Wells Fargo Succeeds by Keeping It Simple

Erik Kobayashi-Solomon: Hi. I'm Erik Kobayashi-Solomon, co-editor of Morningstar OptionInvestor, and today it's my great pleasure to welcome Jaime Peters, who is senior analyst in charge of banks here at Morningstar.

Jaime, thanks for coming.

Jaime Peters: Hello.

Kobayashi-Solomon: So, just recently I did an option strategy on Wells Fargo, a company that you cover. And I want to ask you more about Wells Fargo. But before we get into that, what I'd like you to do is just at a 30,000-foot level talk about the relative quality between these big four banks: Wells Fargo, Bank of America, J.P. Morgan, and Citi.

Peters: It's actually pretty interesting because that has changed over time from beginning of the credit crisis to what is going on now. So, really, we should just focus on what's going on now.

Top of the hierarchy is going to be either Wells Fargo or J.P. Morgan, depending on your point of view. Both have really benefited from this crisis. They've grown quite a bit and they've grown profitably. If you compare their amount of asset growth and their potential for earnings compared to their share count growth, both of them have done a very good job of growing that asset base, that earnings potential, but keeping the share count growth under control.

That is in stark contrast to Bank of America, who, like J.P. Morgan, also tried to play the hero by buying Countrywide and Merrill Lynch, but paying way too much, having to issue a lot more equity because of poor underwriting themselves. And as a result, you're probably going to see them come out at equal or probably even less earnings per share than when they went into the crisis. Citigroup is just the disaster. They have seen their share count go from 5 billion to about 28 billion.

Kobayashi-Solomon: The government is now trying to get rid of some of these 20 billion shares I think, correct?

Peters: Yes. They've been selling quite a bit of it actually. They still have other things like trust preferreds at the government that they are going to have to work out over time. And even while their share count has just exploded, the amount of assets they have to earn off of it has actually shrunk and they are continuing to shrink. So, if you want to put the bottom of the pile, you're going to look at Citigroup as the bottom. You're going to look at Wells Fargo, J.P. Morgan at the top, and you're going to see Bank of America in between them--closer to the bottom than the top, though.

Kobayashi-Solomon: So, one of the things that you've said before, one of the reasons that you like Wells Fargo is something called net interest margin. This is, of course, the difference between the costs of the borrowing that they have to do versus the money that they receive in interest for lending. Can you explain a little bit about what's the secret sauce about Wells Fargo's net interest margin?

Peters: What's great about Wells Fargo is they stick to the old banking mantra, which is lend at 6, borrow at 3, on the golf course at 3. If you can go on to the golf course and not worry about what's in your bank and you have that ability, that's really where you are going to have a great bank.

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Kobayashi-Solomon: So keep away from all of the funny derivatives and so forth, keep it simple.

Peters: And Wells Fargo does that. Unlike the other big three--J.P. Morgan, Bank of America, Citigroup--Wells Fargo is pretty much just a retail bank. That is their bread and butter, and they do a very good job. They put most of their eggs right there and they watch it very closely.

Kobayashi-Solomon: That's actually one of the big differences between them and J.P., I think. Wells really doesn't have much of an investment banking presence, right?

Peters: That is very true. And that's actually going to show up in what is your net interest margin. That is that spread, and what happens is Wells Fargo actually has a lower cost of funding and tends to lend at a higher interest rate than a typical bank.

Kobayashi-Solomon: So let's talk about the cost of funding. What is their cost of funding and how do they get it low?

Peters: Their cost of funding is going to be just everything added together, the cost of their debt, the cost of their deposits, et cetera. For a bank, deposits are a liability, even though for you, as a customer, it's an asset. So, what Wells Fargo does really, really well is gather as much in deposits as they possibly can.

Kobayashi-Solomon: Because deposits are really low-cost liabilities.

Peters: Certain types of deposits are, and that's where they are good. They get checking accounts and savings accounts. Look at your bank statements, you're not getting very much money for them. And that's great for Wells Fargo because they are paying you very little, and yet they are getting access to billions of dollars. And because their mix of deposits tends to favor these very low-cost deposits, not high CDs or anything like that, what we consider hot money a lot of times, then what we have is a lower cost of funding than the average bank.

Kobayashi-Solomon: I see. So let's turn around and take a look at the interests that they are receiving on the loans that they are making. How are they doing from that perspective?

Peters: Wells Fargo actually does fairly well on that. Their interest yield that they receive is actually higher than the typical bank. They are taking a little bit more risk, though…

Kobayashi-Solomon: That's what I was just going to ask.

Peters: The real reason. So, what you're going to actually find is their charge-offs are higher than the typical bank as well. Pre-credit crisis, a lot of banks were showing a 0.5 percentage point of charge-offs. Well, Wells Fargo was showing a full percentage point. But when you take that net interest margin, subtract the charge-offs that kind of cost of doing that business, what we call the risk-adjusted net interest margin at Wells Fargo is higher than the typical bank. So, in other words…

Kobayashi-Solomon: Still looks attractive in other words.

Peters: That's right. They are taking more risk, but they are doing it in a smart manner and getting paid for that risk. And that's the really important part.

Kobayashi-Solomon: Right. Now, one thing we hear a lot about on the news right now, banking has really become the subject of vitriol for politicians.

Peters: Yes.

Kobayashi-Solomon: It's also becoming the subject of increased regulatory scrutiny. We have Basel III in the pipeline. We have got the Volcker Rule being discussed right now. What do those kind of things--how do those kind of things impact Wells Fargo?

Peters: In several different ways, actually. So, if you start with the regulatory reform that was passed by the House and Senate and signed into law by Barack Obama over the summer, what you have is several things that are going to hurt Wells Fargo's ability to earn money--such things as debit card interchange fees. And it's a very complicated thing where basically they are getting paid every time you swipe your debit card, and that percentage of how much they're going to get paid is probably going to go down, and it's a really profitable business for them.

They are going to have to hold more capital. That's that Basel III idea. That basically is out of Switzerland. Basically the entire G-20 is going to agree on how much bank should hold as far as capital goes and in order to prevent another capital crisis because this crisis has not happened just here in the United States, it's a global crisis as far as banking goes.

Kobayashi-Solomon: So, in other words, they'll have to keep more of their deposits there. They will have to keep more on deposit with the Fed, let's say, and they won't be able to borrow as much, they won't be able to lever up as much?

Peters: There is a liquidity issue, which is how much they're going to put with the Fed, and that is going to hurt much more banks like J.P. Morgan, who is a large investment bank because it's based on assets, than a Wells Fargo.

What it really comes down to is what we call common equity, which is very basic stuff. But what happened was banks tended not to hold a lot of common equity. They have a little bit of common equity, then they have something called trust preferred equity, that add up to something called Tier 1, which is what the bank regulators compared to their asset base to decide if they were well capitalized.

Well, every single ratio of what you need is going to go up. What they are introducing is something called Tier 1 common, which is actually showing that common equity, which is A) the most expensive type of funding for the banks; and B), something the hardest to get sometimes – you know, you have to either retain their earnings or you have to go out and raise funds – has to go up. And that level is going to be 7% in several years – I think it's 2019 that it has to be 7%. So they've got some time to get there.

Kobayashi-Solomon: But Wells Fargo actually looks pretty good in terms of that, right?

Peters: It's already there. Now there's going to be some adjustments on how it's calculated. So it's possible they are just a little short or they're just a little over, but the reality is that the earnings power of Well Fargo is going to make it so they can easily accept it. In addition to that, Basel III includes something called systemic risk. If you were a bank that is systemically important to the government, in other words, if you're too big to fail, you're going to have an additional burden. That burden has not been laid out yet. But we know they're going to have to have some sort of additional capital. It might come in the form of bonds, it might come in the form of equity, it might come in the form of what they call contingent capital. It's a bunch of different types of ways, but we know that there's going to be something. The question is really whether Wells Fargo is going to be subject to it. Right now, our best guess is yes. But there is a legitimate argument that says that Wells Fargo being the kind of "Mini-Me" of the big four could potentially skate by.

Kobayashi-Solomon: Well, Jamie, thanks for coming in and talking about the banks and about Wells Fargo, too. Sounds very interesting.

Peters: Thank you.

Kobayashi-Solomon: And thank you for joining us. Please stop by the OptionInvestor website where you'll find many more option ideas based on Morningstar's fundamental research.