Monday, July 14, 2014

Wells Fargo: Sticking to What It Does Best

Wells Fargo:  A well-deserved Double-A rating
Give some deserving credit to the bank Wells Fargo.  It's one of the largest, most important financial institutions in the world and certainly one of the most recognizable banks anywhere in the U.S., thanks to a widespread branch network that puts a Wells Fargo office on just about every other corner in most regions of this country.

Among regulators, the bank is deemed, like other big institutions wielding similar financial impact, a "systemically important financial institution," (or "SIFI," as they are called).  (Accompanying that tag are extra attention, potentially more capital requirements, and a requirement to pass occasional stress tests administered by regulators.) Its "SIFI" designation came about because of its size and geographic scope and because of its large customer base of both retail and institutional clients.  Wells Fargo, like its peers Citigroup, Bank of America and JPMorgan Chase, is a "trillion-dollar bank" with assets now above $1.5 trillion dollars.  A trillion dollars in deposits support a loan portfolio of hundreds of billions.

Without much fanfare and limelight, Wells Fargo has maintained profitability and market strength, while its peers continue to wrestle with financial-crisis issues and scramble for ways to generate profits investors like. The bank just reported second-quarter, 2014, earnings:  Another period of excellent performance ($5.7 billion in net income for the first quarter, $11.5 billion for the first six months). Yet some market doubters have begun to worry about revenue growth and about how the bank will be able to sustain such performance. 

In the past several years, while big banks have confronted every imaginable detrimental financial risk, from strangling new regulation to huge losses tied to imploded mortgage portfolios, Wells Fargo hangs in there from quarter to quarter with handsome returns on equity (12% in 2013, 13% in the second quarter, 2014, e.g.), a relatively clean balance sheet, and fairly basic business lines.

Headlines about  financial institutions often scream about management shortcomings or major challenges at banks like Goldman Sachs, Morgan Stanley, JPMorgan, and Citi.  Wells Fargo, perhaps to its liking, gets crowded off the front pages.  Even those who follow the industry closely won't know its CEO by name (John Stumpf) as well as everybody knows the names Jamie Dimon at JPMorgan Chase or Lloyd Blankfein at Goldman Sachs.

What is Wells Fargo doing right? And how does it get it done?

1.  A bread-and-butter business.  The bank sticks to its niche, for the most part, and that seems to be basic commercial banking: deposit-taking and loan-making. Profits come from a shrewd management of interest spreads, maintaining loan quality and managing costs carefully.

Its peers long ago ventured into far-ranging activities such as investment banking, institutional sales and trading, derivatives and financial engineering of all kinds (and did so successfully until the crisis and until regulators decided to put straps on all that activity).

The bank has now reached a trillion dollars in deposits, which accrue low or no interest expenses.  Over 75% of the these low-rate deposits (no rates, in some cases) support a vast loan portfolio, now exceeding $800 billion (but not growing as fast lately as some investors and market-watchers would like).  (Because of the deposits, net-interest spreads exceed 500 basis points.)

2.  A clean balance sheet.  Like all big banks, Wells had to scrub its balance sheet to manage through or get rid of bad corporate loans, defaulting mortgages and trading assets, while raising capital and reducing risks. (Over $175 billion in equity capital anchors that balance sheet.)  The clean-up exercise, however, didn't lead to billions and billions in settlements and reserves, as other banks incurred. Some banks are still suffering from the recession, still paying settlements to investors and regulators (Bank of America in recent months), and still trying to shake off the crushing blows of the crisis.

Despite the many ways mortgage abuses and incompetence in managing mortgage risks led to billions in losses, Wells Fargo emerged as a leader in mortgage banking, devoting even more capital to this business line than ever, but likely prudent in what it does and how it does it.  Mortgages today comprise a large portion of its $800-billion loan portfolio; mortgage-servicing contributes about 11% of total net revenues.

Marketable securities and trading assets comprise about 20% of all assets, suggesting the bank is still vulnerable to market volatility and still maintains a big trading operation.  Yet in 2014, it hasn't had to grapple with big trading losses, nor is it entrenched in the trading activities (fixed-income, derivatives, e.g.) that are pummeling other big banks.

3.  Few thorns from the Wachovia merger. Wells Fargo had to digest Wachovia in recent years.  Wachovia had not been healthy financially in the late 2000's, and Wells Fargo was even nudged to make the acquisition.  Years after acquiring it, Wells Fargo doesn't appear to have had regrets in the way Bank of America and JPMorgan Chase are second-guessing themselves on acquisitions of Countrywide, Merrill Lynch, Bear Stearns and Washington Mutual.

Either Wachovia was in far better shape than the quartet Bank of America and JPMorgan purchased, or Wachovia and Wells Fargo complemented each other more perfectly than expected.

4.  Less temptation to get too fancy.  With regulators pounding their doors, many banks have retreated, too, to more basic banking activities to comply with tough new rules and to find ways to be profitable.  Wells Fargo, it could be argued, has had an easier time, because it didn't have an aggressive global investment-banking and trading operation and it never seemed tempted to expand beyond what it is comfortable doing.  Think Wells Fargo, and you think of mortgages booked in North Carolina and not exotic derivatives traded in Singapore.

5.  Ability to prepare for regulation.  The bank is well prepared for the Basel III and Dodd-Frank.  It has already begun to meet capital requirements for 2014-19, and Volcker Rules prohibiting proprietary trading won't have the impact it has had on, say, Morgan Stanley and Goldman Sachs.  Equity capital has grown steadily with earnings (about 11% the past 15 months). 

6.  Strong ratings from ratings agencies. The ratings agencies like Wells Fargo, too.  It has one of the best ratings among large financial institutions (Aa3 by Moody's).  Compare to Baa2 at Bank of America, Morgan Stanley and Citigroup, several notches below, or A1 at JPMorgan and Baa1 at Goldman Sachs.  It's not just the clean balance sheet it likes, but stable, consistent earnings in easily understood business segments help, too.

Are there worries?

Investors (and the equity markets) will push for more.  They want assurance the bank can generate 12-13% returns on equity from quarter to quarter and evidence that every quarter going forward will result in more than $5 billion in net profits.  They'll want to see earnings growth from steady increases in the loan volume. But loan volume is a function of other factors, as well, including limits on customer demand, economic cycles, and a long list of competing banks that won't give in. Wells Fargo will strive to push volume without sacrificing loan quality and taking desperate steps.

For now, slap its back and applaud the San Francisco-based institution for showing how plain-vanilla activities can achieve good returns, strong ratings from credit agencies, and a nod of approval from regulators.

Tracy Williams

See also:

CFN:  JPMorgan: Is $13 Billion a Lot of Money? 2013
CFN: Morgan Stanley: Can It Please Analysts? 2012
CFN:  Why Was Citi's CEO Asked to Resign? 2012
CFN:  Basel III: Becoming Real, 2013
CFN:  UBS Throws in the IB Flag, 2012
CFN:  What About Corporate Banking? 2010
CFN:  Today's "Bulge Brackets," 2013

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