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Wells Fargo & Co (WFC), JPMorgan Chase & Co. (JPM): How Banks Can Roll the Dice and Lose It All

Recently, fellow Fool David Hanson posted a video of former Countrywide CEO Angelo Mozilo being interviewed on CNBC way back in 2007. Mozilo’s words are both prescient and oblivious, and it got me thinking about risk. Or, perhaps more accurately, how many banks have failed to understand risk and reward.

Countrywide, the remnants of which are now owned by Bank of America Corp (NYSE:BAC), epitomized the false thinking in banking, the skeletons of which can be seen across the country from Wells Fargo & Co (NYSE:WFC) to JPMorgan Chase & Co. (NYSE:JPM) to American International Group Inc (NYSE:AIG).

Wells Fargo & Co (NYSE:WFC)Two scenarios, same math, dramatically different outcomes
Bear with me for a moment, because the math is the backbone of understanding how banks got it all wrong.

Mark Buchanan of explains it in terms of two scenarios. First, suppose that you roll a die. If you roll a 6, you win $10. Roll anything else and you lose $1. If you roll 1 million times, you will on average win $0.83 per roll — not bad.

Scenario 2 ups the ante. Instead of winning $10, you now will win 10 times your net worth if you roll a 6. However, if you don’t roll a 6, you lose everything. Not quite as tempting; however, the math works out the same. If you did this roll 1 million times, on average you would still win $0.83 per roll.

The difference is that Scenario 2 makes it obvious that you may not get 1 million rolls. You may just get one and then be bankrupt. And that brings us back to Countrywide.

The Mozilo interview occurred just after Bank of America Corp (NYSE:BAC) provided financing to Countrywide and just before the bank bought Countrywide outright. Mozilo talked up the company’s capitalization, value, and bright future prospects, yet in the same breath, he predicted that housing will lead the U.S. into recession.

He was a salesman putting a positive spin on an otherwise unsavory situation. But he was probably also confusing his math, a la the two scenarios I mentioned. He understood that housing would eventually rebound (and he was right; low interest rates have led to a genuine boom in mortgage refinances), but he failed to understand that Countrywide may not survive to profit from that return to normality.

On average, Countrywide was positioned to profit over a million rolls, but the reality of the times was that the company didn’t have financial wherewithal to survive the losing roll.

Trying to find a common theme
Countrywide isn’t alone in this failure. Wachovia (now part of Wells Fargo & Co (NYSE:WFC)), Bear Stearns (now part of JPMorgan Chase & Co. (NYSE:JPM)), Lehman Brothers, IndyMac, and all the others were probably positioned to reap exponential profits in the long term, over a million rolls. But none did. None waas able to survive the series of bad rolls that hit during the crisis.

What can we take away from this? Has the industry learned from these mistakes? Can we rest easy at night knowing that our financial futures, our savings, our investments, are safe and in capable institutions?

If you read the news or have listened to politicians and pundits of late, you’ll think capital is the solution to all bank problems. The FDIC defines “well capitalized” as having Tier 1 Risk Based Capital greater than 6%. JPMorgan Chase & Co. (NYSE:JPM) reported a capitalization ratio in 2007 of 8.4%. Wells Fargo & Co (NYSE:WFC) reported 7.59%, and Countrywide reported 7.2%.

Despite all being “well capitalized” by FDIC standards, Wells Fargo & Co (NYSE:WFC) and JPMorgan Chase & Co. (NYSE:JPM) survived the crisis as pillars of balance-sheet strength while Countrywide was bailed out by Bank of America Corp (NYSE:BAC). American International Group Inc (NYSE:AIG) had $1.8 trillion in derivative exposure at Dec. 31, 2008, via more than 35,000 different contracts. The scale of that exposure is staggering alone, but even more so when you consider that this represented 34 times shareholder equity on the balance sheet.

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