Wells Fargo Could Plummet From Foreclosure Issues

| About: Wells Fargo (WFC)

As the economic outlook for the U.S. improves, banks stand to gain as consumers and businesses spend with bank-backed credit cards and loans of all types. Wells Fargo (WFC) is no exception. With the final stages of its merger with Wachovia completed in the first quarter of 2012, Wells Fargo remains focused on reducing expenses, particularly in operations. The firm has announced a goal of $11 billion in non-interest expenses per quarter, and is currently averaging $13 billion per quarter. I think that the $11 billion goal will be attainable for Wells Fargo over the next few quarters, and should result in a much more appealing balance sheet for the finance giant.

Diversifying High and Low End Service Portfolios

Wells Fargo is also working on its balance sheet from an investments angle. The yield on 10-year Treasury notes, even while creeping forward (up 35 basis points in the first quarter of 2012), continues to be low. This is forcing banks, which are also now required to hold greater assets against liabilities under new regulations, to be more cautious with investment opportunities while at the same time seeking growth drivers. Somewhat counter-intuitively, part of this money is finding its way back into mortgage loans; over 50% of loan growth in the first quarter for the industry overall was driven by residential mortgage lending.

Student lending is one growing lending area of medium risk where most banks have exposure. JP Morgan recently stated that it will be reducing its private student loan availability, while U.S. Bancorp (USB) announced it was halting such loans altogether amid pundit calls that student lending was the next toxic debt class. Wells Fargo countered by indicating that it is open to expanding its private student lending business.

Private student loans, indeed private loans in general, have had historically high default rates. It is not surprising college students are unable to repay their loans, which is due in large part to high unemployment rates, and are defaulting at higher than average rates. If Wells Fargo were to expand its business with protections in place, such as stricter co-sign requirements, I see no problem with Wells Fargo expanding and profiting on this niche.

Wells Fargo is diversifying its appeal to investors as margins continue to be squeezed. One result of this is the new 'boutique' brand Abbot Downing, a wealth management firm officially announced on April 2. This subsidiary will target ultrahigh net-worth individuals, and was created through a merger of Lowry Hill and Wells Fargo Family Wealth. The target audience for Abbot Downing is just 10,000 households in the U.S., and according to Wells Fargo 600 of these households are already doing business with Abbot Downing, leaving room for growth.

Current Legal Challenges

On the legal front, Wells Fargo is facing allegations of deliberately neglecting the up-keep of foreclosed properties in minority neighborhoods, following similar allegations against its competitor U.S. Bancorp. Complaints against both banks were brought by the National Fair Housing Alliance and are being investigated by the U.S. Department of Housing and Urban Development. This is not surprising news and should not be impacting the stock of either company, unless of course the banks are found culpable of gross negligence. In such a case, fines, regulatory action, and consumer backlash could have a negative impact on both stocks, depending on the severity of the findings.

Wells Fargo is also dealing with possible fraud allegations brought by the Securities and Exchange Commission, related to the bank's sale of nearly $60 billion in mortgage-backed securities from 2006 to 2008. The SEC believes that Wells Fargo may have misrepresented these offerings. The SEC filed a request with a federal judge on March 23 to require Wells Fargo to submit documents previously requested under subpoena. The request was denied on March 30, with the judge suggesting that lawyers from both sides meet to discuss the issue.

I think that as this case unfolds Wells Fargo's stock has the ability to track up or down. A "win" for Wells Fargo over the allegations should have a minor positive effect on stock prices, but a loss would be a big one indeed. Not only would the bank need to deal with fines and possible leadership changes required by the SEC, but further regulatory actions could hamper the bank's ability to function.

Wells Fargo is also defending itself against a class action lawsuit brought by institutional investors, alleging Wells Fargo misrepresented a risky securities-lending program as safe. The suit was certified as class action on March 27. This case should be watched together with the SEC case mentioned above. If a verdict in this class action is entered against Wells Fargo, I think the SEC could use it in building its own case.


Wells Fargo is currently trading around $33 per share, giving it a forward price to earnings ratio of 9.1, which is higher than many of its competitors. Bank of America (BAC) comes in at a forward P/E of 8.8 at around $9 per share, similar to Goldman Sach's (GS) forward P/E of 8.8 at around $118 per share, while JP Morgan comes in at a forward P/E of 8.0 at around $44 per share. Among major competitors Citigroup (C) is notably lower with a lower forward P/E of 7.5 at around $35 per share.

Comparing the price to book of these five banking giants, it's quite clear that the repercussions of the world financial crisis are far from over. Conservative investors seem to be very wary of picking up stock in banks that participated in, and even encouraged, the risky investments that precipitated near-collapse. In fact, listing the price to book on these firms in order of their continued exposure to these investments dovetails nicely with a declining P/B: Wells Fargo is at 1.4, JP Morgan and Goldman Sachs are both at .9, Citigroup is at .6, and Bank of America trails at .5. This is a huge fall for Bank of America, which like Citigroup took major risks and lost.

Wells Fargo was less exposed to the risks that are still causing problems for its competitors. This simple business model makes it attractive compared with its peers, since it continues to have less exposure to exotics and foreign debt than most of the competition. However, its new found size, which was doubled with the acquisition of Wachovia, means investors will be expecting to see growth and returns that Wells Fargo might not be prepared for as the U.S. economy stabilizes. This may see the bank entering into the riskier lines of business that battered its peers.

With Wells Fargo's current leadership and overall track record, it is unlikely that the company would take on risks to an extent that would jeopardize its reputation and overall performance. Wells Fargo is currently outperforming the industry average for revenue growth, with a three-year average of 24.6%, compared with the industry average of 11.2%. Comparing Wells Fargo to its competitors by all of these measures, the stock is an attractive investment, even at a higher P/E.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.