New York | In this edition of The Institutional Risk Analyst, we assign a neutral risk rating to Wells Fargo & Co (NYSE:WFC), the fourth largest bank holding company (BHC) in the US at $1.9 trillion in total assets. We own the WFC preferred.
Disclosures: NLY, CVX, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN,
Review & Outlook
WFC has been caught in regulatory purgatory for more than five years, resulting in changes in the bank’s officers and directors that we’ll not recapitulate here. The timeline of events since 2016 created by the Congressional Research Service makes compelling reading for those not familiar with the disastrous past five years for WFC.
The increase in operating expenses at WFC since last year has caused the bank’s efficiency ratio, a key operating measure of expenses vs revenue, rise 20% in the past year. This ratio measures the proportion of net operating revenues that are absorbed by overhead expenses, so that a lower value indicates greater efficiency. Most of WFC's peers have efficiency ratings in the 50s and 60s. The table below shows efficiency ratios for the lead bank units of each group.
Efficiency Ratio
Noninterest expense less amortization of intangible assets/
net interest income + noninterest income
Source: FDIC (Q2 2020)
While Citigroup (NYSE:C) is not a good business model comp for WFC, we include them in the table above to illustrate just how poorly WFC is currently performing in terms of operating efficiency vs its asset peers. The fact that Citi has a "4" handle for its efficiency ratio is a testament to the fine job done by CEO Mike Corbat. Until the management of WFC gets the bank back down into the 50s in terms of efficiency ratio, investors should not expect strong performance in either the bank’s debt or equity.
Comparable Companies
JPMorgan Chase
Bank of America
U.S. Bancorp
Truist Financial
Peer Group 1
The bank long favored by Warren Buffett has a problem with internal systems and controls that is partly real and partly a function of attracting the wrong attention in Washington. “If you give me six lines written by the hand of the most honest of men, I will find something in them which will hang him,” noted French Cardinal Richelieu in the early 17th Century.
Those readers familiar with the saga of Ocwen Financial (NYSE:OCN) and the Consumer Financial Protection Bureau will recognize a similar narrative at work here with WFC (See “Abuse of Power: The CFPB and Ocwen Financial Corp.”) There is nothing that has occurred or is now occurring at WFC that does not also occur at other large banks. But WFC is in the spotlight and its financial performance is suffering.
The difference, of course, between WFC’s situation and OCN’s travails with the CFPB is that the former is dealing with the Federal Reserve Board and other prudential regulators, agencies which ultimately have the power to deny WFC permission to continue to act as BHCs with respect to its subsidiary banks. It is always important for investors in bank debt and equity to remember that you most often hold obligations of the corporate owner of the bank, not the insured depository institution itself.
WFC's regulatory problems followed a number of combinations that fundamentally changed the bank. In 1991 in the wake of the S&L fiasco, WFC actually exited the residential mortgage sector entirely. Branch managers sent customers seeking mortgages to other banks. Yet seven years later in 1998, WFC merged with Norwest Corp, which got the conservative Wells into the retail and correspondent mortgage business in a big way.
Norwest in the 1990s, lest we forget, was an aggressive bank aggregator of residential mortgages that competed with Citibank and Countrywide. The Norwest culture prevailed after the Wells purchase. A decade later, WFC acquired Wachovia as it teetered on the brink of bankruptcy in December 2008, adding even more mortgage exposure including the CA portfolio of World Savings.
WFC now has over 70 million customers from coast to coast and $1.3 trillion in core deposits. WFC has roughly 10% market share in the residential lending and servicing business, the largest single piece of a fragmented $11 trillion market, but like other banks has pulled back from that market in recent years. With the period of regulatory punishment, the bank’s assets have remained just below $2 trillion and income has suffered as expenses have risen.
As WFC noted in Q3 2020 earnings: "Our third quarter results also included a $718 million restructuring charge, predominantly related to severance expense, and $1.2 billion of operating losses, largely due to customer remediation accruals.” Hopefully WFC will be able to get control of these extraordinary expenses, but only time will tell how quickly and how much.
Among the top banks, WFC tends to be more like Bank of America (NYSE:BAC) as opposed to JPMorgan (NYSE:JPM), which is really only half commercial bank in terms of assets and even less in terms of risk-adjusted exposures. WFC, on the other hand, is relatively pedestrian in risk terms. WFC has virtually no dependence on volatile funding and is generally a net-supplier of liquidity to the markets.
Whereas JPM and Citi are the biggest over-the-counter derivatives dealers on the planet, WFC provides retail banking, and wholesale financing and servicing to the residential and commercial mortgage markets. Boring, low-risk and profitable. WFC also has a substantial wealth management business, accumulated via a string of acquisitions. Today WFC includes over 400 direct affiliates, including five national banks and several more non-depository trust companies and broker dealers.
Quantitative Factors
At the close on Friday October 16, 2020, WFC was trading at 0.6x book value with a beta of 1, meaning that it tracks the volatility of the broad equity market. In terms of credit at the close on Friday, the 5-year credit default swaps for WFC were trading wide of JPM and U.S. Bancorp (NYSE:USB) at ~ 65bp, but inside Citi and Goldman Sachs (NYSE:GS) near 100bp. We see little likelihood of default by WFC, but the CDS spreads reflect the deep discount for the public equity and market sentiment toward this credit more generally.
Looking at the financial performance of WFC, the first thing that jumps out is the recent underperformance vs the strong historic performance of the bank. After reporting a loss of $2.4 billion in Q2 2020, WFC swung back into profit of $2.3 billion in Q3 2020, but half the profit of Q2 2019. More important, WFC is not performing particularly well vs the top commercial banks above $500 billion, as shown in the chart below. We have deliberately excluded Citi but added Truist Financial (NYSE:TFC).
Source: FFIEC
Prior to the end of 2019, as the chart shows, WFC was performing in line with its money center peers, but since that time the earnings have suffered. In the past nine months, for example, the bank’s net interest margin has slipped 20bp.
Most of the larger names along with WFC saw higher earnings in Q3 2020 because of the large number of consumer and commercial loans that are currently in some form of forbearance due to COVID. This means that the banks do not yet need to treat these forbearance loans as delinquent. But as anyone in the credit channel will tell you, there is an accumulation of past-due and doubtful credits in consumer and commercial that will likely push provisions and credit losses higher in 2021.
Source: FFIEC
In the chart above, we show the historical performance in terms of funding costs of WFC and the other BHCs we included in the comparable group for this report. Perhaps the key factor driving bank earnings in the past year is funding. In the past nine months, WFC has seen its interest expense cut in half, but some banks have seen even larger reductions in funding costs.
Notice that WFC has benefitted from the actions of the FOMC even more than USB and Peer Group 1 more generally, but lags behind JPM, TFC and BAC in this regard. At the end of 2016, by comparison, WFC had the lowest cost of funds among large banks.
In addition to income and funding costs, another important gauge of WFC’s performance is the bank’s gross spread on its $1 trillion in loans and leases. If you take the gross spread, subtract the average cost of funds, credit costs and SG&A, you basically have net income. Half of WFC’s portfolio is real estate loans, another $200 billion is in C&I loans, and almost $200 billion in “other loans and leases.”
Source: FFIEC
As the chart above suggests, the larger banks are seeing reduced pricing for loans even as the FOMC pushes down the cost of funds. The top performers among the banks discussed in this report are JPM and TFC followed by USB and Peer Group 1 as a group. Both WFC and BAC are in last place and both are performing below their asset peers, never a good sign. But as the chart shows very clearly, BAC has under performed their peers for years and, in the case of WFC, since 2019.
WFC has seen its net interest margin compress by 50bp over the past year, ending up at just 2.13% as of September 30, 2020. The open market operations by the FOMC also compressed spreads in the debt markets. As WFC noted in their Q3 2020 results: “Net unrealized gains on available-for-sale debt securities were $4.3 billion at September 30, 2020, compared with $4.4 billion at June 30, 2020, as the impact of lower long-term interest rates was predominantly offset by tighter credit spreads.”
The fourth key metric to consider is the bank’s credit performance. Historically, WFC has been quite conservative on credit, with low default rates, good recoveries and a relative conservative profile in terms of Exposure at Default or "EAD." This metric comes from Basle I and compares unused credit lines vs total loans. There are four line items for EAD reported by banks in Peer Group 1, two consumer and two commercial.
As calculated by the TBS Bank Monitor, WFC’s lead bank, Wells Fargo Bank N.A., has an EAD of just 60%, meaning if all of its unused lines were drawn and then the obligors defaulted, the hit to the bank would be about $600 billion. In the case of Citi, by comparison, the EAD is 150% of total loans, illustrating the bank’s large consumer and institutional credit book. JPM’s EAD at the end of June 2020 was 124% of total loans.
Prior to 2008, WFC typically had an EAD below 50% and Citi was often above 200-250%. Again, as we never tire of noting, not all large US banks are the same in terms of business model and risk profile. The default rate for Citi is several times higher than for WFC, illustrating the subprime business model of this institution. The chart below shows the historical net loss rate for the comparable banks in this report.
Source: FFIEC
As the chart above suggests, WFC has historically had net credit losses that were lower than large asset peers such as JPM and USB, both of which tend to take a more aggressive posture to loan pricing and default risk – and are successful doing so. WFC was performing just above Peer Group 1, which is an unweighted average of the 127 banks above $10 billion in total assets and is thus quite conservative. But since 2019, however, the credit performance of WFC has deteriorated.
Qualitative Factors
As we note at the start of this report, many of the problems facing WFC are self-inflicted have been due to management missteps and a board of directors that has often seemed detached and entirely insensitive to what is happening around them, in Washington and in the media. Often times when banks get into regulatory trouble, the reasons stem from poor credit underwriting and financial factors. In this case, the officers and directors of WFC are facing sanctions from the Fed because of a breakdown in internal systems and controls.
Many investors are familiar with the issue of internal systems and controls because of the 2002 Sarbanes-Oxley law. In the world of banking, however, the issue of internal controls is even more serious. State and federal regulators expect bank managers and board members to prudently and comprehensively plan and execute a bank’s business plan over a period of years. You must present a road map of goals and objectives to regulators, and then hit those hurdles.
In this case, WFC has a good business model from a qualitative perspective, but has failed miserably in terms of execution by managers and oversight by the bank’s board. WFC’s managers encouraged illegal acts, tried to hide those criminal acts, and then colluded with the board to conceal the entire mess from investors and regulators. The officers and directors of federally insured depositories have an affirmative duty to identify and manage risks to the enterprise. This was not done.
We also fault the Federal Reserve Board in Washington, which over the years has apparently lost the capacity to pick up the telephone and read the riot act to WFC’s CSUITE in a timely and private fashion. We asked a Fed governor recently why a more proactive approach was not taken sooner with WFC, but was told rather pathetically that “we don’t do that anymore.” Had the Fed taken action more quickly, WFC would be further along in remediating the damage.
When investors and the media ask us when the Fed will let WFC out of jail, our response is simple: You are asking the wrong question. Instead, WFC will earn its way out of jail as and when the management team and the board demonstrate to the Fed and other regulators that the bank has sufficient if not superior internal systems and controls. But things could be worse. WFC could instead by Citi, which faces a far more profound problem with internal systems and controls as the new CEO Jane Fraser takes the reins in February 2021.
Risk Assessment
We assign a neutral risk assessment to WFC. The assessment is based upon several factors, including:
Financial Performance: The bank’s earnings and other quantitative factors have deteriorated in recent quarters, although the core franchise remains stable. This bank has the potential to again become a superlative performer, but at present we are a long way from realizing that goal.
Operating Efficiency: Perhaps the most basic and direct measurement of any bank’s management team is the efficiency ratio. WFC currently has an efficiency ratio in the mid-70% range, suggesting to many quantitative models an increased chance of default. We will not consider upgrading this assessment until WFC gets it’s efficiency ratio back into the low 60s or high 50s.
Credibility: The most urgent but also most difficult hurdle for WFC management is to win back the confidence of regulators and key policy makers in Congress. In the event of a Biden win in November, you can expect progressive forces to continue to treat WFC as their political punching bag. In political terms, it will be difficult for the Fed to let WFC out of purgatory unless and until the bank has stayed out of the headlines for months if not years.
The fate of WFC is in the hands of the current management team and board, but sadly shareholders are paying the bill. As and when WFC management start to address issues of profitability and operating efficiency, we'll reconsider our assessment.
Bank Group: AXP, BAC, BK, C, COF, DB, DFS, FRC, GS, HSBA, JPM, MS, OZK, PNC, SCHW, TD, TFC, USB, WFC
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