Wells Fargo: Likely To Regain Premium Valuation Despite Earnings Pressure From Regulator Issues

| About: Wells Fargo (WFC)


There have been several news items related to Wells Fargo over the past month.

At first glance, the issues will likely add to Wells’ reputational challenges and put further pressure on earnings.

Will Wells Fargo regain its premium valuation?

There have been several news items related to Wells Fargo (NYSE:WFC) over the past month.

First, the Office of the Comptroller of the Currency (NASDAQ:OCC) rolled back some of the settlement terms it agreed with Wells in September. As a reminder, on September 8th, Wells Fargo announced USD185mn in settlements with the Consumer Financial Protection Bureau, the OCC, and the Office of the Los Angeles City Attorney, regarding allegations that 'some of its retail customers received products and services they did not request.'

The regulator's statement effectively means that Wells is banned from offering golden parachutes payments to its former employees. WFC must also seek prior approval before naming senior management or the board of directors:

Pursuant to certain enforcement actions1 by the Office of the Comptroller of the Currency against Wells Fargo Bank, N.A. (Bank), the OCC informed the Bank today that it has revoked provisions of the enforcement documents2 that provided relief from specific requirements and limitations regarding rules, policies, and procedures for corporate activities; OCC approval of changes in directors and senior executive officers; and golden parachute payments. As a result of these revocations, the Bank is no longer an "eligible bank" pursuant to 12 C.F.R. § 5.3(g) for purposes of expedited treatment of certain applications; is now subject to the limitation of 12 C.F.R. § 5.51 requiring prior written notice of a change in directors and senior executive officers; and is now subject to the limitations of 12 C.F.R. Part 359 on golden parachute payments.

Both the Federal Reserve and the Federal Deposit Insurance Corporation rejected Wells' resubmitted Resolution Plan ('a living will test'). The original draft was rejected in April. According to the agencies, Wells Fargo did not fix two of the three areas that had been cited for 'deficiencies' in the original plan. Specifically these two categories were 'legal entity rationalization' and 'shared services.' The regulators also said that Wells did not adequately fix its deficiency in the so-called 'governance' category. As a result, the Federal Reserve and the FDIC imposed restrictions on the growth of international and non-bank activities of Wells Fargo and its subsidiaries. In particular, Wells is prohibited from establishing international bank entities or acquiring any non-bank subsidiaries. Wells has until March 31, 2017 to resubmit its results. According to the regulators, if the bank does not fix its deficiencies in March, more serious actions will be taken including limiting the size of the company's non-bank and broker-dealer assets. We believe this could be a material headwind for Wells, given that the bank is growing its investment business. If WFC has not fixed the deficiencies within two years, the Federal Reserve and the FDIC may require the bank to divest certain assets or operations.

Prudential Financial (NYSE:PRU) announced that it will suspend the distribution of MyTerm insurance policies through all Wells Fargo bank branches and website, pending the results of Prudential's review of how the product is sold by Wells Fargo:

Prudential Financial, Inc. announced today that it will suspend the distribution of MyTerm policies through all Wells Fargo bank branches and website, pending the results of Prudential's review of how the product is sold by Wells Fargo

Launched in 2007, MyTerm is a simplified issue term insurance product that was created to give customers greater choice and access to life insurance through a self-assisted, technology-enabled application process. In June 2014, Prudential entered into a distribution agreement with Wells Fargo, whereby the MyTerm product was made available to Wells Fargo customers through self-service kiosks in Wells Fargo bank branches and its website.

Last year, Prudential's Individual Life Insurance business surveyed Wells Fargo customers about their experience with MyTerm, including reasons why some of them allowed the product to lapse. The customer responses did not indicate potential fraudulent activity. Following the revelations about Wells Fargo's sales practices this fall, Prudential expanded its review into how the product was sold and asked for Wells Fargo's assistance in gathering all the necessary facts.

We believe the suspension will not have too much effect on Wells' financials, given that MyTerm insurance policies represent a negligible amount of the bank's fee income. That being said, this is a sign of the increased scrutiny over WFC, in our view.

Bottom line

Prior to the CFPB settlement, Wells Fargo was thought of as a classic safe-heaven stock. Moreover, WFC had been one of the most successful large-cap U.S. banks in navigating the tough regulatory and legal environment. As such, the several open regulatory issues will definitely remain the key focus for investors. In addition, in our view, further underperformance versus the sector cannot be ruled out in the coming months. Having said that, there have already been several cases where large-cap U.S. banks were negatively affected by an unexpected material event: JPMorgan (NYSE:JPM) and 'The London Whale trading scandal'; Goldman Sachs (NYSE:GS) and 'The Abacus Suit'; Bank of America (NYSE:BAC) and 'The $4bn accounting error'; M&T Bank (NYSE:MTB) and its anti-money laundering problems. We do agree that those cases are not exactly comparable to WFC's situation. Moreover, one could argue that the WFC settlement is a much bigger deal since it was from a retail issue and included the fraudulent opening and closing of accounts, while other cases were from a more institutional issue. However, while the banks affected by unexpected material events have underperformed the sector in the 1-3 month period, they have each regained their multiples within the 9-12 month period. In other words, those issues have not had a lasting impact on the banks' valuation metrics. As such, while in the short-term Wells may underperform the sector, we believe the stock will likely regain its premium multiples over the next 9-12 months.

As a buy-side analyst and a deputy portfolio manager, I oversee a financials-focused fund, and will be continuously providing research coverage on developments with Wells Fargo and other global banks, insurers, asset managers and other financial companies. If you are interested in the topic, consider following us by clicking the "Follow" button beside our name at the top of the page. Thank you for reading.

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Disclosure: I am/we are long JPM.

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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