Basics Of Banking, And Wells Fargo Vs. Bank Of America

Basics Of Banking, And Wells Fargo Vs. Bank Of America

On the last day of March, my bullish article on Wells Fargo (WFC) debuted.

It is arguably the worst piece I’ve written in a year. I’ve had a handful of articles registering poor results; however, most were written pre-pandemic and highlighted stocks suffering the damaging effects of the COVID-19 crisis.

Although I understood the headwinds facing Wells Fargo, I reasoned that “shares are trading at near historical value levels” – an observation that holds true today. I also noted “the company boasts a yield over 7%.”



Of course, the last statement no longer holds, even though the stock tumbled more than 4% after I penned those words. The foundation of my ruminations was the belief that the asset cap imposed by the Fed would be lifted. I was so focused on the firm’s prospective growth that I minimized the looming headwinds. The bear arguments present when that article published are still in force, and some have grown more virulent.

Delinquency rates for credit card, automotive, mortgage and student loans were up trending throughout 2019, a phenomenon greatly exacerbated by the pandemic. Meanwhile, Fed stress tests require banks to set aside additional funds for potential loan losses.

It doesn’t take a bank maven to understand low interest rates can cripple bank stocks, and it’s likely the Fed will keep interest rates low for years. That translates into lower profits for banks. Or does it?

I provide hard data that, contrary to conventional wisdom, there is no correlation between the Fed funds rate and net interest margin. As cyclical stocks, the primary headwind for financial companies is the economy, not interest rates.

Tell Me It Ain’t So! A False Metric For Evaluating Banks

Net Interest Margin (NIM) is a widely followed metric that provides investors insight into a bank’s profitability. NIM calculates the difference between the interest income generated by loans and the interest paid to clients’ savings accounts and certificates of deposit. Expressed as a percentage (the higher the better), it is akin to gross profit margin.

Conventional wisdom holds that when the Federal Reserve lowers interest rates, the NIM is compressed, resulting in lower bank profits. This is so commonly believed that it is a veritable maxim. But what if it isn’t true?

Observe the chart below.

(Source: Federal Reserve Economic Brief)

The darker of the two lines charts the Federal funds rate. Note that despite fits and starts, the rate trends downward over two decades.

Now study the lighter line representing the corresponding NIM. NIM remains relatively steady. Furthermore, peruse the years associated with rate hikes (indicated by the vertical shaded lines). There is no real correlation between rate hikes and NIM, and there is little observable deterioration of NIM as rates drop. In fact, during periods of rate cuts encompassing 1984-86, 1989-92, 2001-02, and 2008, average NIM increases.

I anticipate some readers will object to my observations, but the data appears conclusive: interest rates and NIM are not strongly correlated.

Do not misinterpret my assessment. I acknowledge that falling interest rates place pressure on banks’ Net Interest Income (NII). (NII is the difference between interest income earned by a bank from lending activities and the interest it pays to depositors.) However, I would argue that the pressure on earnings is transitory in nature and should not affect an investor’s medium- to long-term assessment of an individual bank as a prospective investment.

Great Recession Data Supports My Position

The two charts below show the lack of correlation between Fed rates and banks’ net income. The first chart outlines the Fed rate during the Great Recession. The second chart provides the net income of the four largest US banks during that period.

(Source: Data from The Balance / Chart by Author)

(Source: Data from Macrotrends / Chart by Author)

(The figures above are in $millions.)

As you can see, the Fed rate plummeted, and net income for the four largest US banks also deteriorated. One might claim this is evidence that falling interest rates drive lower revenues for banks. I would argue that depressed interest rates are often a symptom of a struggling economy, and it is economic conditions that push revenues down.

Additional proof of my contention is that the recession ended in June 2009. From 2010 through 2015, the Fed funds rate was zero. However, the chart below shows robust growth in revenues for Wells Fargo and Bank of America (BAC) during that time period.

(Source: Data from Macrotrends / Chart by Author)

So, if prevailing interest rates don’t result in deterioration of bank revenues, what is the cause?

It’s The Economy, Stupid

Don’t take the header personally. That’s a quote from a prominent American political consultant directed at his rivals.

If NIM has little bearing on bank profits, then I would argue economic conditions are the primary factor leading to poor performance by bank stocks. Therefore, the number of loans generated and the delinquency rates associated with recessions should be closely monitored by investors.

Once again, I provide data contrary to that which is widely accepted.

According to a report issued in August by the Consumer Financial Protection Bureau, the rate at which auto loans, mortgages, student loans and credit card accounts are falling into delinquency each month is improving. Current delinquency rates are better than those witnessed in January.

The auto loan delinquency rate improved by 0.1% from February to June, and the delinquency rates for mortgages and credit cards improved by 0.2% and 0.5%, respectively, during the same time period. Delinquency rates for student loans improved by 0.7%.

The report also noted credit card balances dropped approximately 10% between March and June 2020.

The figures mesh with those provided by Experian (EXPN). That firm reported that from January through March, overall debt dropped 1%, while credit card balances were down 14%.

However, this flies in the face of a survey by WalletHub stating 67 million Americans anticipate difficulty meeting their monthly credit card bills. Additionally, a report issued by CreditCards.com in early May stated 28 million Americans increased their credit card debt due to the pandemic.

The fact is that the deeper you dig, the more contradictory information you find. I think the following two charts serve somewhat to understand these differing viewpoints. The first chart outlines YoY changes in financial hardship rates as of last June. Hardship rates include accounts with deferred payments, those in forbearance programs, frozen accounts or accounts with frozen past due payments.

(Source: Data from TransUnion / Chart by Author)

The next chart records delinquency rates.

(Source: Data from TransUnion / Chart by Author)

So the numbers on hardship rates are at odds with delinquency rates. I assume some consumers with stable finances took advantage of forbearance programs to insure against an uncertain financial future, thereby raising the numbers related to hardship rates.

I would add that some utilizing forbearance programs and/or those that were propped up by government assistance programs will ultimately renege on their loan obligations.

Consequently, although I took a deep dive into the numbers, I believe the data cannot provide me with a clear picture. Nonetheless, investors that are aware of one set of statistics without having knowledge of the conflicting metrics could easily conclude otherwise.

Where The Rubber Meets The Road

With conflicting data regarding consumers’ financial positions, we must turn to other sources to assess the outlook for the banking industry.

Consider these facts:

– Auto loan delinquency rates reached record levels at the end of 2Q20.

– However, new home sales are robust, the best since 2006. Existing home sales are up 10.2% year over year, while housing starts increased 2.8% YoY. The National Association of Home Builders and the Wells Fargo Housing Market Index rose to 83 in September. That marks the highest reading in 35 years.

I could cite a variety of conflicting data ad nauseum. I used these two examples to note, once again, that the path forward is not transparent. However, I provide the five following charts which, I believe, add some clarity.

Although investors are aware of the drop in jobless claims, I think the above chart helps bring the magnitude of the change into focus.

The following graph fortifies the view that the American consumer is better off than one might expect. It is important to recall that a previous chart indicated credit card delinquencies have fallen substantially year over year. When taken together, evidence of an economic rebound appears more certain.

(Source: Yahoo Finance)

The next chart shows a substantial increase in excess savings. This, too, leads one to believe consumers can ameliorate the economic effects of the pandemic.

(Source: Yahoo Finance)

These two charts are evidence of the recovery of home and retail sales over the last few months.

(Source: CNBC)

This last chart speaks to the dynamic nature of small business in America. Despite the body blow the economy received, there is reason to believe we are poised for a fairly strong recovery.

(Source: Yahoo Finance)

Businesses with a high propensity to succeed are defined as those best-positioned to survive. This number reached the highest quarterly level on record for the third quarter.

Comparing Wells Fargo To Bank Of America

Since Warren Buffett’s divestiture of his Wells position and recent investment in Bank of America stock is well-known, I thought an investigation of the two companies would prove useful. The following chart compares the two companies’ loan portfolios.

(Source: BAC/WFC from most recent 10-Q / Chart by Author)

I was unable to determine the current percentage of auto loans in Bank of America’s portfolio; however, for many years, it has been roughly 60% of that of WFC. Of the nearly $81 million in consumer loans for Wells, over $48 million consist of auto loans. Earlier in this article, I noted that of the varying categories of loans, auto loans were experiencing the greatest delinquency rates by a wide margin.

However, Wells is the top mortgage lender, and it is likely that mortgage loans will remain robust for the foreseeable future.

An important source of funds for banks comes from deposit market share. The chart below provides data for the growth of deposits of 8 large banks. The period covered is June 2019 through June 2020.

(Source: FDIC summary of deposits / Chart by Author)

Wells Fargo ranks last. Furthermore, BAC’s deposit growth rate is nearly double that of WFC.

The chart below provides ROE, ROA and the efficiency ratios of the two banks during 2019.

(Source: Company financials / Chart by Author)

BAC outperforms in each of the categories.

The two banks have reasonably similar loan loss provisions.

(Source: S&P Global Ratings)

For those considering investing in banks, it is important to note lending institutions will almost certainly have to set aside additional sums for potential loan losses. The Fed’s worst-case stress test scenario projects COVID-19-related loan losses at 6.3%. This would exceed loan losses experienced during the Great Recession. In 2009, 5% of loans were charged off.

S&P Global Ratings provides a 3% loan loss as the most likely scenario. This would result in a doubling of loan loss provisions for US banks from the $115 billion set aside in the first half of 2020.

One major difference in the two banks is the much greater exposure BAC has to wealth management services. In Q2 2020, the bank’s wealth management services generated $624 million in net income versus Wells’ net comparable net income of $180 million. According to the Wall Street Journal, Wells Fargo’s wealth management segment has been in the doldrums since 2016, while Bank of America’s posted double-digit gains.

Of concern is the continual loss of financial advisors from the firm. When conducting research for this piece, I noted numerous articles chronicling defections of advisers, dating from 2018 to the present.

(Source: On Wall Street)

The Elephant In The Room

The cap imposed by the Fed prevents the growth of Wells Fargo beyond $1.95 trillion in assets. There are estimates the asset cap cost Wells $4 billion in profit, and this sum does not include costs associated with the efforts to have the company meet Fed requirements.

I will opine that the bank’s failure to have the cap permanently lifted to address PPP loans likely signals Wells Fargo will be in the penalty box for longer than many anticipated. Until the cap is lifted, the company will not grow.

Valuation And Dividend

Shares of BAC currently trade for $25.36. The average 12-month price target of 22 analysts for the stock $29.50. The 5 analysts providing a price target for Bank of America since the last quarterly report have an average price target of $28.87.

Shares of WFC currently trade for $25.30. The average 12-month price target of 24 analysts for the stock is $31.63. The analysts providing a price target for Wells Fargo since the last quarterly report have an average price target of $28.67.

BAC has a current and forward PE of a bit above 12. The company’s PEG is 10.02. WFC has a current P/E of nearly 29 and a forward P/E of 12.61. Wells’ PEG is 8.32.

Bank of America has a yield of roughly 2.8%, a payout ratio around 43% and a 5-year dividend growth rate of nearly 41%.

Wells Fargo has an annual yield of approximately 1.6%; however, the payout ratio is nearly 460%. I think it is likely the dividend will be cut before year’s end.

My Perspective

I see the path forward for Wells Fargo as rather opaque. Until the Fed’s cap is lifted, the stock is likely to tread water. Once the cap is lifted (and assuming the economy at that time is robust), I think it likely we will see a surge in share price.

I believe shares of Bank of America will probably outperform those of WFC, and as a dividend-focused investor, I find the yield and the long-term prospects for dividend growth attractive.

As noted in this article, the outlook for the economy is unpredictable. Therefore, the immediate future of both companies is uncertain. For those that believe the economy will recover rapidly, bank stocks present a sound investment.

As one who gravitates towards stocks in beaten-down sectors, I rate WFC as a Hold and BAC as a Speculative Buy. As such, I initiated a very small position in BAC on 09/28 for $23.86 per share.

While ratings such as Sell, Hold and Buy have clear meanings, I believe there may be some variance among authors regarding the definition of a Speculative Buy. I view stocks in that category as holding significantly more risk, while also offering greater mid-term upside potential than most investments.

For a differing perspective on the banking industry, I direct readers to an article by SA author Paul Franke. In that piece, he discusses his concerns regarding dollar devaluation on banks, and also provides a number of charts providing differing perspectives on banking stocks, including WFC and BAC.

One Last Word

I hope to continue providing articles to SA readers. If you found this article of value, I would greatly appreciate your following me (above near the title) and/or pressing “Like this article” just below. This will aid me greatly in continuing to write for SA. Best of luck in your investing endeavors.

Disclosure: I am/we are long BAC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have no formal training in investing. All articles are my personal perspective on a given prospective investment and should not be considered as investment advice. Due diligence should be exercised, and readers should engage in additional research and analysis before making their own investment decisions. All relevant risks are not covered in this article. Readers should consider their own unique investment profile and contemplate seeking advice from an investment professional before making an investment decision.


Originally published on Seeking Alpha

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