The financial markets appear to be on edge this week ahead of the government’s release of the methodology for “stress testing” the top banks which is set to be issued on Friday, April 24.  Much of the attention has centered on the levels of tangible common equity held by banks and the protection implied by Tier 1 capital ratios.  If government regulators regard the Tier 1 capital ratio of a “stress tested” bank to be insufficient, it is possible that banks will be forced to raise equity capital during a period of low share prices causing potentially serious dilution for current shareholders.

“Banking is a very good business unless you do dumb things”

In an interview today, Warren Buffett was asked about a number of topics related to the banking system in general, and regarding Wells Fargo in particular.  Berkshire Hathaway is the largest shareholder of Wells Fargo and Buffett has made positive comments about the company in the past, going so far as to make what I believe was a rare buy recommendation in early March very close to the low point for Wells Fargo and the overall market.

The entire interview is worth reading but what I found particularly interesting had to do with Buffett’s comments on tangible common equity given the upcoming banking stress tests:

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.

Essentially, Buffett is making the case that asset quality is the key criteria rather than the level of tangible common equity.  With Wells Fargo, he appears to believe that asset quality is good enough to provide a comfortable margin over the cost of funds even once provisions for loan losses are taken into account.  However, from a regulatory perspective he notes that there are difficulties due to the wide variation in asset quality and the difficulty of regulators discerning such factors.  Buffett had the following to say when asked for his metric for evaluating a bank:

It’s earnings on assets, as long as they’re being achieved in a conservative way. But you can’t say earnings on assets, because you’ll get some guy who’s taking all kinds of risks and will look terrific for a while. And you can have off-balance sheet stuff that contributes to earnings but doesn’t show up in the assets denominator. So it has to be an intelligent view of the quality of the earnings on assets as well as the quantity of the earnings on assets. But if you’re doing it in a sound way, that’s what I look at.

Risks of New Capital Requirements

It appears clear that much of the risk concerning investors in bank stocks today is that the regulatory requirements imposed by the stress tests will require new capital.  On this topic, Buffett had some comments that apply specifically to Wells Fargo but also should be considered by regulators when coming up with the overall stress test methodology:

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.

Buffett is making the case that even if regulators determine that Wells Fargo requires additional equity, they should be allowed to earn their way to the desired level.  The dividend cut alone should allow Wells Fargo to substantially increase equity levels without issuing common equity at the cost of serious dilution to current shareholders.

Although most of Buffett’s comments in the interview were specific to Wells Fargo, regulators should think carefully before imposing requirements that punish existing shareholders if it appears that the bank in question is reporting quality earnings that will allow equity to rise to higher levels within a reasonable timeframe.  Of course, the difficulty for regulators will be to determine exactly how to evaluate the quality of assets and the level of risk implicit in a bank’s portfolio of loans.  Wells Fargo may be in a good position if one accepts Buffett’s evaluation but this is not the case in general.

One thing is for certain:  Investors will be looking for the stress test methodology on Friday to shed some light on the serious concerns related to dilution that are weighing heavily on this market.

Disclosure:  The author does not own shares of Wells Fargo directly, but owns an indirect interest in Wells Fargo through ownership of Berkshire Hathaway shares.