Outside experts hired by Wells Fargo to pour through its books are reportedly shocked at the bank’s exposure to derivatives trades it took on when it acquired Wachovia may trigger huge losses at the bank, Teri Buhl reports at BankImplode.com

It appears that Wachovia wrote credit default swaps on the junior tranches of commercial mortgage backed securities it was selling, which means that it is on the hook for losses in the riskiest CMBS tranches it sold. Wells itself might not even know the size of its exposure, Buhl reports.

From Buhl:

According to sources currently working out these loans at Wells Fargo when selling tranches of commercial mortgage-backed securities below the super senior tranche, Wachovia promised to pay the buyer’s risk premium by writing credit default swap contracts against these subordinate bonds. Should the junior tranches eventually default, then the bank is on the hook. Dan Alpert of Westwood Capital says these were practices that he saw going on in the market at large.

Alpert says in reference to how he saw CMBS trades get done, “These guys would say ‘We’ll just take back that silly credit risk you’re worried about.’ Of course that was a nice increase to earnings when they got the security sold. The bank made money at the time.”

Buhl points out that investors might be caught off-guard if Wells has to start paying out on the swaps it sold. Wells, like most banks, almost certainly holds the credit default swap liabilities off balance sheet and most likely does not recognize them as a loss until they actually have to pay, Buhl writes. Wells says it carefully monitors its derivatives exposure. "We have provided extensive transparent disclosures on our derivatives in our 2008 annual report beginning on page 132,” Wells says.

Here’s Wells own calculation of its derivatives exposure as of the day it closed the Wachovia deal.

wachovia-wellscreditdefaultswaps.png

But it seems fair to wonder if Wells really understood all of the derivatives exposure it took on when it acquired Wachovia. Buhl wonders if Wells really has enough capital set aside to handle the derivatives liability.

…So could Wells really have enough capital to handle the liability of credit derivatives that will likely come due within the year? As we watch more and more of the junior tranches of commercial mortgage back securities Wachovia sold become worthless, how will Wells Fargo afford to pay for the risk premiums Wachovia promised they’d cover if the loans blew up?  From all indications, the bank cannot meet these obligations unless it raises more capital, sells good assets for a loss, or puts more of that TARP money to use instead of sending it back to taxpayers, as CEO John Stumpf has promised.  So much for “earning our way out” of the financial crisis.

The losses from the credit default swaps might hit even earlier than Buhl expects.

One of the lessons from AIG is that a company can be brought down by collateral demands even before the swaps are triggered by defaults. If the buyers of the swaps have the right to demand additional collateral as CMBS tranches are downgraded–a very likely scenario–Wells could find itself having to scramble for liquidity even though the underlying credits haven’t yet triggered the credit default swap payments.  This, recall, is exactly what killed AIG.