“Real Estate for Breakfast” Podcast
By Kevin Dobbs
When Wells Fargo & Co. reports second-quarter earnings next week, analysts will look for signs that it is increasing profits after a lull in growth that followed the bank’s 2016 sales-tactics scandal.
Regulators last September said they had fined the San Francisco-based bank after learning that bank staffers opened millions of deposit and credit card accounts for customers without their permission. New account opening dropped in the ensuing months, hurting revenue growth, and both legal and regulatory costs rose. The result: Wells posted fourth-quarter 2016 and first-quarter 2017 earnings that were below year-earlier levels.
But an S&P Global Market Intelligence analysis of Wall Street’s expectations found that, on average, analysts expect Wells to post revenue and earnings per share figures that are higher than the previous quarter and a year earlier. “They have gone through a lot of pain, but I think they can now start focusing on growing earnings again,” Vining Sparks analyst Marty Mosby, who covers Wells, said in an interview.
In June, Wells got a key nod of approval from regulators: After the bank passed an annual stress test designed to ensure it could navigate a financial crisis, Federal Reserve officials approved the bank’s plan to increase its dividend and stock buyback program. Both moves are signs of capital and overall strength, Mosby said. He added that the Fed’s nod indicates the effects of the sales fraud, while still hindering the company in terms of legal costs and lingering reputational damage, are temporary and starting to fade.
“It’s kind of a stamp of approval,” Mosby said of the Fed checking off on Wells’ capital deployment plan.
He said Wells had “ring-fenced” the sales issue and publicly outlined important steps it took to prevent such a debacle from occurring again, including changes to the way it pays and motivates retail bank employees.
“Ultimately, I don’t think it was really a threat in terms of what they asked the Fed for with their capital planning,” Mosby said. “I think this is the inflection point for Wells.”
Jon Winick, president of bank adviser Clark Street Capital and a long-time Wells observer, agreed. “Wells is so big that the damages aren’t going to be that impactful as far as their capital position,” he said in an interview. Regulators “are probably seeing that the actual cost of the Wells accounts issue is pretty low and quantifiable.”
Mosby anticipates that Wells will gradually rebuild sales levels in its retail bank over coming quarters. That, in concert with an ongoing cost-cutting effort, should help the bank shake off the aftershocks of the scandal, lower its efficiency ratio and gather notable earnings momentum in 2018. Mary Mack, head of Wells’ community bank division, said while speaking at a conference in June that the bank is continuously looking for new ways to increase efficiency, even while it is in the midst of carrying out a plan to consolidate 450 branches and reduce expenses by some $4
billion by the end of 2019.
Wells’ first-quarter efficiency ratio, which measures noninterest expense as a share of revenue, increased to 62.7% from 58.7% a year earlier. The expense reductions are part of an effort to bring the ratio back down below 60%, where Wells has historically operated.
Speaking at a separate June conference, Wells President and CEO Timothy Sloan said it was realistic to expect that the bank could bring the efficiency ratio into a range of 55% to 59% by next year.
Later that month, Wells said it would sell its commercial insurance business to USI Insurance Services LLC, an anticipated move aimed at reducing staffing costs in noncore business lines.
That sale, and perhaps others to follow, are the kinds of moves that, on top of branch consolidation, “will help Wells get the expense ratio down to their long-term target,” Mosby said. “I think they are getting on that path now and can really get things going again by 2018.”
Wells is slated to start big-bank earnings season July 14 along with JPMorgan Chase & Co., Citigroup Inc. and PNC Financial Services Group Inc.
Wells Fargo & Co. continues to grapple with the aftershocks of a sales-fraud fiasco. But during the company’s annual investor day May 11, executives touted improvements and vowed to bolster an efficiency ratio recently headed in the wrong direction.
Driven in part by higher regulatory and legal costs tied to the fallout from a sales scandal that erupted last September, when regulators fined Wells and said it had opened millions of phony accounts to meet overly aggressive sales goals, the San Francisco-based bank’s expense base expanded in 2016.
The trend continued during the first quarter of this year, when expenses rose 6% from a year earlier. That increase, combined with a roughly 1% decline in revenue generation that was hindered by customer apprehension tied to the sales matter, pushed up the company’s efficiency ratio. Wells’ first-quarter efficiency ratio, which measures noninterest expense as a share of revenue, increased to 62.7% from 58.7% a year earlier.
“Operating at this level is completely unacceptable,” President and CEO Timothy Sloan told investors and analysts. First-quarter earnings were flat, again hindered by the sales issue and lower levels of lending and new customer generation tied to it. Wells said new consumer checking account openings in March declined 35% from a year earlier, while new credit card applications fell 42%, continuing a trend that took hold early in the fourth quarter of 2016. Total average loans declined during the first quarter.
In previous years, Wells targeted a sub-60% efficiency ratio, and during the investor day presentations, executives said they will build on a sweeping branch reduction effort already in motion to squeeze out billions of dollars in costs and bring the efficiency ratio down into a range of 55-59% in coming years. “We’ve undertaken a rigorous review across the company,” CFO John Shrewsberry said. Wells executives previously said they planned to close about 200 branches in 2017 and 200 more in 2018, among other steps to reduce expenses by $2 billion annually. Mary Mack, head of Wells’ community bank division, told investors May 11 that the bank is on pace to meet the 200 goal for this year and that executives now envision
closing some 250 in 2018. Savings from those efforts are slated to be reinvested in new technology and other innovation endeavors, among various business needs, with the goal of both operating more efficiently and driving revenue growth.
Wells joins a broader industry movement toward fewer branches amid a yearslong trend of customers visiting branches less and increasingly doing routine banking online and via mobile devices.
“Branch visits have been free-falling for years,” Jon Winick, president of bank adviser Clark Street Capital, said in an interview. “In my opinion, the banks in
this country can’t close branches fast enough.”
In addition to the branch consolidation, Wells executives say they now aim to ring out another $2 billion in annual expenses by the end of 2019. These savings would flow directly to the bottom line, executives said.
Mack and other Wells leaders spoke mostly in generalities about how the additional savings would be produced. But they emphasized Wells is capitalizing on advancing technology to improve efficiency in everything from call centers to the delivery of products, including plans for the second half of this year to begin allowing customers to submit one credit application for multiple product approvals.
Executives also noted efforts to increase the use of data to more quickly identify and meet customer needs, as well as ongoing facility reductions, among other efforts. Wells also is reportedly considering business line divestitures. Bloomberg News reported this week that Wells is exploring the potential sale of an insurance brokerage unit that employs about 3,500 people.
In the near term, Mack said that while Wells continues to endure the effects of the sales scandal, its consumer account openings have begun to improve on a month-over-month basis, and customer satisfaction surveys also are now trending favorably. “We are emerging stronger than before,” Mack said. Winick, however, said that at least in the near term, with the cloud of scandal still hovering over it, Wells likely will struggle to grow lending and revenue. That makes the cost-cutting paramount, he said.
Longer term, it could prove difficult for big banks such as Wells that are reliant on loan growth to boost revenue meaningfully, said Ken Mayland, president of ClearView Economics and a bank adviser. He said the strong credit quality environment that banks have enjoyed for years has begun to deteriorate and recent indications from the likes of Wells suggest a trend could be forming.
Wells’ first-quarter credit card charge-off rate of 3.54% was up from 3.09% at the end of last year and up from 2.82% at the end of the third quarter of 2016. Its first-quarter auto loan charge-off rate, at 1.10% of average loans, was up from 1.05% at the end of the 2016 fourth quarter and up from 0.87% atthe close of the 2016 third quarter.
After Wells reported those figures, Mayland said in an interview that the bank may need to pull back on lending in key areas. “I think risk aversion only grows from here,” he said. During the investor day, Wells executives said they had already eased up some in auto lending and are more broadly willing to give up some market share to guard against risks to the strength of the company’s balance sheet.
Lending by the largest U.S. banks was flat in the first quarter, held in check by a seasonal pullback in demand and uncertainty in the nation’s capital.
Total first-quarter loans and leases among the 10 biggest commercial banks by assets inched down 0.1% from the previous quarter on an aggregate basis,
according to an S&P Global Market Intelligence analysis of regulatory filings.
Commercial-and-industrial lending rose 2.2% during the quarter among the big banks, a decent advance but mild relative to expectations heading into the
quarter. Commercial real estate and multifamily lending advanced more modestly, by less than 1% in both categories.
Lending in other key categories fell notably during the first three months of the year, including a 3% dip in consumer lending, offsetting moderate gains
Analysts say that loan demand among consumers often slows during the first quarter, as Americans ease up on borrowing after holiday spending sprees
and shop less amid winter weather. Demand for credit also often stagnates some among commercial clients, who tend to tap credit lines late in a given year
in order to shore up business plans for the following year, leaving them with fewer borrowing needs early in a new year.
But analysts noted throughout first-quarter earnings season that investors had expected more for the start of this year, largely because of lofty optimism fueled by promises in Washington for healthcare reform, deregulation and, perhaps most significantly, corporate tax cuts.
Republican President Donald Trump, who took control of the White House in January, has vowed to work with a GOP-controlled Congress to get legislative
wins on each of those fronts — wins that would lower costs for many businesses and provide them more resources for expansion, the thinking goes.
Banks could finance such expansion, lenders say.
Trump also has touted plans for new international trade policies and domestic infrastructure spending that could benefit American businesses.
But Trump and allies in Congress have made little progress to date on the legislative front, and the likelihood and timing of major reforms remain uncertain,
analysts say. “There is a lot of waiting to see what happens,” among business owners, “a lot of questions and not a lot of answers yet,” FIG Partners bank
analyst Christopher Marinac said in a post-earnings interview.
“So with the slow first quarter loan growth, right now, it’s hard to tell how much of what we saw is seasonal and how much of it has to do with people
waiting to see what Trump can accomplish,” Jon Winick, president of bank adviser Clark Street Capital, said in an interview.
Minneapolis-based U.S. Bancorp, whose first-quarter commercial lending was essentially flat from the previous quarter, attests to the uncertainty.
“Our large corporate customers tell us that they are optimistic about the future but are awaiting more clarity regarding potential changes in tax and regulatory
reform, infrastructure spend and trade policies,” U.S. Bancorp President and CEO Andrew Cecere said during the company’s first-quarter earnings call.
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There is something for everyone looking for lending pitfalls in the coming months.
Mortgages, subprime auto lending, commercial-and-industrial loans and student lending are ripe for setbacks and, in some cases, crises.
Here is a breakdown of each of those risk factors, the reasons behind them and the possible upsides or alternative strategies.
The refinance market has largely carried the mortgage industry over the past few years because consumers took advantage of historically low rates. Now that the Federal Open Market Committee has raised rates twice in the past year, and the benchmark 10-year Treasury has spiked upward since the presidential election, many expect the refinancing market to nosedive.
“We’ll see refinancing all but dry up, and the mortgage business is going to really suffer” in 2017, said Donald Musso, CEO of FinPro Capital Advisors, a bank consulting firm in Gladstone, N.J.
The question becomes whether an improvement in the overall health of the housing market can take up the slack.
“It’s going to be sales that drive your mortgage lending now,” said Jay Pelham, president of the $3 billion-asset TotalBank in Miami.
That may be easier said than done. The incoming Trump administration and the Republican-led Congress have signaled they may reduce the mortgage interest deduction, a move that the National Association of Realtors and other housing industry groups have warned will wallop the housing market.
Banks’ mortgage fortunes could vary among geographic markets, too. The South Florida market, especially downtown Miami, appears to be set for a high level of purchase activity, Pelham said.
“If you look at our downtown market, it’s full of restaurants, jobs and apartments that both professionals and young people want,” he said. “When I look at prices per square foot here, we are still cheap compared to New York, London and Chicago.”
For months, regulators have forcefully warned about soaring balances of subprime auto loans and the risks associated with them. The data seemed to back them up.
In March, Fitch Ratings reported that more than 5% of securitized subprime auto loans were at least 60 days late, the highest delinquency rate in 20 years.
And the 90-day delinquency rate for subprime auto loans was 2% in the third quarter, versus 1.9% a year earlier and 1.4% in the third quarter of 2012, according to a Federal Reserve Bank of New York report. Over the same period, delinquency rates for borrowers with higher credit scores were relatively flat. Meanwhile, about 3.6% of overall auto loan balances were 90 days behind in payments.
Lenders have downplayed those concerns, saying that they have applied strict underwriting standards.
Yet some banks have begun to take precautions. The $143 billion-asset Fifth Third Bancorp in Cincinnati and the $147 billion-asset Citizens Financial Group in Providence, R.I., this fall announced plans to scale back indirect auto lending.
At the same time, some community banks have shown greater interest in auto lending as consumer demand for car loans continues to soar. The $4 billion-asset Fidelity Southern in Atlanta and the $9 billion-asset First Interstate BancSystem in Billings, Mont., each posted double-digit increases in auto loans in the third quarter.
Lenders have recently made improvements in how they underwrite subprime auto loans, and that may prevent a big meltdown, said Jon Winick, CEO of Clark Street Capital, a bank consulting firm in Chicago.
“There have been real innovations in the subprime auto space that are unique to that asset class,” he said. “You can prevent someone from using their own car if they’re 30 days delinquent and you don’t have that level of control with a real estate deal.”
Tough competition for commercial-and-industrial loans has created one of the riskiest situations as many banks are said to have cut pricing to win business.
Banks have crowded into the C&I space for plenty of reasons. One is that regulators have placed a great deal of emphasis on commercial real estate loan concentrations, and banks have responded by improving risk management and bolstering capital levels. Those steps may help limit CRE losses, but they have encouraged more banks to risk expansion in C&I loans as they hunt for places to deploy their capital.
There is so much competition in the C&I market that many players have caved to borrowers’ demands for lower rates and better terms, Winick said.
“Underwriting standards have collapsed the most in C&I,” he said.
At the same time, C&I loans present significant challenges when they default as they are typically not collateralized by tangible assets.
“If a C&I project defaults, you don’t have an automobile you can repossess or a house you can foreclose on,” Winick said.
But there are some potential bright spots for C&I. One is that the presidential election is over, which should remove the anxiety that had led many businesses to hold back on capital spending for months because of political uncertainties, Musso said. Talk of tax cuts and regulatory relief has played well in commercial sectors.
“I actually think we may see a modest uptick there because the business community believes we’ll see some relief from the Trump administration,” Musso said.
Another is that banks may have already suffered through the worst part in two subcategories of C&I lending, energy and taxi medallion loans. A rebound in oil prices dampened the losses at energy lenders, while some banks like the $72 billion-asset Comerica in Dallas reduced their exposure to the sector. And executives at the $38 billion-asset Signature Bank in New York recently said that they have restructured troubled taxi loans.
“I think the new normal has come out in taxi loans,” said Dave Etter, managing director of loan review services at Sheshunoff Consulting. “To try to sell taxi loans now is just impossible. You’re just looking to generate some cash flow.”
Finally, some banks have attempted to carve out specialties within the C&I category to diversify loan portfolios and improve yields. The $28 billion-asset First Horizon National in Memphis, Tenn., for example, has expanded in franchise finance and health care finance to help dilute its C&I exposure.
The massive pile of student loan debt threatens to send scores of consumers into financial ruin. The Congress and the incoming Trump administration may try to address the situation by getting the U.S. government out of the student loan business. That could create an opportunity for banks to re-enter the private student loan market.
Investors are betting that will happen. Shares of SLM Corp., the Newark, Del., company known as Sallie Mae, rose 54% from Nov. 8 to Dec. 28, to $10.95. Sallie Mae is the largest private student lender.
Only a few banks remain active in student loans, including Citizens Financial. Those banks stand to benefit from the new political environment, KBW analysts wrote in a December report, and other banks may want a piece of the action.
What most analysts agree on is that the amount of student-loan debt that consumers are carrying is unsustainable.
“It’s my biggest concern in the consumer space, hands down,” Winick said. “We know the losses will be terrible.”