There is a lot to learn from Wachovia’s fall from $38 per share in 2008 to approximately $2 per share prior to being acquired by Wells Fargo stock for less than 10% of its book value during the financial crisis. If I had to answer the question “What disastrous investment was most likely to ensure a long-term investor”, the answer would almost certainly be Wachovia.
Heading into the summer of 2008, Wachovia was a company earning almost $10 billion per year in annual profits, operating banking subsidiaries across the northeast and southeast portions of the United States, and had such a strong-business model that it had reported profits in 158 years of the 161 it had operated between 1879 and 2008 and had paid out a dividend in 147 of those years.
For someone who was making an investment in Wachovia, it was a conservative, old-school, generation-to-generation type of no-nonsense investment. The company was well-capitalized, and it engaged in traditional lending, asset and wealth management, and had a dividend growth rate of 8.68% from 1958 until 2008. It thrived during the financial crisis of the late 1980s. It was supposed to be one of the “good banks.”
Then, in 2006, management decided that it wanted to get into the subprime mortgage market by spending $25.5 billion to acquire Golden West Financial, a specialty mortgage company that permitted borrowers to obtain as large of a home as possible through interest-only and delayed interest loans that would result in massive balloon payments at the end of the loan term that would require refinancing.
In order to identify the risk posed by the Golden West Financial acquisition in real time, investors would have to possess the historical acumen to recognize that bank crises tend to afflict financial institutions with mortgage arms the hardest. The reason is inherent in the nature of a mortgage, in which hundreds of thousands of dollars are doled out in exchange for a claim against a piece of property and a claim against the individual(s) or entities engaged in the borrowing. And the latter is a shaky source of possible repayment because many states deem mortgages as non-recourse debt (i.e. you can’t pursue a deficiency against the borrower for the remaining balance owed after foreclosure) and even in states where deficiency recoveries are permitted, people who can’t pay the mortgage generally lack other reachable assets as well.
This means that the typical Golden West mortgage leading into the financial crisis was only backed by the asset itself–the home. Well, that’s a problem because it was accepting down payments of only 5% down with interest-only mortgage payments at the start (and there was no private mortgage insurance program in place either). When those homes fell in value 20% to 40% and homebuyers walked away, the results were catastrophic because a bad loan is instantly realized upon foreclosure. A $300,000 mortgage loan that results in a foreclosure recovery of $200,000 (and even less once foreclosure sale fees and expenses are taken into account). When quick, six-figure losses mount across 100,000 foreclosures occurring simultaneously, you are looking at a $10 billion instant problem.
And, from the financial institution’s perspective, these Golden West liability cannot be “shut off” via a bankruptcy proceeding that protects the parent entity due to an arcane banking rule called the “source of strength” doctrine which prohibits financial companies from quarantining bad business divisions that are imploding to protect the profits of the parent company. It’s one of the most important exceptions to the general American rule in favor of limited liability that exists.
The investor community often talks about the need to monitor banking-sector investments without specifying how to do so. The answer is that you have to pay attention to the mortgage arms of a particular bank holding, and from there, get an idea of how much equity is in the recent homes being foreclosed and what the typical borrower profile is. For what it is worth, it is almost always the subprime mortgages that cause the trouble. As a result, I would be generally wary of investing in any firm whose mortgage division relies upon subprime mortgages to earn a profit because the high growth during ordinary times can easily be wiped out. After all, Wachovia, which was so strong that it survived the Great Depression and multiple world wars and extreme technological change, was largely brought down by its 2006 acquisition of Golden West.