Wells Fargo: Risks Outweigh the Benefits

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About: Wells Fargo & Co. (WFC)
by: Robert Maltbie

The balance of risk remains highly skewed towards the negative, with further asset write-downs, earnings revisions, and dividend contractions to come. We are initiating coverage on Wells Fargo (NYSE:WFC) with a SELL rating.

INVESTMENT THESIS

  • Until home prices stabilize, Wells Fargo expects higher losses in its home mortgage portfolio. We expect further deterioration in Wells Fargo's balance sheet and earnings.
  • Wells Fargo trades at a significant premium to its peers. We expect Wells Fargo's price-to-book multiple to revert towards the group's average and historical lows in comparable eras.
  • Wells Fargo has the lowest Tier 1 capital ratio of its comparison group, thanks in part to its huge acquisition of Wachovia. We are skeptical of the reliability of future dividend payments.
  • Good things come in threes, except Level 3 assets, which grew by 50% to $34.7 billion from the first quarter to third quarter of 2008. We expect both further growth and further losses related to these suspect assets.

RISKS

  • Wells Fargo has utilized this turbulent time period to gain market share and position itself for the eventual economic recovery better than its peers.
  • Both fiscal and monetary policy are squarely focused on solving (or at least minimizing) the effects of the financial crisis. With governments around the world throwing trillions at this problem, short positions in this sector will continue to face headline and/or intervention risk.

SUMMARY

Wells Fargo & Company has long focused on building relationships, both with consumers and businesses. With an emphasis on customer loyalty and its customers' well being (a.k.a. cross selling multiple products and making each customer more profitable), Wells Fargo did not become entrenched with toxic assets from pick-a-pay loans and the like as did many other financial institutions. Nevertheless, the credit crisis affected all banks last year, resulting in increased write-downs, the building of credit reserves, and the raising of capital. Regarding Wells Fargo specifically, it reported a net loss of $2.5 billion in the fourth quarter of 2008, including $6.9 billion of credit losses, securities write-downs, the building of credit reserves, and almost $300 million of Madoff-related charges. The quarterly loss, however, was overshadowed by Wells Fargo's purchase of Wachovia Corp. and the resulting $36 billion in fund raising that followed.

Wells Fargo's Level 3 assets are growing, while its Tier 1 capital ratio is decreasing and well below that of its peers. In order to maintain sufficient capital, and maintain the lofty common and preferred dividend payments, we believe Wells Fargo will need to raise even more capital. We believe WFC is likely to cut the common dividend. We initiate coverage with a SELL rating.

Disclosure: Short WFC.