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Inefficient Market Theory: Wells Fargo and the Subprime Crisis

For many among us, the financial crisis of 2008 and 2009 was not theory, it was a very real and very present disaster unfolding day after frightening day. It was especially hard for investors who had substantial holdings in bank and financial stocks.

But for other investors, and especially value investors, it was like lunching at a sumptuous smorgasbord. Why the difference?

As Jeffrey C. Hood explained in chapter eight of "Inefficient Market Theory: An Investment Framework Based on the Foolishness of the Crowd," the difference depended on your perspective.

A few market observers had been warning of potential trouble with the packaging of subprime loans and lax lending practices earlier (Warren Buffett (Trades, Portfolio) warned of "financial weapons of mass destruction" in 2003), but the market mostly ignored them.

Complacency quickly changed to fear in September 2008 as several major banks and financial institutions collapsed or had to be merged into other firms. Among those lost were the Wall Street stalwarts Bear Stearns and Lehman Brothers.

In addition, there was concern that the banks might have to raise new capital to cover their loans. If that happened, new equity would dilute that of existing shareholders, making their existing holdings worth less.

Even Wells Fargo (NYSE:WFC) was caught up in the downdraft; its shares plunged from more than $34 to less than $10 in March 2009. It wasn't alone in feeling the pain; Bank of America (BAC) had traded as high as $52 per share in 2008 but dropped to just over $3 per share in March 2009.

The variant perception

A minority of investors did not buy into the panic that had infected much of the market crowd. Where others saw imminent financial catastrophe, they saw several reasons to stay calm and to start buying.

That awareness of a positive side to the subprime crisis is what is called a "variant perception," which is to say they had analyzed companies like Wells Fargo and determined there were solid reasons for optimism. Rather than generalize, they looked at specific companies and their unique circumstances.

One aspect of the variant perception was that the Too-Big-to-Fail banks would survive since governments would likely step in to save them if necessary. After that, they would eventually return to normalcy and reward their shareholders again.

Contrarian investors also noted that many banks were selling for less than their liquidation values, which provided a substantial margin of safety. In addition, they were making a distinction between the banks with bigger problems and those with lesser problems. Wells Fargo fell into the latter category.

In fact, Wells Fargo found itself in the awkward position of trying to reject Troubled Asset Relief Program assistance, but could not. Hood quoted CEO Dick Kovacevich as saying in 2012 that the program was an "unmitigated disaster" and that "TARP contributed to an unnecessary panic in the marketplace that still hasn't been fully restored." The problem with TARP money was that it led many consumers and investors to assume that even healthy banks were in deep trouble.

A popular joke at the time went this way: Q: What's the definition of optimism? A: An investment banker who irons five shirts on a Sunday evening.

Inefficient rationale

That pessimistic perception was one of several reasons why uninformed investors were panicking, or in other words, part of the inefficient rationale. The author has made a strong case that value investors should find out why the crowd is undervaluing a stock as part of their analysis.

He attributed the inefficient rationale in this case to a combination of fear ("verging on outright panic"), loss aversion, uncertainty and "a host of other minor contributing psychological forces were acting in concert to stampede the market herd into a selling frenzy, particularly with financial stocks."

For the herd with its short-term focus, no one could see that not all banks were affected in the same way, that some might be financially stable. They also might not have known, or ignored, the possibility that some of the troubled banks might recover in the longer term. That probability increased significantly when the banks began receiving bailout money.

A summary

  • Consensus view: Big banks are in trouble and might even go bankrupt. In addition, the whole American economic system might fail. The fact that all banks received bailout money led to the presumption that all are in trouble. There was also a worry that the banks might need to raise new capital, thus diluting the value of existing shares. All of that led many investors to sell their stock in a hurry, which drove share prices down.
  • Variant perception: Although there are serious problems with the financial system right now, the economy--and the banks--will recover. Wells Fargo wasn't even in difficult financial straits, but it appeared that way to the crowd. Like the other big banks, its share price was depressed (Hood does not tell us if it was one of the banks selling at less than liquidation value, but it seems unlikely).
  • Inefficient rationale: Yes, there is a problem, but the crowd is overreacting because of a combination of loss aversion, uncertainty and fear. These factors, along with their short-term perspectives, make it unable to imagine the banks operating normally again.

Hood pointed out that things did get back to normal, and more quickly than many expected. Wells Fargo went from a high of more than $34 in 2008 to a low of $9.66 in March 2009, then, in less than two months, it nearly tripled to about $27 a share.


This is the third case study (after the Salad Oil Scandal and the Tylenol poisoning scare) in which Jeffrey Hood has helped us think our way through low stock prices caused by distressing circumstances.

The inefficient market theory involves a process in which we assess the overall situation, look for facts and information that rebut the story of distress and force ourselves to explain what psychological biases or other reasons underlie the foolishness of the crowd.

It offers a model with which we might address any company's story of woe, now or in the future.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.