their commercial loans in California … the geography, which was a positive for so many years, is now a headwind."

Up until now, Wells has predicted that the inflection point in its overall commercial portfolio should come somewhere in the third or fourth quarter of 2010. Evidence that Wells' timing is still on target would do a great deal to shift attention back to the banking company's strengths, perhaps chief among them its mortgage origination business and a net interest margin that stood at 4.36% last quarter.

For Bush, that is the number most likely to matter in the long run, though she does not expect them to be at the fore next week. After so many years of prerecorded calls, skeptics will be looking forward to taking a shot at management.

"Howard Atkins is going to get some pretty direct questions," she predicted.

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