What You Need To Know About Wells Fargo & Co’s Regulatory Smack-Down

The Fed's sanctions will hit WFC's 2018 and 2019 earnings. But that's priced into the stock -- and more.

By Ian Bezek, InvestorPlace Contributor

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Still Easier Ways to Make Money Than Wells Fargo & Co (WFC) Stock

Source: Mike Mozart via Flickr (Modified)

For years, it seemed like a safe bet that too-big-to-fail banks would suffer minimal consequences for bad behavior. As Netflix, Inc.‘s (NASDAQ:NFLX) recent documentary series Dirty Money showed, HSBC Holdings plc (ADR) (NYSE:HSBC) suffered only a slap on the wrist after serving as a money laundering service for Mexican drug cartels. And as political activists have reminded us, almost no banking executives personally faced criminal charges for the illicit lending activities that led up to the 2008 Financial Crisis.

So, it comes as a surprise that Wells Fargo & Co (NYSE:WFC) is taking meaningful regulatory heat for its recent sales scandals. WFC stock is down 10.6% since Monday on the news, and remains weak subsequently as investors digest what’s transpired. Here’s what you need to know.

The Fed’s Consent Agreement

Last Friday evening, the Fed published a statement: “Responding to recent and widespread consumer abuses and other compliance breakdowns by Wells Fargo, the Federal Reserve Board on Friday announced that it would restrict the growth of the firm until it sufficiently improves its governance and controls.”

The statement goes on to list the specific punishments against Wells Fargo. Among them, four current board members must resign. All of the board must agree to a cease-and-desist order and promise not to allow the bank’s total assets to exceed end-of-2017 levels. This growth cap will only be lifted once WFC has proven that it is no longer behaving inappropriately.

In one her final official acts as Fed chairwoman, Janet Yellen said that the regulator “cannot tolerate pervasive and persistent misconduct at any bank and the consumers harmed by Wells Fargo expect that robust and comprehensive reforms will be put in place to make certain that the abuses do not occur again.”

Growth Cap = A Limit On WFC Stock

While there are several factors that could hit WFC stock in the wake of this punishment, the growth cap will have the biggest impact. Banks rely on asset growth to boost earnings. Ultimately, banks have three main ways of improving results: Raise net interest margin on loans; Increase the total number of loans outstanding; or, Focus on increasing non-interest income, aka fees.

Wells Fargo can’t try to charge more fees now. Due to their scandals — auto insurance, unwanted new accounts, and questionable consumer lending — America’s third-largest (for now…) bank simply can’t try to earn more money that way.

Regulators will be watching them intently on that front. And now, Wells can’t write more total loans either due to the Fed cap. That leaves them with just one of the three usual engines of banking EPS growth.

But that won’t be enough. Management suggested the growth cap will cost the company $300 million-$400 million in 2018 earnings. That’s a fairly small percentage against $22 billion in 2017 total operating income. That said, the growth cap will cost the company more and more with each passing year as long as it is stuck at 2017 levels of assets while its peers keep growing.

WFC Stock: No Longer Best In Class…

Anyone who invested during the financial crisis remembers that U.S. too-big-too-fail banks were a disaster. The majority of them went bust, merged, or needed government bailouts. Wells Fargo, due to its more prudent lending standards, managed to avoid the industry meltdown. In fact, WFC stock was one of the few that never seriously faced the threat of tanking to zero in 2008.

It parlayed that solid experience into a reputation as America’s best big bank. That upgrade came following news that Warren Buffett had bought heavily into the firm and said positive things about WFC stock. Buffett’s approval is pretty much the gold standard. Since then, Wells was viewed with a halo. While investors continued to shun the rest of the banking industry, WFC shares earned blue chip status.

Sadly, the recent scandals knocked the bank down from that pantheon. In the space of a few short quarters, Wells Fargo went from the country’s best big bank to the worst. For the all troubles that institutions like Bank of America Corp (NYSE:BAC) got into to, none of them ended up the subject of a massive Federal Reserve crackdown.

It Is Fairly Cheap Though

This reputation reversal has also come with a swing in relative valuations. For years, WFC stock was among the most expensive of the big American banks. Buffett’s endorsement and its sterling reputation during the financial crisis gave it premium appeal.

That’s all changed now though. Over the past year, the Financial Select Sector SPDR Fund (NYSEARCA:XLF) is up 20%. Bank of America stock has led the big banks, rallying 34%. WFC stock, on the other hand, has pulled up the rear, eking out less than 1% in the period.

That leaves WFC stock at just under 14x trailing earnings and 12x forward earnings (though analyst estimates will fall moderately once the Fed’s punishment is priced in). Wells Fargo is at 1.6x book value versus an industry average 1.3x, according to Morningstar data. That isn’t ridiculously cheap, but it’s hardly pricey for a leading national bank with an above-average quality loan book.

WFC Stock Verdict

If you believe that Wells Fargo’s rotten sales culture is an easily fixable problem, there is a lot to like here. The core business remains highly appealing. Sure, WFC stock was overpriced due to its heretofore superior reputation. But it’s not hard to make the case that things have gone too far in the other direction now.

WFC stock has badly trailed both its sector and the market for the past year. And it’s only gotten worse over the past week. WFC stock plummeted 9% on Monday, outpacing the market’s 4% decline overall. Tuesday is where the value gap really opened up though. Wells dropped another 1.5% while the Dow rebounded more than 500 points and the S&P jumped 2%. Another day or two of divergence like that, and WFC stock will look positively cheap compared to peers. Sure, earnings won’t meet expectations for 2018 due to the Fed’s actions – but at this price, there’s still plenty of margin of safety here.

At the time of this writing, the author held no positions in any of the aforementioned securities. You can reach him on Twitter at @irbezek.


Article printed from InvestorPlace Media, https://investorplace.com/2018/02/what-you-need-to-know-about-wells-fargo-cos-regulatory-problems/.

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