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Wells Fargo & Co Gets No Respect

February 21, 2018

 

 "Al", retired Wells Fargo stagecoach pony  

 

New York | Wall Street more than bounced last week as the secular shortage of stocks quickly snapped investors out of their collective funk.  But one once stellar performer in the large cap financials, Wells Fargo & Co (NYSE:WFC), hung back from the surging crowd.  In years gone by, Wells was the quiet exemplar of operating efficiency among large banks, but no more. Today WFC is the bank that everyone loves to hate.

 

But while WFC may be the object of scorn, its operations continue pretty much as before.  As we told SquawkBox a week ago, having WFC trading at a discount to JPMorgan (NYSE:JPM) is not a normal state of affairs. The former has better nominal as well as risk adjusted returns than JPM on most days, but of late WFC senior management has been slicing off figurative fingers and toes in a stunning display of reputational self-destruction.

 

With WFC up just single digits for the year following the perfunctory sanctions from Chair Janet Yellen and the Federal Reserve Board, and its large bank peers up 3x this amount, the question many investors ask naturally is whether Warren Buffett’s favorite bank is good value compared with JPM and other peers.  The short answer is “Yes” – but only if you believe that WFC,  sans problemas, ought to be trading at 2x book value. 

 

With JPM at 1.7x book, WFC in normal times should be trading at a 20-25% premium to the House of Morgan. But these are hardly normal times.  It seems more than ironic that at a time when financials are trading at all time highs, one of the more dependable large banks has managed to put itself into the penalty box with progressive politicians and federal regulators.  Ron Lieber of The New York Times last week listed the long bill of particulars against WFC:

 

“Any one of the sins that Wells Fargo committed against consumers would have been bad enough. There was the unnecessary auto insurance it forced auto loan borrowers to buy. And the data breach where scores of the bank’s wealthiest clients woke up to the news that a lawyer for the company had handed over their personal information to an adversary. Plus accusations of unauthorized changes to people’s mortgages. And those fake accounts — numbering in seven figures — that employees created in customers’ names.”

 

Lieber then goes on to bemoan the fact that he cannot pull all of his business from WFC, including the operationally challenged world of loan servicing. WFC has $1.7 trillion in loans it manages as a loan servicer. In the consumer centric world of financial journalism, it may seem entirely appropriate for borrowers to have the option – nay, the right – to decide who services their mortgage.  But in fact it is the investor in the mortgage note, frequently Uncle Sam, who ultimately makes that decision. 

 

For the past two decades, WFC has built a huge business originating and servicing residential and commercial mortgages. By default, when investors purchase a mortgage backed security (MBS) issued by a large universal bank such as Wells, they also select the loan servicer.  WFC originates or buys the billions of dollars per year in residential mortgage loans, packages them into securities, and then issues MBS while retaining the right to service the loans, what is known as mortgage servicing rights or “MSRs.”

 

Servicing rights such as MSRs are naturally occuring negative duration assets, the opposite in technical terms to a loan portfolio or a Treasury bond.  This invaluable quality makes MSRs perform well in a rising interest rate environment as we see today.  But most Sell Side analysts neither know nor care about such details when it comes to following mortgage focused banks and non-banks such as WFC.  And only a few members of the mainstream financial press such as John Dizard at the FT dare to write about MSRs.

 

The total carrying value of WFC’s residential and commercial MSRs was $14.7 billion at September 30, 2017, and $14.4 billion at December 31, 2016, or a bit less than one percent of the $1.7 trillion in total outstanding principal balance of mortgage paper that Wells services.  The nation’s largest loan servicing portfolio (WFC owns about one third of all bank owned MSRs)  generates significant income for the bank, but is also perhaps the most problematic business for WFC due to the consumer facing risks that arise in the mortgage world every single day.

 

You can argue that the large financials are overvalued, as we did on CNBC's Halftime Report the other day, but don’t fight the Fed, ECB and Bank of Japan all at once.  The path to “normal” as defined in the Gospel according to St Janet will take years longer than the Federal Open Market Committee admits publicly. Note, for example, that the estimated timing of prepayments on the Fed’s portfolio of RMBS is clustered in the mid-2020s, at least for now.  Like Sell Side bank earnings estimates, the FOMC numbers on monthly portfolio runoff rates will change over the course of 2018. 

 

The beauty of MSRs is sadly called “extension risk.” Rates rise, bond prices fall, prepayments decrease, duration and IRR increase, and the fair value of your MSR magically grows.  Kidder Peabody (1986)?  Long Term Capital Management (1998)?  Citigroup (2008)?  All of these firms died due to extension risk on various types of pass through securities, one reason why the SEC effectively banned non-banks from issuing their own MBS in 1998.  By amending Rule 2a-7, the SEC not only may have killed LTCM, but it made it impossible for nonbanks to issue their own paper. The SEC under Chairman Arthur Levitt handed the largest banks a monopoly in making and servicing home mortgages.

 

It is hard to ignore the superior performance of WFC vs other large banks, even if you assume no balance sheet growth due to the Fed sanctions and the risk of its many consumer facing businesses. WFC has equity returns that are two points better than its assets peers and with similar risk adjusted returns on capital (RAROC).  The only name in the top five banks with even close to WFCs’ equity returns is USB, which deliberately manages its size at below half a trillion in total assets.

 

              Source: TBS Bank Monitor Q3 2017

 

Could smaller mean higher ROEs at WFC?? An intriguing possibility.  The travails of WFC are a blissful situation, however, compared to the life and death situation that confronts many non-bank mortgage firms as the first quarter of 2018 heads to a close.  Indeed, market pressures are seemingly driving a renewed focus on M&A.

 

Nationstar Mortgage (NYSE: NSM) last Tuesday announced a nearly $4 billion merger with WMIH Corp. (NASDAQ: WMIH), the successor company to mortgage originator Washington Mutual. After 2008, WFC and other large banks sold problematic mortgages to non-banks such as NSM. Firms such as Countrywide and Washington Mutual, though technically commercial banks, operated as non-banks in the secondary market for home loans and funded themselves mostly with short-term money.

 

Let’s walk down memory lane.  In September 2008, readers of The IRA will doubtless recall, JPMorgan Chase acquired the banking operations of Washington Mutual Bank in a transaction facilitated by the Federal Deposit Insurance Corporation.  JPMorgan Chase acquired the assets, assumed the qualified financial contracts and made a payment of $1.9 billion to the FDIC. Claims by equity, subordinated and senior debt holders of WMIH were not acquired and ended up in bankruptcy in Delaware. 

 

"For all depositors and other customers of Washington Mutual Bank, this is simply a combination of two banks," FDIC Chairman Sheila C. Bair said that fateful day. "WaMu's balance sheet and the payment paid by JPMorgan Chase allowed a transaction in which neither the uninsured depositors nor the insurance fund absorbed any losses," Bair added significantly.

 

Of course, when the FDIC seized the bank and sold it to JPM, it left the controlling financial investor, Texas Pacific Group, high and dry.  From bankruptcy, the predecessors of WMIH commenced nearly a decade of litigation with the FDIC and other parties over disputed assets of the failed bank.  When WMIH won a $2 billion judgment against FDIC, the bank insurance agency then turned around and sued the officers and directors of WaMu for the now $2 billion deficiency in the FDIC fund.  God does have a sense of humor.

 

WMIH’s merger with NSM marks a new page in the firm’s corporate history.  With a decade of litigation behind it, WMIH now boasts a couple hundred million in capital and $6 billion in usable net operating loss (NOL) carryforwards.  WMIH also has a new private equity sponsor, KKR, who is joined by Texas Teacher Retirement Fund and Greywolf Capital.

 

The NSM transaction also may mark the start of a consolidation in the world of mortgage finance and servicing, where over-capacity is hurting profitability as loan volumes and servicing assets steadily fall.  But don’t look for any large banks to be buyers of large non-bank mortgage firms.  WFC is one of the few large banks that remain in the market for government-guaranteed FHA loans and Ginnie Mae securities.  

 

As non-bank seller servicers exit the GNMA market, banks such as WFC and Flagstar (NYSE:FBC) will be under pressure from regulators to pick up the slack or even acquire insolvent non-banks, but likely that door is closed for the largest banks. Thanks to Dodd-Frank and the CFPB, federal bank regulators consider consumer facing businesses toxic for the large banks. They have effectively told WFC et al to avoid reputation risk at all costs. 

 

Even if WFC is not allowed to grow its assets for the next several years, we expect the bank to eventually return to a slight premium to JPM. We see two possibilities.  Either a) WFC is going to slowly rise to 2x book value vs JPM’s 1.7x multiple or b) JPM and the other larger banks will slowly adjust downward as the full weight of securities issuance descends upon the major banks in the post-QE world. 

 

Just for the record, we are betting on the latter scenario as Wall Street desperately seeks a reasonable explanation for current market valuations. Just remember that reaching “normal” and adjusting asset prices accordingly will take years thanks to the over-generosity of Chair Yellen and the FOMC.    

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