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Buffett Explains Why He Has So Much Invested in Wells Fargo

December 20, 2011 | About:

Buffett's investment record with Wells Fargo (NYSE:WFC) is actually surprisingly mixed. The first go round in the early 90s was obviously a grand slam home run. But he also did a lot of buying in the run up to the housing collapse and he is still underwater several years later.

I came across a surprisingly recent article where Buffett discussed with Fortune why he likes WFC so much. Here it is:

Dick Kovacevich specifically told me to ask you your views on tangible common equity.

What I pay attention to is earning power. Coca-Cola has no tangible common equity. But they've got huge earning power. And Wells ... you can't take away Wells' customer base. It grows quarter by quarter. And what you make money off of is customers. And you make money on customers by having a helluva spread on assets and not doing anything really dumb. And that's what they do.

Incidentally, they won't lend Berkshire money. They're not interested in national credits or any of that stuff where the spreads are narrow. We did a big deal about six or seven years ago on Finova, which we did jointly with Leucadia. And what was then the old First National of Boston sort of headed the deal up, and people would come in for $500 million or $200 million. Wells wasn't interested. There wasn't enough money in it, basically. I got a big kick out of that because that was exactly how they should think. Everybody else wanted to be in it, and they were doing it for 20 basis points or something of the sort. And they'd make commitments for all kinds of credit for 6 or 8 basis points, and the ones that were in the underwriting business, they would do it just get the underwriting.

But back to tangible common equity...

You don't make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on. And that's where people get all mixed up incidentally on things like the TARP. They say, 'Well, where'd the 5 billion go or where'd the 10 billion go that was put in?' That isn't what you make money on. You make money on that deposit base of $800 billion that they've got now. And that deposit base I guarantee you will cost Wells a lot less than it cost Wachovia. And they'll put out the money differently.

They'll have to work through a lot of this stuff that they inherited from Wachovia. Those option ARMs, they explained exactly how they break them down, and in the end they may lose 3 or 4 billion more. Nobody knows exactly. But I would say that California residential real estate is not deteriorating. It hasn't moved up. But it has flattened out with good volume recently. So my guess is that the option ARMs will work out about as they guessed.

What if the Treasury imposes new capital requirements? Will it hamper their earnings power?

I don't think it'll hamper their earnings. But if you make them sell a lot of common equity it would kill the common shareholder. It wouldn't increase the earning power in the future, and it would increase the shares outstanding. Wells, if they want another $10 billion in common equity or something like that in Wells, they'll have it in a very short period of time at this dividend rate. [In March, Wells cut its dividend by 85%.] Wells will be piling up the equity while they're paying nominal dividends. They could afford to pay the old dividend. But since they won't be paying the old dividend, that's $4 billion a year or something that they'll be adding to equity.

I would have been fine if they had just said, 'Look it, we'll quit paying any common dividend until our equity has gone up by whatever it might be, 10 or 15 billion.' And they'd get there in no time. Then they could pay the regular dividend. They elected to do it this other way because everybody seems to be kind of doing it. The idea of forgoing all or most of the dividend for a year to build the common equity ratio up, if that's what the government wants, that's fine. But that isn't really the key to the future of Wells, unless the regulators make it the key to the future of Wells. The key to the future of Wells is continuing to get the money in at very low costs, selling all kinds of services to their customer and having spreads like nobody else has.

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