Is Wells Fargo Making AIG’s Suicidal Mistake?

WellsFlannelManBIG AP 10 03 08

Wells Fargo may be making the same mistake that destroyed AIG, turning the insurance company into a seemingly endless blackhole of losses.

The San Francisco bank has responded with irritation to media reports and questions from research analysts about its derivatives exposure. It insists it has a firm handle on the losses it could take from credit default swaps Wachovia sold and it inherited.


We read closely the company’s annual report. It has a brief and very boring discussion of exposure to credit derivatives. But nowhere does the company express an awareness of (or exposure to) what we now think of as Collateral Call Risk.

It was not bond defaults that killed AIG, after all.  It was collateral calls.

Recall that AIG also thought that it was exercising the utmost caution, hiring a Wharton/Yale professor to build “risk models,” and AIG was confident that many of the bonds on which it wrote insurance would never default. And AIG was right—many of those bonds didn’t default and still haven’t. But that wasn’t enough to save AIG.

What AIG’s risk models missed was the possibility that AIG would have to post additional collateral in the event of a decline in the value or ratings of bonds that had yet to default. They had only analysed the likelihood that they would be forced to pay off credit default swap policies insuring bond defaults.

In other words, AIG’s PhDs analysed only the most unlikely risk the company faced–defaults–and not a far more likely risk: That the value of the bonds it was insuring might decline, forcing it to come up with more capital as collateral.

Is it possible that even after AIG, Wells Fargo could make the same stupid mistake? Could they really have overlooked Collateral Call risk?

At this point, given the widespread idiocy in the banking sector, anything’s possible.

We’re not sure Wells Fargo has overlooked this risk. We’re not even sure that the company has this risk—their annual report discussion isn’t detailed enough for us to tell.  But neither, we expect, was AIG’s.

We’re told that the right to demand more collateral is completely standard in such credit default swaps, so it is likely that Wells does have Collateral Call Risk. Which is what makes it alarming that we haven’t seen evidence that they have taken this risk into account.

In fact, when Wells Fargo does discuss its exposure to the credit default swaps, it sounds frighteningly like AIG, assuring us that the likelihood of the repurchase obligations being triggered is remote and that the residual value of the underlying bonds hedges the risk. But it says nothing about collateral risk.

Here’s the discussion in the annual report:

In certain loan sales or securitizations, we provide recourse to the buyer whereby we are  required to repurchase loans at par value plus accrued interest on the occurrence of certain credit-related events within a certain period of time. The maximum risk of loss represents the outstanding principal balance of the loans sold or securitized that are subject to recourse provisions, but the likelihood of the repurchase of the entire balance is remote and amounts paid can be recovered in whole or in part from the sale of collateral. In 2008 and in 2007, we did not repurchase a significant amount of loans associated with these agreements.

As we said, there are two possible ways to account for the lack of discussion of Collateral Call Risk.

Either Wachovia wrote its derivative contracts in ways that don’t permit buyers to demand more collateral or Wells Fargo is not disclosing this risk.  (A third possibility—that they don’t even seem aware that they have this risk — seems remote after AIG.)

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.