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GE vs Wells Fargo: Who's Really Subprime?
April 17, 2007

GE vs Wells Fargo: Who's Really Subprime?

The other day, a reader who works in the bank IR channel reflected that banks are "losing their sense of humor" now five plus years into a Fed tightening cycle. Business conditions are growing less hospitable for lenders and borrowers alike, thus convincing investors that banks represent good value in the near-term is not easy.

CNBC pundit Jim Cramer thinks that the worst is over for the banks and, indeed, that lending is back in vogue, this after a couple of weeks of hand wringing from risk-averse investors. Bulls like Cramer are right, in a sense, because loan loss rates and credit spreads both remain very tight, well-below long-term averages. But buying into the Cramerian, bullish on banks world view means that you believe this extraordinary situation is stable.

One name that's been in the front seat of the roller coaster over the past month is Wells Fargo & Co. (NYSE:WFC), at $430 billion in total assets one of the larger US bank holding companies and by reputation a leading subprime lender. WFC sold off sharply in March when the investor hoard decided that subprime lending was unattractive. But with attention spans comparable to domesticated rodents, the very same group of investors now is buying WFC and its peers. Go figure.

When we say subprime, it must be said that WFC and most larger US banks occupy the upper circles of the inferno of non-investment grade consumer lending. Unlike General Electric (NYSE:GE) and other non-bank lenders, where double digit percentage default rates are commonplace, most commercial banks don't go there, preferring the safer climes of mid-teens loan yields and single-digit default rates.

Late last week, GE announced that in Q1 2007, the number of people defaulting on mortgage payments to its GE Money unit soared, driving the delinquency rate for GE Money to 5.5% or 550 basis points of default. In Q1, GE lost $373 million in subprime mortgages and added $330 million to reserves in Q1.

Of interest, defaults for GE Money Bank barely reached 500bp in 2006 vs 433bp in 2005 and 743bp in 2004, according to data from the FDIC and calculations by the IRA Bank Monitor. The dozen or so banks in the WFC group, by comparison, in aggregate reported just 50bp of default during all of 2006, 47bp in 2005 and a whopping 80bp back in 2002, the near-term peak.

The two credit card units of WFC, which combined account for $6 billion in assets, sport default rates in the 200-300bp range, but are still not in GE's category. The $13 billion asset Wells Fargo Bank Northwest, National Association, reported 175bp of defaults in 2006, half a standard deviation below peer, and had a 90% loss given default ("LGD") for the same period.

One telltale differentiator between WFC and GE's Money unit is found in the gross loan spread, 761bp for the former and 1,550bp for the latter. This measure excludes fees, but when added to the default rates, provides a stark comparison between two business models in the same industry. Of interest, at 70% the LGD for GE's Money Bank unit has consistently outperformed that of WFC and other large bank peers, a testament to the credit culture at the GE unit.

The differences in performance between WFC and the GE Money illustrate two different business model strategies operating in the consumer finance marketplace. If Jim Cramer is right and the worst is over in lending, subprime or otherwise, then GE Money's default rate should trend lower as 2007 progresses.

If the bears are right, though, and credit spreads are on the verge of an outward readjustment, look for GE and WFC both to challenge recent default rate peaks. In that event, the differences between individual players will recede into the background, overwhelmed by the growing noise of a generalized credit crunch.

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