After the 2008 financial crisis and ensuing great recession, four U.S. banks emerged as one semi-oligopoly to dominant the U.S. banking landscape. One of those four is Wells Fargo (WFC), the largest U.S. bank by market capitalization. Wells Fargo’s name is iconic, and Wells Fargo’s stagecoach logo has become a consumer brand that many generations of Americans can identify.
Wells Fargo’s brand has translated into a dominant market position in which the bank holds the largest in dollar deposits in many cities west of the Mississippi. Most large banks make money through interest rate arbitrage, in which they borrow money at an interest rate that is less than what they lend money to others for (this is referred to as a bank’s net interest margin).
Wells Fargo is no exception to this rule. With such a wide base, from which to draw deposits to fund new loans, Wells Fargo has a virtual unlimited amount of lending power. With 97% of Wells Fargo revenue being derived from the U.S., Wells Fargo is also at a distinct advantage to its global competitors to take advantage of an increasingly stronger U.S. economy.
It’s All About Mortgages, Mostly
Having access to such a wide amount of deposits is not always a good thing, especially when there are not sufficient opportunities in which to invest the capital in new loans at profitable interest rates. This dynamic played out for Wells Fargo last quarter with the bank’s net interest margin narrowing to 3.06 % from 3.39% the year earlier and 3.15% last quarter as deposits continue to grow faster than loans.
What is the cause of lower loan growth? Fewer mortgages.
Wells Fargo is the largest U.S. housing lender, and improvements in new home purchases were unable to overcome lower mortgage refinancing with mortgage originations for the third quarter coming in at $48 billion, a sharp decrease from $80 billion the prior year but a slight increase from the second quarter.
Offsetting lower mortgages is Wells Fargo’s other consumer lending operations that have grown recently, including auto lending, which was up 11% in the third quarter to $55.2 billion but was not enough to cover lower mortgage volumes.
Wells Fargo Mortgage Malaise
The U.S. housing market continues to slowly recover. Federal and state regulators’ overreactions in the wake of the Great Recession have driven increased compliance and risk management at all U.S. financial institutions. Consumer protection is very important and cannot be underscored, but arguably the more stringent requirements, coupled with lower household formation and higher student loan debts, have left many Americans out in the cold when it comes to home ownership.
According to Fannie Mae’s Economic and Strategic Research group, home prices are on the rise but so are interest rates, which will drive total home sales down 2.7% this year but up 5.4% in 2015. Mortgage ooriginations (which include refinancing as well as purchases) are expected to decline this year and next from 2013 levels.
Lower mortgage volume does not necessarily mean lower profits. Due to the more stringent lending requirements, credit quality has improved, allowing Wells Fargo to release $300 million in reserves in the quarter. This is down from $900 million in the prior year and $500 million last quarter, but releasing reserves are still better than accumulating them.
WFC Stock a Buy Even at High Price
Wells Fargo’s 12-month consensus stock price is at $55, right around the current trading range. The bank offers a decent dividend yield of 2.6% with a low 32% payout ratio. Wells Fargo’s price to book of 1.7 is higher than the industry average of 1.1, which takes into account Wells Fargo’s strong competitive advantage.
As a value investor, I seldom recommend a stock that has such a small margin of safety in regards to stock price, but I will make an exception for Wells Fargo. I see Wells Fargo’s earnings increasing through next year on improving credit quality, rising interest rates (allowing for higher net interest margin) and cost cutting.
Wells Fargo is also looking to expand beyond its traditional stronghold in the western U.S. into New York and other eastern seaboard markets, which adds additional potential. Plus, Wells Fargo stock’s nice dividend makes WFC worthwhile to hold.
As of this writing, Kenneth Fick did not hold a position in any of the aforementioned securities. Write him at kfick@piercethefog.com or follow him on his blog at www.piercethefog.com.
