I think many investors have been willing to give Wells Fargo (NYSE: WFC) The benefit of the doubt in recent years. After its fake account scandal in 2016, the bank agreed to pay a massive $ 3 billion settlement. The Federal Reserve then placed an asset cap of $ 1.95 trillion at the bank. Then came the coronavirus pandemic.
While the company’s stock price continued to drop, many saw it as an opportunity to enter a bank with a solid business model that is too big to fail. The advantage seemed huge, and could still be.
But after a disastrous second quarter that resulted in a loss of $ 2.4 billion and an 80% reduction in the quarterly dividend, it’s hard to find excuses for Wells Fargo’s worst quarter since the Great Recession.
Image source: Wells Fargo.
A huge supply of unexpected credit
Wells Fargo’s $ 2.4 billion loss ($ 0.66 per share) was much worse than most analysts expected. I will give the bank a pass for its drop in revenue, which has decreased by $ 3.7 billion since the second quarter of 2019. After all, the asset cap prevents Wells Fargo from expanding its balance sheet, which is the main way to offset the Smaller loan spreads. resulting from the fall of the Fed interest rates to zero.
What is hard to excuse is the absurdly high provision expense of $ 9.5 billion (cash that banks set aside to cover potential loan losses) that Wells Fargo took in the second quarter, which is more than double what it took in the first trimester.
| Bank | Provision of credit Q2 |
|---|---|
| JPMorgan Chase (NYSE: JPM) | $ 10.5 billion |
| Bank of America (NYSE: BAC) | $ 5.1 billion |
| Citigroup (NYSE: C) | $ 7.9 billion |
| Wells Fargo | $ 9.5 billion |
As you can see above, other large banks also took large provisions. But Wells Fargo is much smaller than JPMorgan Chase in terms of total assets. Additionally, it has a much smaller credit card loan portfolio, which tends to have higher losses, than JPMorgan and Citigroup. In terms of exposure to business and credit card loans, its loan portfolio is much more similar to that of Bank of America, which only received a quarterly loan provision of $ 5.1 billion.
Bad loan projected in the first quarter
The pain for Wells Fargo came from his business loan portfolio. The bank increased reserves to account for potential business losses by nearly $ 6.4 billion in the quarter. Commercial loans face enormous pressure as the pandemic not only greatly reduces foot traffic in businesses and the public, but it also changes the potential value and demand of some buildings, not to mention the damage to the oil industry and the gas. In its earnings presentation, Wells Fargo projects that commercial real estate prices will fall somewhere in the low percentages in mid-teens.
I have no problem conservatively banking, but the reason you had to take such a large provision in the second quarter is that you did a poor job of properly projecting losses and economic conditions in the first quarter.
| Bank | Q1 Provision for credit losses | Coverage radius |
|---|---|---|
| Wells Fargo | $ 12.0 billion | 1.19% |
| Bank of America | $ 17.1 billion | 1.51% |
| Citigroup | $ 22.6 billion | 2.91% |
| JPMorgan Chase | $ 25.4 billion | 2.32% |
Source: SEC files of the company.
As you can see above, Wells Fargo saved much less cash to cover potential total loan losses than its peers, not only from a total cash perspective, but also as a percentage of total loans (coverage ratio), which is a best comparison.
The way Wells Fargo calculated its loan loss reserve in the first quarter of the year seemed more hopeful than conservative. Many banks in the first quarter, including Wells Fargo, adopted a new accounting method called the Current Expected Credit Loss Method (CECL), which essentially requires banks to forecast losses over the life of a loan as soon as it originates and is added the balance sheet.
While many banks ended up significantly increasing their total reserves to account for this new methodology, Wells Fargo said that CECL actually decreased its total reserves by $ 1.3 billion. So even when the bank took a $ 3.8 billion loan provision in the first quarter to account for potential loan losses from the coronavirus pandemic, it only ended up increasing its reserves to cover potential losses on commercial and industrial loans. at $ 630 million in the first quarter, a modest number considering economic conditions.
The bank also ended up reducing its reserves to cover potential losses in commercial real estate and commercial real estate construction loans in the first quarter by $ 388 million and more than $ 1 billion, respectively. I know accounting policies are complex, but this makes little sense to me. By the end of the first quarter, many states had already started implementing shelter orders in place, and many banks were already preparing for large losses. It seems like a strange time to decrease bookings for these business categories.
CEO Charlie Scharf said in the company’s earnings call that “our view of the length and severity of the economic downturn has deteriorated considerably due to assumptions used in the last quarter, which drove the addition of $ 8.4 billion to our credit loss reserve in the second quarter. ” He also acknowledged that “we are extremely disappointed with our second quarter results” and that, despite the pandemic, “our franchise should work better.”
Scharf was hired to clean Wells Fargo after the bank’s fake account scandal. He has decades of experience in executive functions in financial institutions, previously he was CEO of Visa and the Bank of New York Mellonand performing other leadership roles at Citigroup and JPMorgan. He is a protégé of JPMorgan Chase CEO Jamie Dimon. Therefore, it is troubling to see someone with so much experience allowing the company to use optimistic and, ultimately, wrong assumptions. Isn’t it a great rule of thumb to always be conservative and prepare for the worst?
Wells Fargo has never had credit problems; Even in the Great Recession, the bank performed reasonably well compared to others. Now would be the worst time for the bank to add another problem to its list.
Management needs to do better
To Scharf’s credit, he basically acknowledged that the bank was in bad shape. Also, the bank’s loan loss reserve as a percentage of total loans is now much better at 2.19%, one percentage point higher than Q1. Scharf is also in the process of modernizing senior leadership and said the bank needs to cut $ 10 billion in spending.
All of this should go a long way in helping the company run properly, but the second quarter didn’t reflect well on Scharf or the rest of the Wells Fargo management team, and leadership must do better now.
