Wells Fargo Attracting More Scrutiny

| About: Wells Fargo (WFC)

Summary

Wells Fargo & Company is one of the largest banks in the U.S. and therefore its solvency benefits from highly likely governmental support in case any serious problems arise.

Stability of WFC’s earnings is underpinned by the fact that it services $1.33tn off-balance sheet mortgages sold to FNMA, FHLMC, GNAM (mortgage-related fees amount to 15.2% of noninterest income).

WFC now traded just 5% above 52-week low price of $45.16 so this is an attractive buy in the moment for those investors who are looking for stable income.

Wells Fargo & Company (NYSE:WFC) is one of the largest banks in the U.S. with significant and widespread national banking franchise and therefore its solvency benefits from highly likely governmental support in case any serious problems arise (and it in fact received more than $25bn in 2008 bailout). Below we briefly outline possible sources of future problems as well as positive factors.

WFC's conservative balance sheet (only 13.8% represented by AFS securities) as aligned towards low-risk loan portfolio. Risky credit card loans (yielding 11.6% on average in 1Q16) account for just 7% of retail loans and they do not have significant growth potential as utilization rate is already at 32.5%.

Real estate loans constitute half the overall loan portfolio with 16% commercial real estate and 34% residential mortgage. These loans are highly geographically concentrated but this concentration is mostly in prosperous regions. Exposure to California is the largest with 27.1% in CRE and 37.3% (including a large portion of PCI loans). Combined with New York and Florida top-3 regional exposures amount 41.4% and 50.2% respectively. Stability of WFC's earnings is further underpinned by the fact that it services roughly $1.33tn off-balance sheet mortgages sold to Fannie Mae (FNMA), FHLMC, GNAM (mortgage-related fees amount to 15.2% of noninterest income).

Even with such low-risk profile WFC faces elevated NPAs especially in its consumer lending. Total problem loans equaled 3.7% of the portfolio with solid 6.0% in retail portfolio. While this ratio declined from 6.3% at end-FY2015 it's still high. Foreclosing mortgage is costly so declining portfolio quality might depress WFC's operational efficiency (currently average in 55-60% band). Sharp increase in problem corporate portfolio (1.43% at end-1Q16 and 1.13 at end-FY2015) is attributable to energy-related loans (which are now a common headache for U.S. wholesale lenders) and we do not suppose it will either grow significantly higher further or affect WFC's earning materially.

Interest rate rise effect should be positive - floating rate loans account for 84.3% of portfolio. Although interest-bearing and market rate deposits exceeds this by 2.3x times their sensitivity to rate changes should me much lower due to overall low rate level. So we believe WFC is favorably aligned against potential rate increase and its spread shouldn't bear significant interest risk (disclosure regarding interest rate risk is scarce but WFC indicates that 0.5% growth in long-term rates should increase earnings by up to 5%).

Trust and investment business has the highest share in noninterest income (32.2%) and dropped by 8% YoY due to overall market decline. Recovery in this business should be significantly positive for WFC in the future although it's not very likely in near term given political risks related to presidential race. Mortgage fees and investment services-related commissions combined form 41.7% of WFC's solid noninterest income (40.8% of total revenue in 1Q16) which further contributes to earnings stability.

One more positive factor for WFC is its limited M&A activity - in the last 8 years (after the purchase of Wachovia Corporation) the bank focuses on buying loan portfolios and selected business lines rather than expanding rapidly by aggressive acquisitions.

Negative factors for WFC are more difficult to quantify. WFC is systemically important bank and a market maker (i.e. in April it was included to prime dealers list by the Fed) facing heightened regulatory scrutiny which somewhat limit its development. As an example, one possible source of downward pressure is total loss absorbing capital (TLAC) requirement. Under Dodd-Frank act, U.S. systemically important banks are to face higher loss-absorbing capacity mostly related to increased requirements for unsecured debt (which is to cover 50% of TLAC instead of FSB's proposed 33%). The management outlines that WFC may be required to issue more long-term debt (moderate 13.8% of total liabilities at end-1Q16). As this (unsecured) debt is more costly than deposits (by roughly 1%) an increase of $50bn should subtract about 3% from net income.

To further extent, in April 2016 FDIC and the Fed declared that WFC's resolution plan was not credible (under so-called "living will" requirement) and would not facilitate an orderly resolution under the Bankruptcy Code (along with 5 other large banks of total 8 who submitted such plans). Regulators stated that WFC's 2015 plan had "material errors". WFC must now update its plan by October 2016 and failing to do that can lead to severe regulatory consequences such as more stringent capital, leverage or liquidity requirements, restricting growth, divesting assets or operations. We do not expect that the resolution plan will be rejected after all but such signals can indicate possible problems which only the regulator is now aware of.

WFC offers slightly above average dividend yield of 3.26% which has grown due to price decline by roughly 13% in 2016. Common stocks are traded at roughly 40% premium to tangible book value. It's now traded just 5% above 52-week low price of $45.16 so this can be an attractive buy in the moment for those investors who are looking for seeking stable income.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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