Wells Fargo (WFC) has enjoyed a well-deserved reputation on Wall Street as a very strong, conservative bank that came through the financial crisis virtually unscathed and stronger than ever. Following the bank's acquisition of the then-failing Wachovia, Wells catapulted itself into the ranks of too-big-too-fail, joining other household names such as JPMorgan (JPM), Citigroup (C) and Bank of America (BAC). Wells also has the reputation for focusing more on "core" banking activities such as taking deposits and making loans than the other money center banks and a look at some historical loan and deposit shows this to be true. However, should we consider Wells to be the conservative, traditional bank it is seen as? In addition, given that Wells has transitioned to a "risk-off" model in recent years, relatively speaking, what could Wells be worth once risk returns to the housing market?
To estimate the shareholder value that could be created if Wells turns risk back on in its lending practices, we first should see where the bank has been to forecast where it could potentially go.
This chart shows WFC's nominal loans and deposits for the past ten years.
We can see that, prior to the financial crisis, loans (blue line) actually dwarfed deposits most of the time. Then, after WFC acquired Wachovia, as noted on the chart, Wells went into a risk-off mode wherein the loan base has largely been stagnant as deposits have soared. This is quite evident in that the lines begin to diverge rather significantly immediately following the financial crisis. Deposits have grown since the Wachovia acquisition from $800 billion to about $950 near the end of last year. Meanwhile, loans have decreased from $840 billion to $795 billion in the same time period.
In this depiction of the same data, we see the loan to deposit ratio shows Wells' generous, 100%+ loan to deposit ratios prior to the financial crisis. Again, we can see that once the financial crisis hit, Wells' decided to reduce risk by building a deposit base that is substantially greater than its loan portfolio.
Another important thing to notice about Wells' loan to deposit ratio is that it appears the company has found a level where it is comfortable, near the current level of 83%. After the sharp decline from a whopping 116% in 2008 to the current level of 83%, I believe it is telling the ratio has stopped declining.
In addition to a general risk-off policy, we can see in this next graph another potential reason why WFC has stagnated its nominal level of loans.
This graph shows net interest margin from the last 10 years. We see a very pronounced, fairly rapid decline from 5.3% to just over 3.5% at the end of last year. The reduced reward for taking risk has no doubt contributed to WFC's appetite for loan risk.
The good news is that once the economy, and the housing market in particular, begins to gain momentum, NIM should begin to rise as interest rates rise in tandem with the growing economy. In addition, the Federal Reserve's QE Infinity will be wound down at some point, paving the way for rising interest rates and, ostensibly, higher NIM.
Assuming these things happen, which I believe is a fair assumption over the medium term, we can attempt to assign a value to these variables for WFC.
First, the assumptions for NIM and the LTD ratio are seen below.
I am building in LTD rising from 82% this quarter to 88% at the end of 2016 and NIM rising from the current 3.56% to 4.25% in the same time period. Before you laugh, these numbers are well within historical norms for Wells and in fact, may prove to be quite conservative.
Using these assumptions, we can then calculate the amount of net interest income that WFC could derive from such parameters.
The graph above shows what could happen if Wells' NIM and LTD ratio rise to the levels I have shown in my forecast. It is also important to note that these assumptions have zero deposit growth built in. In other words, these are conservative forecasts as Wells has been growing deposits quite rapidly in recent years, as we saw above.
The assumptions show that Wells should earn something like $28.5 billion in net interest income (line, right scale) this year and that net interest income could rise to about $35.5 billion in four years' time. Since additional NIM is largely cost-free in terms of SG&A costs, we can assume most of that income would trickle down to net income. Thus, if we apply a multiple of nine to the additional income, Wells could add something like $63 billion in additional market cap between now and 2016 simply from marginally increased NIM and loan balances. Given WFC's current market cap of $184 billion, a gain of roughly 33% is implied. In addition to my assumptions representing what I believe to be a conservative set of estimates, these gains are irrespective of any SG&A efficiencies WFC may implement and other income that is unrelated to interest rate spreads, which is quite significant.
While my forecasts for LTD ratios and NIM are subject to conjecture, the point is that even though WFC is immensely profitable now, there is still a substantial amount of net income that is being left on the table for a variety of reasons. Wells has the ability to affect some of these, such as LTD ratios, but some, such as interest rates, are largely out of its control. Given the macroeconomic tailwinds we are experiencing, the rebirth of the housing market and the eventual end of QE Infinity, the risk for WFC shares over the medium term is to the upside.