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By Steve Murray

One of the most surprising outcomes from the government’s “stress test” release comes from a bank that many thought was adequately capitalized to weather further deterioration in the markets. Among the 9 banks which the government will be forcing to raise new capital to cushion their equity position is Wells Fargo (NYSE:WFC). Wells Fargo has been one of the few large-cap banks that was extremely conservative during the banking boom. Now it is being asked to raise an additional $13.7 billion, when management feels the bank's current capital position is fine.

During the banking boom, Wells Fargo avoided tactics used by other banks to raise its bottom line. Since it was founded in 1852, the bank has proven itself to be one of the most (if not the most) conservative banking institutions. It does not like to be classified as a typical Wall Street bank, because that is not how it operates. Rather than trading with its own book, or profiting off of huge fees from investment banking businesses, it prides itself by operating as banks used to. Wells Fargo makes a majority of its money by old fashion lending (which is hard to say for many other banking institutions).

John Stumpf, CEO of Wells Fargo, took over Dick Kovacevich’s job last year. During the height of the credit crisis, Kovacevich was quick to shoot down short sellers and fought against the media which classified Wells Fargo as just another large-cap bank that has been destroyed by toxic assets and poor lending standards. He has also publicly stated that the government’s decision to conduct a “stress test” and publicly release the data is “asinine” as the government conducts stress tests every day.

Struggles with Wachovia

With the recent acquisition of Wachovia (NASDAQ:WB) last year, regulators are worried that write-downs from its books will severely affect Wells Fargo. Wachovia’s acquisition of Golden West Financial (a large sub-prime lender) led to the downfall of the prestigious bank. About 2 weeks after the announcement of Wachovia’s acquisition came the government’s TARP injections to U.S. banks. Kovacevich reluctantly accepted the money because he wanted regulators to pass the deal.

In an interview with Fortune, Kovacevich reluctantly explained: “You want to do what your country and your regulators want…” When the Wachovia deal was officially closed for $12.5 billion (almost $3 billion less than the original offer), Wells wrote down $37 billion of a Wachovia loan portfolio worth $94 billion. Many analysts were expecting this write-down to be significantly larger than $37 billion, and bashed the stock with downgrades.

"Unprecedented times"

The downgrades were warranted as Wells' TCE, or tangible common equity (a measure of a bank’s capital cushion), fell to 2.7%. This was below the industry standard and expectation of 3%, which many consider the bare minimum to operate healthily. Wells Fargo was able to raise $12.6 billion, more money than any non-IPO on record, to buy Wachovia. Many felt this was a sign of things to come for the bank, as it had targeted to raise as much as $20 billion in the issuance. Since then, Wells followed suit by unexpectedly cutting its dividend by 85%.

Defending the move, Stumpf said: “We’re going through unprecedented times, and more capital is better than less capital.” This cut did not ease investor’s concerns about the bank, which continued to trade down with the rest of the banking world. Since October, the bank has been able to raise $43 billion ($25 billion in TARP, $13 billion in private fundraising, and $5 billion in cost savings from the dividend cut), which is $23 billion more than management said it would need. Fed officials disagree though with the results of the “stress test”.

Out of the $13.7 billion, which Wells will need to raise, a large portion of the estimated write-downs come from first lien mortgages ($86.1 billion), second lien mortgages ($32.4 billion) and commercial & industrial loans ($14.7 billion). Analysts are extremely concerned with a $355 billion pool of commercial mortgages, and a $137 billion pool of credit derivatives. These assets were not added to Wells' books after the merger, but rather kept off-balance sheet through “Special Purpose Entities” or SPE. If these were added to its books, some analysts believe that Wells would need over $20 billion in additional capital.

Growth areas

Wells Fargo focuses on gaining customers, and making their lives better. Cross-selling products has been at the forefront of Wells Fargo’s success. Whether it be credit cards to mortgages for consumers, or even treasury-management and insurance for businesses, its primary focus has been increasing the number of products it sells per customer. Over the past 10 years, Wells Fargo has successfully increased the average number of products for retail customers from 3 to almost 6.

Growth has also skyrocketed for business customers too, as they now average almost 8 products per customer. Growth has not been hindered by the current financial crisis though. Both retail and business customers have been flocking to Wells to give them what they desire: Security. This business model has served the bank well from both retail consumers and businesses, because the more products they have with Wells, the less likely they will move their businesses to a competitor.

These segments have proved investors and analysts wrong about its business strength during this banking crisis. Wells Fargo pre-announced first quarter earnings results of $3 billion, which sent shares up over 30% that day as the results were more than twice what analysts were expecting.

What needs to be done

It is critical to Wells Fargo’s future success to complete these three necessary steps: 1. Continue operating as they have since the bank's inception, with conservative standards; 2. Raise enough money to cover the stress test results and to payback TARP; and 3. Successfully complete one of the largest bank mergers in history. The latter of the three is already ahead of schedule. The hardest step will be to distinguish themselves from the rest of the pack as an extremely conservative banking institution. This will allow them to raise enough capital to get them back on track.