Silver as an investment

JPM Downgrades Wells Fargo; Expects More Probes “Following Tough Senate Hearings”

One day after what was a rather disastrous hearing for Wells CEO John Stumpf, which culminated with a Senator telling the embattled chief executive he may want to consider going to prison, the bad news continued overnight when the bank that overtook Wells in the “biggest US bank by market cap” category, JPMorgan, downgraded Wells to Netural, cutting its price target from $53.50 to $48.00 as a result of “tough Senate hearings and mounting public scrutiny following the opening of fraudulent accounts” and because the “senate hearings are likely to expand probes.”

Here is the full note:

Senate Hearings Likely to Expand Probes; Uncertainty About Timing, Expenses – Downgrade to Neutral

We are downgrading Wells Fargo to Neutral following tough Senate hearings and mounting public scrutiny following the opening of fraudulent accounts. We expect these will result in additional investigations which would likely pressure expenses and revenues and continued media scrutiny with an election year – there is significant uncertainty about how much some issues will cost and how long they will take.

 

In our view: 1) Wells will need to spend a lot more on litigation, examining past violations in additional areas, and responding to requirements from more hearings, investigations and lawsuits; 2) revenues will likely face some slowdown in growth including potentially impact on cross-sell in Retail brokerage, a key focus in that area; 3) this is a material reputational hit given the large number of unauthorized accounts (2 million) and how long it went on; and 4) this will likely result in a shift to greater earnings growth from areas such as investment banking which carry lower multiple. Impact on earnings is hard to determine because of uncertainty about likely total expenses – no comparable lawsuit as this matter is very different from the mortgage crisis. The stock has fallen recently but the uncertain timeframe and earnings impact is likely to keep the stock under pressure. $1-2 bil increase in costs would lower EPS by $0.20-0.40 and imply 11.7x-12.3 P/E multiple respectively (if not tax deductible), which is within the range of regional banks – unclear if these penalties would be tax deductible. What is particularly disappointing to us is that we and investors have long held Wells Fargo management in very high regard – they have been smart contrarian thinkers and made thoughtful decisions. We expect management to turn this around but it will likely take some time and expense – hence the downgrade.

 

It is unclear whether this will lead to criminal prosecutions and lawsuits will expand – State Attorneys General, SEC, and potentially criminal investigations. Wells Fargo has been viewed as a core long term holding for many investors – uncertainty around these issues could drive more investors to exit.

 

There is significant uncertainty about some issues – 1) how to compensate customers whose credit scores were increased; 2) how to compensate employees who were fired for not meeting sales targets; and 3) how far back in time Wells will need to go to scrutinize sales. We expect the scrutiny is likely to require lot of investigations and increased compliance and training spending, pressuring expenses.

 

We do not expect this scrutiny to impact Wells’ capital but could slow dividend growth. If the fines/penalties go into several billions, that would add a little to operational risk RWA.

And some additional details from JPM as it hammers the nail in:

  1. There is a lot of pressure from Congress for Wells to take more steps: 1) reimburse customers for impact on credit scores and hence increase in their borrowing costs because of unauthorized credit checks; 2) compensate employees who were fired for not meeting sales quotas that were too onerous and seem to have contributed to this problem; and 3) examine credit overdraft protection sales for
    unauthorized sales.
  2. Timeline uncertain. There has been lot of focus on how long these unauthorized account openings have been going on. The fines were paid based on unauthorized openings from 2011 to 2015. On average 1,000 employees were fired each year from 2011 onwards for fraudulent transactions. However, the CEO seems to have been informed of this only in 2013. This time gap in information flow was surprising and troubling
  3. Investigations by the Consumer Financial Bureau (CFPB), Office of the Comptroller of the Currency (OCC), and the City of Los Angeles revealed that Wells Fargo opened ~2 mil customer deposit and credit card accounts without customer authorization from 2011 to 2015. Regulators have been investigating whether Wells’ set sales goals for branch employees that were too aggressive which in turn encouraged fraudulent activity. In response Wells has fired over 5,300 employees, agreed to a $185 mil fine, and has incurred customer remediation charges in relation to $2.6 mil charged to customers in relation to the unauthorized accounts. It appears that these transactions were more prevalent in certain areas – Southwest (Los Angeles, Nevada and Arizona), New Jersey and Florida.
  4. It does not seem that Wells made any material income from these transactions. However, change in the overall sales process may pressure revenues. The cross-sales that are being investigated do not appear to have added much to earnings – the overdraft fees that seem to have been generated were very small at $2.6 mil. In fact, cross-sales have declined a tad recently. We have generally focused more on analyzing receivables and transactions volume that drive revenues rather than crosssell.
  5. Wells has recently been focused on increasing cross-sell in Retail Brokerage, the largest fee income category (11% of revenues). This pace of cross-sell could slow which would temper revenue growth in the business.
  6. Mix of revenues and earnings could change. Community banking has accounted for 62-67% of net income over the past 3 years, while Wholesale banking accounted for 36-40% of net income. We would expect this mix to shift more to Wholesale Banking – the key business in Wholesale segment where Wells has low market share is investment banking. Faster commercial loan growth will depend on customer demand and the economy.
  7. Wells Fargo’s capital position remains strong – CET1 ratio was 10.6% fully phased in at June 30, 2016 and we do not expect any impact on capital return.