Warren Buffett Is Gobbling Up This Stock

According to Bloomberg, 50 lenders have failed this year, more than 13% of subprime borrowers are behind in their mortgage payments, and the number of foreclosures is 48% higher than it was this time last year.

The market has hammered the stock prices of all mortgage lenders, even those that have nothing to do with subprime. The big question is: Which of these weather-beaten wonders, if any, is worth owning?

As outside passive minority investors, we know one thing about mortgages, one thing that's more important than any other thing you can name: Making loans is just like selling insurance. It's all about the underwriting.

Underwriting is simply deciding which risks are safe enough to take and how much you ought to get paid for doing so. If you take on the wrong risks or don't get paid enough, the results can be disastrous. According to the Implode-O-Meter website, 56 subprime mortgage lenders "have croaked since late 2006." The 56 croakers were bad underwriters. They took on too much risk. Put another way, they didn't get paid enough for the risk they did take.

Of all the companies involved in the subprime space, the one that really leaps out at me is Wells Fargo (NYSE: WFC). Wells Fargo is without a doubt the highest-quality mortgage underwriter I've found in my research.

In 2006, Wells Fargo was the second-largest mortgage lender in the United States (next to Countrywide Financial). It was the largest and by far the highest-quality subprime lender, with 13% of all 2006 subprime originations. It was also the third-largest Alt-A lender. Mortgage loans can be made through many channels. But for the last 15 years in a row, industry publication Inside Mortgage Finance has listed Wells Fargo as the top retail mortgage lender.

Wells Fargo is the only AAA-rated bank in the United States, one of only two AAA-rated banks in the world. In its annual report, Wells Fargo says, "We do not believe negative amortization or option ARMs benefit our customers and have not made or purchased these loan products." A couple of paragraphs later, Wells Fargo reports, "We offer interest-only products but ensure that the customer qualifies for higher payments after the initial interest-only period. The majority of our reduced documentation loans are initiated based on our determination that the customer is creditworthy without having to supply unnecessary paperwork." This is so simple and straightforward. And the lending business is potentially wonderful. It's mind-boggling how anyone could screw it up.

When we step back and take it all in, are we surprised to learn that Wells Fargo, the bank with the highest credit rating on earth, the bank Warren Buffett loves, is also the highest-quality subprime lender in existence? We are not.

During 2006, as the subprime blowup began and gained momentum, Buffett more than doubled his holdings in Wells Fargo from 85 million shares as of December 31, 2005 to 204 million shares as of December 31, 2006. Berkshire Hathaway now owns more than 6% of Wells Fargo. The Sage of Omaha isn't worried about underwriting standards at Wells Fargo. He's gobbling up shares.

At December 31, Wells Fargo's delinquencies stood at 0.73% of total loans. Over the last five years, net charge-offs have fluctuated from 0.62% to 0.96%. Not bad at all.

Like other subprime lenders, Wells Fargo is making cutbacks. It has laid off roughly 500 employees, all of whom were in subprime lending. The layoffs are due to the company's decision to tighten lending standards. The market has indicated to Wells Fargo that the risks are greater than anyone had anticipated, so it's reducing its exposure to that risk.

Earlier this year, Warren Buffett said the pricing for catastrophe reinsurance of hurricanes was falling, so Berkshire was reducing its exposure. Same thing. That is how you do underwriting. Big hints like these are how outside investors like you or me figure out who knows what they're doing. Wells Fargo is in a position to take market share as subprime lending capacity evaporates. As real estate prices fall (yes, it happens), housing will become more affordable, and buyers with lower-quality credit will have to go to Wells Fargo.

Wells Fargo is trading at nine times pretax earnings. It yields 3.3%, and the board just authorized a share repurchase of 75 million shares, about 2.4% of the outstanding total. Both the quarterly cash dividend and the share repurchases constitute cash distributions to shareholders. To my way of thinking, that puts the current pretax yield up around 5.7% (3.3% + 2.4% = 5.7%).

If Wells Fargo should fall in price from here, perhaps I'll revisit it. But for now, my newsletter – Extreme Value – has more than enough exposure to mega-cap stocks. However, were I in the market for a large-cap stock, I'd back up a U-Haul and fill it with Wells Fargo common stock.

Good investing,