U.S. Markets open in 2 hrs 27 mins

Wells Fargo Could Catch a Break as Asset Cap Is Lifted

On April 8, the Federal Reserve announced that it will be temporarily lifting the asset cap on Wells Fargo & Co. (NYSE:WFC), the third-largest bank in the U.S.

The decision came after Wells Fargo pointed out that the asset cap prevented it from participating in the government's small business lending efforts, which are being implemented in an attempt to lessen the economic blow from the spread of the novel coronavirus (Covid-19).


The move will "temporarily and narrowly modify the growth restriction on Wells Fargo so that it can provide additional support to small businesses," according to the Fed, though there is a condition; unlike the other big banks, Wells Fargo will have to donate any potential profits from the lending programs, either to the Treasury or to a Fed-approved non-profit.

However, this isn't as bad as it may sound. For one, the U.S. central bank has already lowered the base interest rate to zero and plans to keep it that way until the economic impacts from the virus subside, according to the minutes from its latest meeting. Thus, any potential profits from these loans would be minimal, especially considering that many businesses, both small and large, have a high potential to default on their loans if they already have heavy borrowing on their balance sheets.

Thus, the decision to allow Wells Fargo more lending capacity could provide the bank a path toward redemption in the eyes of the government and the public, and any blow to its balance sheet is likely to be about the same as the other major U.S. banks. Let's look at why.

Coronavirus relief lending

As mentioned above, Wells Fargo will now be able to up its lending, though only for the purpose of coronavirus relief lending efforts. Specifically, lifting the asset cap "provides additional support to small businesses hurt by the economic effects of the coronavirus by allowing activities from the PPP and the Main Street Lending Program to not count against the cap."

PPP loans, also known as loans made under the new Paycheck Protection Program, are loans where businesses can borrow up to two and a half times their average monthly payroll costs, excluding salaries above $100,000, as calculated from the previous 12 months before the date of the loan. These loans, which are part of the $2 trillion coronavirus stimulus package, are for businesses with between one and 500 employees and will be funded with $350 billion in taxpayer dollars. The interest rate is set at 1%, and there is a catch to the loans being forgivable - in order to be forgiven, 75% of the money must go toward payroll.

The Main Street lending program will lend to businesses that have more than 500 employees, but which still have fewer workers than larger corporations. These loans will get $100 billion in federal funding to begin, with interest rates set at 2% to 2.5% and due dates in two to five years. While PPP loans are being provided through banks of all sizes, the Main Street lending money is expected to flow through the top banks, including Wells Fargo, JPMorgan Chase & Co. (NYSE:JPM) and Bank of America Corp. (NYSE:BAC).

Banks are also being encouraged to up their lending to mid-to-low-income Americans who have lost their sources of income. In exchange for making these high-risk loans, banks will receive bonus regulatory points through the Community Reinvestment Act, a 1977 law that attempts to rate banks by how well they meet the credit needs of lower-income customers.

Who will pay for all these loans, especially the ones that are forgiven or defaulted on? The answer will only be clear in hindsight, though it will likely be some sort of combination of the banks, taxpayers (via taxes) and bank customers (through reductions on deposit interest rates and other banking rewards programs). That's nothing new, though; banks always lose money when the economy tanks. What's most important for industry players in this environment is gaining customer loyalty and regulatory credits, both of which Wells Fargo now has the chance to do.

Guru investments

The top guru shareholder of Wells Fargo is Warren Buffett (Trades, Portfolio), who owns 7.9% of the bank's total shares outstanding as of the end of 2019. According to GuruFocus estimates, the investment has earned a total estimated gain of approximately 70% over the past decade.

2c2e04fefdc40102a0a2dd480e07b12c.png

"They obviously had a very dumb incentive system ... and the big thing is they ignored it when they found out about it," the Oracle of Omaha said in a CNBC interview on Feb. 24, after Wells Fargo reached a $3 billion settlement agreement for the fake accounts scandal.

Though the guru has curbed the stake in the years since the scandal, it is still Berkshire Hathaway's (NYSE:BRK.A)(NYSE:BRK.B) fifth-largest holding, making up 7.18% of the equity portfolio. In the interview, Buffett also said, "I feel very good about the banks we own. They're very attractive compared to most other securities I see," indicating that at the time of the interview, he believed in the long-term prospects of bank stocks, including the Wells Fargo stake.

Other top guru shareholders of Wells Fargo include Dodge & Cox with 2.07% and Primecap Management with 1.25%.

Valuation

Given an opportunity to improve its reputation and regulatory credit, does this mean that Wells Fargo could be a value opportunity once the economy begins to recover?

In 2013, a Los Angeles Times article reported that "relentless pressure to sell has battered employee morale and led to ethical breaches" at Wells Fargo. "To meet quotas, employees have opened unneeded accounts for customers, ordered credit cards without customers' permission, and forged client signatures on paperwork." This snapshot of brutal company culture points to the kind of toxic working environment that often results in employees bending the rules in order to avoid being fired for not meeting unrealistic goals. In a top U.S. bank, this environment led to rule-bending that destroyed the bank's credibility in the eyes of the government and potential customers.

One big question investors may have when attempting to find the intrinsic value of the company is whether or not the company culture has changed. The answer is not clear-cut. On the one hand, the company claims to have scaled back aggressive sales goals to levels similar to competitors. According to job review boards such as Glassdoor, Wells Fargo employees still face unrealistic sales goals, though they are now in a similar range as those of other big bank employees. On the other hand, this "progress" is only reverting to the mean, which may not be enough in the eyes of customers and investors.

In terms of share price, Wells Fargo traded around $29.70 per share on April 8 for a market cap of $122.11 billion and a price-earnings ratio of 7.53 (slightly above its 10-year low earlier the same month).

For comparison, JPMorgan traded at a price-earnings ratio of 8.75 on the same date, while Citigroup (NYSE:C)'s price-earnings ratio was 5.11 and Bank of America's was 8.53. Year to date, Wells Fargo shares are down 46% compared to JPMorgan's 34% loss, Citigroup's 48% loss and Bank of America's 37% loss.

b3627a1dad0564fdc9059ca07ef20990.png

Conclusion

Even though the temporary removal of the asset cap will provide Wells Fargo a valuable opportunity to repair its reputation and boost its regulatory credit, now is probably not the best time for new investors to snap up shares. The bad news for bank earnings is far from over, and the negative effects of increasing lending to an economy that has already borrowed approximately $10 trillion, or 47% of its net worth according to data from the Federal Reserve, will not be pretty.

"We are sitting on the top of an unexploded bomb, and we really don't know what will trigger the explosion," Emre Tiftik, a debt specialist at the Institute of International Finance, said. Will the Covid-19 crisis be what triggers the U.S. corporate debt bomb? There is no way of knowing in advance, but it certainly seems to be a possibility.

Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful research or consult registered investment advisors before taking action in the stock market.

Read more here:



Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.

This article first appeared on GuruFocus.