The recent lawsuit on America's largest home lender is part of an initiative by the U.S. president, where a committee was appointed to check the wrongdoings that led to the financial meltdown, and implicate money center banks for their involvement. We believe Wells Fargo (WFC) is well positioned to benefit from the recovering U.S. housing markets in the coming quarters. Therefore, the current lawsuit will not have a significant adverse financial impact. Therefore, we reiterate our buy rating on the stock.
Wells Fargo was slapped with a civil law suit on October 10 for reckless originations and underwriting of over 100,000 retail Federal Housing Administration (FHA) loans from May 2001 until October 2005. Hundreds of millions are being demanded by the U.S. government in damages. Wells Fargo stands to be the fourth largest U.S. bank and also the largest home lender. The bank originated a third of all mortgage originations during the second quarter of the current year. Therefore, the bank has a strong reliance on the recovery of the U.S. housing sector. Under the same lawsuit, the bank is being accused of violating underwriting rules by maintaining an under-trained staff, and hiring temporary and inexperienced workers to speed up the approval of FHA loans. Additionally, the largest home lender is being accused of failing its own self-reporting requirements to the U.S. Department of Housing and Urban (HUD), not only during the period considered, but also after 2005 until 2011. This led to poor quality control. As much as 6,320 improperly certified and deficient loans to HUD went unreported. This is claimed by the office of the Attorney General of Southern District of New York, which was responsible for filing the complaint. The scope of damages and Wells Fargo's liability will not be determined by a jury.
In a similar case earlier in October, the Attorney General of New York filed a lawsuit against JPMorgan Chase (JPM) for committing fraud in the creation and sale of residential mortgage-backed securities by one of its wholly-owned subsidiaries. However, both the cases are being handled by two different bodies.
Impact on Earnings:
We believe the liability imposed by the jury on the bank will be manageable for Wells Fargo. We estimate a settlement of around $600 million or 7 cents per common share outstanding. This forms approximately 2% of the 2013 consensus earnings per share. The bank is expected to post its third quarter's performance on October 12, 2012.
During the most recent quarter, the bank posted an earnings figure that was almost 1% above what analysts were expecting, on revenues that met consensus mean expectations. At the end of the second quarter of the current year, the bank had a Tier 1 capital ratio of 11.69%, as compared to 11.3% for JPMorgan.
The stock of Wells Fargo trades at a 36% premium to its book value. In comparison, the stocks of JPMorgan and the Bank of America (BAC) trade at 25% and 54% discounts to their respective book values. Analysts have a consensus mean price target of $38.22 per share for the stock, which is currently trading at $35.23 per share. This is an upside of 8.5%.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.