Wells Fargo (NYSE:WFC)

Wells Fargo (NYSE:WFC)

OWNERSHIP: I first bought WFC in FEB-2010. It is my top holding at 12.5% of my portfolio.

Figures as of 24-APR-2017

 SUMMARY

Wells Fargo is one of the biggest banking / financial institutions in the United States.  The company is organized into three operating segments: Community Banking which offers a complete line of financial services for consumers and small businesses (representing ~50% of earnings); Wholesale Banking which offers banking to larger businesses and government institutions (representing ~35% of earnings); and Wealth and Investment Management which offers personalized wealth management, investment, and retirement products (representing ~10% of earnings).

In general, Wells Fargo makes money in two ways.  Firstly, it earns a spread on its interest-earning assets by borrowing at low rates and lending at higher ones.  Secondly, Wells Fargo collects fees for the products and services it offers (non-interest income).  Non-interest income only partially offsets the company’s non-interest expenses; thus, it is only accretive to earnings if it outpaces costs.

Keys to banking include profitability as measured by Return on Assets (ROA), deposit growth, and leverage.  Return on assets is dependent on the cost of a bank’s interest-earning assets (primarily the size of their low-cost and non-interest bearing deposit base), the quality of the loans it makes (the frequency of loan defaults), its ability to generate non-interest income (earn fees for products and services), and its ability to keep costs down (low overhead).  Deposit growth translates into higher earnings by increasing a bank’s low cost deposit base and allowing it to earn a spread on additional loans.  Leverage is important because it can magnify both earnings and losses.

I believe Wells Fargo securities represent a safe investment.  U.S. banks are very durable businesses with high customer / deposit retention.  Most American consumers and businesses use their bank accounts for transactions and are generally indifferent to interest payments on the money they use month-to-month.  Banks could change for the worse, but changing for the better is much more likely. Traffic to branches is declining, which should lead to branch closures and cost reductions.  Wells Fargo has a strong competitive advantage built on a strong branch network, huge base of low cost deposits, conservative lending practices, and an ability to increase non-interest income by cross-selling its products.  Wells Fargo serves one-third of American households and its deposit base accounts for 10.8% of all U.S. deposits.  Credit has seldom been a problem; the bank successfully navigated severe real estate downturns in California (its largest market) in 2009, and the early 1990s, and there are no signs that the company has become a more aggressive underwriter.  The bank has earned a positive net income in each of the last 58 years (as far as I went back) and is less exposed to the risky investment banking and trading business than its peers.  The improper sales practices that occurred in Community Banking are the biggest concern because they have tarnished the bank’s reputation and suggest a problem with the bank’s culture; however, if the company implements the measures it has proposed, the long-term effects should be minimal.

Wells Fargo is a good company.  The bank’s ROA is consistently well above the industry average, and over its history, its deposit growth rate has always exceeded the industry’s growth rate.  In the last 20 years, it has managed to increase its book value per share more than eight-fold (this compared to peers like JP Morgan at 4.0x, Bank of America at 2.0x, and Citigroup at 0.9x).  Despite making headlines in recent months for aggressive sales practices, management is well above average.  Conservative underwriting is engrained in the corporate culture and past capital allocation has been very good (consistent dividends & buybacks, excellent acquisition track record).  Despite the financial crisis, the business has had above average predictability over the last 20 years, and its stock price has outperformed its peers with an annualized return of 6.6% per annum (vs. 3.9% for JPM, 0% for BAC, and -2% for C).

Wells Fargo currently makes an attractive investment.  My low valuation estimate implies a 14-year annualized return of 7.8% per annum while the medium valuation estimate results in a 14-year annualized return of 14.4% per annum:

NYSE:WFC
Amounts are in $MM	Assets / Funding Sources			Relative to FFR			Assets / Funding Sources	LOW Interest / Expense	MEDIUM Interest / Expense
Item	2016	% of Total	CAGR	LOW	MEDIUM		2030	2030	2030
INCREASE in Fed Funds Rate (FFR)				0.0%	2.5%
Commercial Loans	488,162	29%	4.5%	3.0%	3.5%		855,224	38,485	64,142
Consumer Loans	461,798	27%	4.5%	4.5%	5.0%		904,049	27,121	54,243
Investment Securities	356,113	21%	4.5%	2.5%	3.5%		659,502	16,488	39,570
Short-Term Investments	287,718	17%	4.5%	0.0%	0.0%		532,838	0	13,321
Trading Assets	88,400	5%	4.5%	1.5%	2.0%		163,712	2,456	7,367
Other	28,892	2%	4.5%	2.0%	2.5%		53,506	1,070	2,675
Interest-Earning Assets / Interest Income	1,711,083	100%	4.5%	2.9%	3.3%		3,168,831	85,620	181,318
Interest-Bearing Deposits	890,900	52%	4.5%	-0.1%	-0.9%		1,649,898	-1,650	26,398
Non-Interest Bearing Deposits	448,823	26%	4.5%	0.0%	0.0%		831,195	0	0
Long-Term Debt & Other Liabilities	256,173	15%	4.5%	2.5%	2.0%		474,418	11,860	21,349
Short-Term Borrowings	115,187	7%	4.5%	0.0%	0.0%		213,320	0	5,333
Total Funding Sources / Interest Expense	1,711,083	100%	4.5%	0.3%	-0.2%		3,168,831	10,211	53,080
Net Interest Income	47,754							75,409	128,238
In last 38 years, median loans/deposits ratio is 95%, 20Y CAGR of both is 15%.  So, loan CAGR should match deposit growth rate.
Typical interest rate cycle ~32 years.  Are 2 years into the climb (FFR bottom of 0.09% in ’14).  Will take 14 years to reach median.
Net Charge-Offs on Loans	-3,520			-1.1%	-0.8%		1,759,274	-19,523	-14,206
Non-Interest Income	40,513		2.0%				53,456	53,456	53,456
Non-Interest Expense	-52,377		1.0%				-60,206	-60,206	-60,206
Pre-Tax Earnings	32,370							49,136	107,282
Tax Rate	33%							33%	33%
Net Income	21,938							32,921	71,879
Expect Non-Interest Expense to increase by 1% per annum due to net branch closings of 2-3% per annum (internet banking shift).
P/E Ratio	13.07							13	14
Market Cap	260,580							427,976	1,006,308
Shares Outstanding (Diluted Average)	5,070		-1.6%					4,046	4,046
Per Share Price	$53.84							$105.79	$248.75
Pre-dividend Annualized Return								4.9%	11.6%
Dividends	2.8%							2.8%	2.8%
Total Annualized Return								7.8%	14.4%

There are a few reasons that Wells Fargo may be mis-priced in the market.  Firstly, investors may be over-estimating the reputational harm and associated impact that could result from the aggressive sales practice scandal.  In the quarters that have followed, deposits have actually grown at a healthy pace.  Secondly, investors may be underestimating the potential impact of foot-traffic reductions at its branches (to internet traffic), and the potential cost savings associated with branch closures.  Thirdly, investors may not fully appreciate the earnings impact of interest rates normalizing to historical levels.  Even if it takes 15 years, the Fed Funds Rate (FFR) returning to it’s historical average of ~5% would offer a mid-teen annualized return.  Finally, investors may be under-estimating management’s long-term track record and its ability to add value for shareholders.

Disclosure: Long WFC

 

SAFE?  UNDERSTANDABLE

Business Overview

• One of the biggest financial services institutions in the United States (serving 1/3 of American households).
• Services include providing retail, corporate and commercial banking services through banking stores and offices, the internet, etc. to businesses and institutions.
• 269,000 active full-time equivalent employees.
• Wells Fargo is organized into three operating segments:
  • Community Banking (53% of revenue / 54% of net income) offers a complete line of diversified financial products and services for consumers and small businesses including checking and savings accounts, credit and debit cards, and automobile, student, and small business lending. These products also include investment, insurance and trust services in 39 states and D.C., and mortgage and home equity loans in all 50 states and D.C.
  • Wholesale Banking (30% of revenue / 36% of net income) provides financial solutions to businesses across the United States and globally with annual sales generally in excess of $5 million. Products and businesses include Business Banking, Middle Market Commercial Banking, Government and Institutional Banking, Corporate Banking, Commercial Real Estate, Treasury Management, Wells Fargo Capital Finance, Insurance, International, Real Estate Capital Markets, Commercial Mortgage Servicing, Corporate Trust, Equipment Finance, Wells Fargo Securities, Principal Investments, and Asset Backed Finance.
  • Wealth and Investment Management (WIM) (17% of revenue / 10% of net income) provides a full range of personalized wealth management, investment and retirement products and services to clients across U.S. based businesses including Wells Fargo Advisors, The Private Bank, Abbot Downing, Wells Fargo Institutional Retirement and Trust, and Wells Fargo Asset Management. We deliver financial planning, private banking, credit, investment management and fiduciary services to high-net worth and ultra-high-net worth individuals and families. We also serve clients’ brokerage needs, supply retirement and trust services to institutional clients and provide investment management capabilities delivered to global institutional clients through separate accounts and the Wells Fargo Funds.

How It Makes Money

• In general, Wells makes money off its interest-earning assets (assets that yield a return on investment).  Interest-earning assets consist of Liquid Assets (mainly Cash and Balances with the Central Bank, Due from other Banks, and Trading & Available-for-Sale Securities), Non-Liquid Assets (mainly Other Financial Assets Designated at Fair Value, Held-to-Maturity Investments and Gross Loans), and the interest-earning components of Other Assets.
• EARNING ASSETS (TOTAL INTEREST INCOME). Wells’ primary source of revenue and earnings generation comes from interest earning assets.  It makes money by earning an interest yield on those assets at rates that exceed its cost of borrowing (interest paid out on the assets + the costs of making those investments).  Interest-earning asset types include:
  • CONSUMER LOANS. Consumer loans have made up ~29% of Wells’ interest-earning assets over the last 3 years.  Based on the last 15 years, consumer loans are Wells’ highest yielding investments, earning average yields of ~4.5% to 5.5% above the Fed Funds Rate (FFR).  Wells’ consumer loan portfolio includes:
    • Mortgages (~19% of earning assets) yielding ~3.5% to 4.0% above the FFR.
    • Automobile loans (~4% of earning assets) yielding ~5.0% to 5.5% above FFR.
    • Credit cards (~2% of earning assets) yielding ~11.0 to 11.5% above FFR.
    • Revolving credit & installment loans (~2% of earning assets) yielding ~5.5% to 6.0% above the FFR.
  • COMMERCIAL LOANS. Commercial loans have made up ~27% of Wells’ interest-earning assets over the last 3 years.  Based on the last 15 years, commercial loans, on average, earn ~3.0% to 4.0% above the FFR.  Wells’ commercial loan portfolio includes:
    • Commercial & industrial loans (~18% of earning assets) yielding ~2.5% to 3.5% above the FFR. NOTE:  Wells Fargo has a very large small business lending operation, where they earn high interest rates.
    • Real estate mortgages (~7% of earnings assets) yielding ~3.0% to 3.5% above the FFR.
    • Real estate construction (~1% of earning assets) yielding ~3.0% to 3.5% above the FFR.
    • Lease financing (~1% of earning assets) yielding ~4.5% to 5.0% above the FFR.
  • Investment securities have made up ~21% of Wells’ interest-earning assets over the last 3 years.  Based on the last 15 years, investment securities, on average, earn 2.5% to 4.5% above the FFR.
  • SHORT-TERM INVESTMENTS. Short-term investments include Federal Funds sold, securities purchased under resale agreements, and other short-term investments.  Short-term investments have made up ~17% of interest-earning assets over the last 3 years.  Based on the last 15 years, short-term investments, on average, earn no spread relative to the Fed Funds Rate.
  • TRADING ASSETS. Trading assets have made up ~5% of Wells’ interest-earning assets over the last 3 years.  Based on the last 15 years, trading assets, on average, earn 1.0% to 3.0% above the FFR.
  • Mortgages held for sale, loans held for sale, other items make up ~1% of interest-earning assets and are immaterial to the investment thesis.
  • LOAN DEFAULTS. Wells is a very good lender with few defaults.
    • Until Wells acquired Wachovia, it had very few problem loans. NOTE:  Wells was willing to merge with Wachovia partly because it would make the resulting company so big the Federal Government could not let it fail.  However, the main reasons were probably because they got it cheap, it expanded their branch network, and it added to their base of low-cost deposits.
    • In the last 38 years (1979 to 2016), Wells has had median net charge-offs/average loans of 0.81% (P25 was 0.56%, P75 was 1.11%). Worst years included (year / net charge-off percentage):
      • 2010 / 2.30% (ROA = 1.01%). Financial crisis.
      • 2009 / 2.21% (ROA = 0.97%).
      • 2008 / 1.97% (ROA = 0.44%).
      • 1992 / 1.97% (ROA = 0.54%). Early ‘90s: Ailing regional economy.
      • 1993 / 1.44% (ROA = 1.20%).
      • 1998 / 1.38% (ROA = 1.04%). Botched merger with First Interstate Bancorp.
      • 1991 / 1.22% (ROA = 0.04%).
    • In the last 38 years (1979 to 2016), Wells Fargo has turned a profit (ie. Had a positive net income) in every single year.
    • Wells Fargo’s current Tier 1 Capital Ratio is 12.8% (top quartile in the last 38 years is anything above 10.8%). Regulators use the tier 1 capital ratio to grade a firm’s capital adequacy and a value of 12.8% earns the highest qualitative score of well-capitalized (>6%).  Banks that are under-capitalized cannot pay dividends, buyback shares or pay management fees and they must file a capital restoration plan.
    • Well’s Fargo’s current Leverage Ratio is 8.95% (top quartile in the last 38 years is anything above 8.4%). The Tier 1 leverage ratio is the relationship between a banking organization’s core capital and its total assets. Similarly, to the Tier 1 capital ratio, the leverage ratio is used as a tool by central monetary authorities to ensure the capital adequacy of banks and to place constraints on the degree to which a financial company can leverage its capital base.  The higher the Tier 1 leverage ratio is, the higher the likelihood is of the bank withstanding negative shocks to its balance sheet.  Bank holding companies with more than $700 billion in consolidated total assets or more than $10 trillion in assets under management must maintain Tier 1 leverage ratios of > 5%. In addition, if an insured depository institution is being covered by corrective action framework, meaning it demonstrated capital deficiencies in the past, it must demonstrate at least a 6% Tier 1 leverage ratio to be considered well capitalized.
  • FEES (NON-INTEREST INCOME). Wells’ secondary source of revenue comes from charging fees for its services and earning income from activities other than lending.  However, for banks, the fees almost never offset the operating costs that a bank incurs.  For the year ending 31-DEC-2016, Wells earned a total of $40.5B (~46% of Revenue).  For the last 7 years (2009 to 2016 inclusive), non-interest income has been very stable around $40B.  Sources of non-interest income include:
    • Trust & Income Fees (~16% of Revenue).
    • Card, Insurance & Other Fees (~10% of Revenue).
    • Mortgage Banking Fees (~7% of Revenue).
    • Service Charges on Deposit Accounts (~6% of Revenue).
    • Lease & Other Income (~4% of Revenue).
    • Gains from Trading, Debt Securities, Equity Investments (~3% of Revenue).
  • FUNDING SOURCES (INTEREST EXPENSE). Wells is able to borrow money very cheaply, resulting in a huge competitive advantage.  Funding sources include:
    • On a bank’s balance sheet, deposits are listed as a liability, but they are the inventory of cash used by banks for making loans and buying other financial assets.  The cost of the deposits can be thought of as Cost of Goods Sold (COGS).  Deposits have made up ~80% of total funding sources over the last 3 years.  Deposits are the cheapest source of funding for Wells.  As interest rates / the Fed Funds Rate (FFR) increases, the relative cost of funding for Wells decreases.  Cost of funding decreases because they earn a much larger spread on their non-interest-bearing deposits, and a smaller, but still larger, spread on their interest-bearing deposits.  Over the last 38 years, the median cost of deposits at Wells Fargo has been 1.86% cheaper than the Fed Funds Rate.  Within the U.S., deposits have grown at an incredibly steady rate over the last 30 years (30Y/20Y/10Y/5Y CAGR’s of 5.8%/6.8%/6.4%/5.9%).  Wells Fargo’s deposit base has grown much more quickly than the national rate over the years (20Y/10Y/5Y CAGR’s of 18.7%/15.5%/7.9%) due to numerous acquisitions including First State Bancorp, Norwest (it was actually Norwest acquiring Wells Fargo and retaining the Wells Fargo name), and Wachovia.
      • Interest-bearing deposits (eg. Savings accounts, interest-bearing checking accounts, savings certificates, time deposits, deposits in foreign offices). As of 31-DEC-2016, interest-bearing deposits totalled $890B (52% of funding sources).  These interest-bearing deposits only cost an average of 0.16% over the course of the year.  Over the last 38 years, the median cost of interest-bearing deposits at Wells Fargo has been 0.96% cheaper than the Fed Funds Rate.  Interest-bearing deposits have grown at 20Y/10Y/5Y CAGR’s of 18.3%/16.0%/6.1%.
      • Non-interest-bearing deposits (eg. Checking accounts or demand deposit accounts). As of 31-DEC-2016, non-interest-bearing deposits totalled $448B (26% of funding sources).  As the name implies, these deposits cost Wells Fargo nothing in the way of interest payments.  Over the last 38 years, the median Fed Funds Rate (FFR) has been 5.0%, resulting in a very health profit on these deposits when interest rates rise.  Non-Interest-bearing deposits have grown at 20Y/10Y/5Y CAGR’s of 19.8%/14.5%/13.1%.
      • Other borrowings (eg. Short-term borrowings, long-term debt). As of 31-DEC-2016, other borrowings totalled $371B (22% of funding sources).  These borrowings cost an average of 1.22% over the course of the year.
        • The short-term borrowings totalled $115B (~6% of funding sources) and only cost 0.29%. They generally cost slightly less than the Fed Funds Rate to borrow (2008 was an exception), and are therefore an attractive source of funding.
        • Long-term debt & other liabilities totalled $256B (~15% of funding sources) and cost ~1.63%. They come at a premium price relative to the Fed Funds Rate (up to 2.0% more), and are generally, not a very attractive source of funding.
      • LONG-TERM DEBT & OTHER LIABILITIES. Long-term debt & other liabilities have made up ~15% of total funding sources over the last 3 years.  These borrowings are not cheap for Wells Fargo, coming at a cost of ~1.50% to 2.50% above the FFR.
      • SHORT-TERM BORROWINGS. Short-term borrowings have made up ~5% of total funding sources over the last 3 years.  These borrowings are cheap for Wells Fargo, coming at the cost of the FFR.
    • SERVICE COSTS (NON-INTEREST EXPENSE). The services provided banks carry a significant cost.  The costs of the services usually exceed the service fees charged for providing the services.  Banks accept this money losing trade-off in order to attract low-cost deposits that can then be lent at a profit (on the spread between the interest paid and the one earned).  Wells Fargo’s non-interest expense for 2016 totalled $52.4B, resulting in an Efficiency Ratio (non-interest expense/revenue) of 59.3%.  The Efficiency Ratio has been very stable for the last 15 years (2002 to 2006) with a median value of 58.3%.  Non-interest expense includes:
      • Sales, General, & Administrative (SG&A). For 2016, SG&A costs totalled $33B (representing 37% of revenue).  SG&A expenses include Salaries, Commissions & Incentives, Employee Benefits, and FDIC & Other Deposit Assessments.
      • Other Non-Interest Expenses. For 2016, Other Non-Interest Expenses totalled $19.3B (22% of sales).  Other Non-Interest Expenses include equipment, building leases, and intangible expenses.

Industry / Business Keys

• Earnings, Profitability (ROA):
  • Buffett CNBC Interview (AUG-2013):
    • A viewer asked, will Bank of America and Citigroup trade above tangible book value like Wells Fargo and JPMorgan Chase?
    • Buffett’s response: “Well, a bank that earns 1.3% or 1.4% on assets is going to end up selling above tangible book value. If it’s earning 0.6% or 0.5% on asset it’s not going to sell above book value. Book value is not key to valuing banks. Earnings are key to valuing banks. Now, it translates to book value to some extent because you’re required to hold a certain amount of tangible equity compared to the assets you have. But you’ve got banks like Wells Fargo and USB that earn very high returns on assets, and they are selling for a higher price relative to tangible book. You’ve got other banks … that are earning lower returns on tangible assets, and they’re going to sell — they’re going to sell [for less].”
  • Another Buffett Interview (regarding NYSE-WFC cost of deposits):
    • “They get their money cheaper than anybody else. We’re the low-cost producer at Geico in auto insurance among big companies. And when you’re the low-cost producer — whether it’s copper, or in banking — it’s huge … The key to the future of Wells is continuing to get the money in at very low costs, selling all kinds of services to their customer and having spreads like nobody else has.”
  • Motley Fool Article (Loan Loss Provisions / Loan Quality):
    • The best banks for the long term — the banks that deserve to trade at a premium — are the banks that make good loans. This is because banks lose money when loans go bad. When loans go bad, the loan loss provision spikes as banks put aside more money to cover those losses. Therefore, a bank that is putting aside a lot of money into the loan loss provision is highly likely to be struggling in general. That means a lower ROA.
    • Look at historical performance during downturns.
    • Loan Loss Provisions / Revenue (20Y): WFC 9.9% vs BAC 13.5% vs C 16.0%.
    • Current ROA (20Y median): WFC 1.2% (1.5%) vs BAC 0.8% (0.9%) vs C 0.9% (1.0%).
  • Motley Fool (Efficiency Ratio):
    • The best banks will have the most consistent efficiency ratios. The ratio won’t spike every few years as the credit cycle changes over time.
    • 1) More efficient banks can turn a profit on less revenue because expenses are held in check. 2) Thanks to that efficiency, these banks do not need to chase higher-yielding assets to overcome excess expenses and meet profitability goals.  3) Those higher-yielding assets are invariably riskier than other lower-yielding assets — that’s just the nature of asset pricing.  4) When the economic cycle turns from boom to bust, the efficient banks avoid the losses associated with those riskier assets because they didn’t need them in the first place.  5) Therefore, the best banks are able to maintain those strong efficiency ratios during downturns just as well as in boom times because their loan loss provisions do not spike when those risky loans go bad. Inefficient banks will have the opposite result, suffering outsized spikes in their efficiency ratios and loan losses while those losses are absorbed.
    • Current Efficiency Ratio (20Y median): WFC 59% (59%) vs BAC 66% (59%) VS C 59% (63%).
  • Branch Closings:
    • Over the next decade, as many as half of all U.S. bank branches could disappear, according to Keefe, Bruyette & Woods, a financial services research firm.
      • Branches have significant overhead costs and face a dwindling number of customers who make regular trips there; there are now more people who bank on a smartphone or computer on a weekly basis than who step foot in a branch.
      • In 2015, 25MM Americans started banking remotely for the first time.
    • Growth in deposits (& Total Interest-Earning Assets):
      • Deposits drive loans, which drive earnings, so the banks that have the best potential for growing deposits, stand the best chance of growing earnings over time.
      • Warren Buffett and Bill Gates interview with Chrarlie Rose (JAN-2017):
        • Charlie asks if the U.S. could grow real GDP @ 4% moving forward?  Buffett says, “That’s pretty high”.  With a little less than 1% growth rate (which is probably what we will), suggests 2% is more realistic (“2%, I think we’ll do 2%”).  3% could be possible, but that would be fabulous.
      • Geoff Gannon Article:
        • “If a bank maintains the same market share, it should be able to grow deposits at the rate of nominal growth in the local economy. This statement assumes that deposits as a percent of nominal GDP will neither rise nor fall. That’s not true cyclically. And it may not always be true even historically over the development of a state, country, etc.”
        • “No one knows what the long-term inflation rate will be. It is much easier to predict population growth. It’s also easier to predict real output per person growth. So, it’s easier to predict the long-term growth in real GDP than in nominal GDP. Let’s say U.S. population growth will be roughly 1%, real output per person growth will be roughly 1%, and then inflation will be roughly 2.5%. That gives you an estimate for nominal GDP growth of 4.5%.”
        • “The growth of the industry’s deposits isn’t very useful to you. Three things matter more. One, the growth in deposits at the bank you’re looking at. Two, the growth in deposits per branch at the bank you’re looking at. And, most importantly, the growth in deposits per share of stock at the bank you are interested in.”
        • “The combination of growth in deposits per share and the dividend yield is what matters. For the U.S. as a whole, nominal GDP growth of 4% to 5% is possible. So, for big banks, deposit growth of 4% to 5% is possible. The question then is how much money they have – after retaining what they need to maintain leverage levels from year-to-year – to pay out to you.”
      • Non-interest bearing deposits + Interest bearing deposits = Total deposits (vs. Total Earning Assets). 6Y growth rates:
        • WFC 351B + $871B = $1.223T (20% + 49% = 69%). 7% / 5.2% / 6.8%.
        • BAC $432B + 765B = $1.197T (23% + 41% = 64%). 8% / 1.1% / 3.2%.
        • C $214B + $715B = $929B (13% + 45% = 58%). 10.4% / 1.0% / 2.7%.
      • Cost of interest bearing liabilities: WFC 0.45% vs BAC 0.77% vs C 0.95%.
      • Total Earning Assets (18Y growth rates): WFC $1.770T (14.4%) vs BAC $1.884T (7.7%) vs C $1.605T (4.9%).
      • Loan Growth (6y CAGR): WFC 2.4% vs BAC -0.2% vs C 1.4%.
      • Loans / Total Deposits (20Y median): WFC 80% (97%) vs BAC 76% (89%) vs C 66% (77%).
      • Loans / Total Earning Assets (20Y median): WFC 56% (79%) vs BAC 48% (56%) vs C 38% (38%).
      • Kevin’s Take: Long-term, it makes sense to me that deposit growth should mimic nominal GDP growth rate, so U.S. deposit growth of 4-5% per annum seems reasonable (call it 4.5%).  Furthermore, WFC’s deposit growth rate over it’s history has always exceeded this figure, so it is a conservative estimate.
    • Buffett Interview (regarding bank leverage):
      • “Banks are not going to earn as good a return on equity in the future as they did five years ago. Their leverage is being restrained for good reason in many cases. So, banks earn on assets but the ratio of assets to equity, the leverage they have determines what they earn on equity.”

Company History

• 1852 to 1871:
  • In 1852, Wells Fargo was founded in 1852 to provide express and banking services to California.
  • In 1855, the California banking system collapsed from unsound speculation. Wells Fargo was one of the few financial and express companies to survive the panic, partly because it kept sufficient assets on hand to meet customers’ demands. Surviving the Panic reduced competition in California after the crisis and also gave Wells Fargo a reputation for dependability and soundness.
  • In 1855 & 1866, Wells Fargo expanded rapidly, becoming the West’s all-purpose business, communications, and transportation agent.
  • From 1866 to 1871, Wells Fargo’s stagecoach empire booms and then busts as the First Transcontinental Railroad reaches completion, causing the stage business to dwindle. Wells Fargo agrees to buy its competitor, the Pacific Union Express Company at a much-inflated price, receiving exclusive express rights for ten years on the Central Pacific Railroad and a much-needed infusion of capital.
• 1871 to 1905:
  • The number of banking and express offices grows rapidly from 436 to more than 3,500. During this period, Wells Fargo also established the first Transcontinental Express line, using more than a dozen railroads and gained access to the lucrative East Coast markets.  In 1885, Wells Fargo also began selling money orders.
  • In 1905, Wells Fargo separates its banking and express operations. The banking operations became known as The Wells Fargo Nevada National Bank.
• 1906 to 1940:
  • The 1906 San Francisco earthquake and fire destroyed most of the city’s business district. With its bank’s vaults and credit left intact, and money flowing into San Francisco from around the country to support rapid reconstruction of the city, the bank’s deposits increased dramatically from $16 million to $35 million in 18 months.
  • The Panic of 1907, caused when several New York banks tried to manipulate the stock market, resulted in bank run when speculators were unable to pay for stock they had purchased. The run quickly spread throughout the country. Wells Fargo lost $1 million in deposits weekly for six weeks in a row.
  • The years following the panic were committed to a slow and painstaking recovery based on a management strategy including both expansion and conservative banking practices.
  • In 1924, Wells Fargo Nevada National Bank merged with the Union Trust Company to form the Wells Fargo Bank & Union Trust Company.
  • The bank prospered during the 1920s and careful reinvestment of the bank’s earnings placed the bank in a good position to survive the Great Depression.
  • Following the collapse of the banking system in 1933, the company was able to extend immediate and substantial help to its troubled correspondents.
• 1940 to 1970:
  • The war years were prosperous and uneventful for Wells Fargo.
  • In the 1950s, it began a modest expansion program, acquiring the First National Bank of Antioch in 1954 and the First National Bank of San Mateo County in 1955 and opening a small branch network around San Francisco.
  • In 1954, the name of the bank was shortened to Wells Fargo Bank, to capitalize on frontier imagery and in preparation for further expansion.
  • In 1960, the Wells Fargo Bank merged with American Trust Company, a large northern California retail-banking system and the second oldest financial institution in California, to form the Wells Fargo Bank & American Trust Company. The merger resulted in the 11th largest banking institution in the United States.
  • Following the merger, Wells Fargo’s involvement in international banking greatly accelerated. The company opened a Tokyo representative office and, eventually, additional branch offices in Seoul, Hong Kong, and Nassau, Bahamas, as well as representative offices in Mexico City, São Paulo, Caracas, Buenos Aires, and Singapore.
  • In 1962, the name was again shortened to Wells Fargo Bank,
  • In 1967, Wells Fargo, together with three other California banks, introduced a Master Charge card (now MasterCard) to its customers as part of its plan to challenge Bank of America in the consumer lending business.
  • Having been blocked from acquiring an established bank in southern California by the Federal Reserve, Wells Fargo had to build its own branch system. This expansion was costly and depressed the bank’s earnings in the later 1960s.
  • In 1968, Wells Fargo changed from a state to a federal banking charter, in part so that it could set up subsidiaries for businesses such as equipment leasing and credit cards rather than having to create special divisions within the bank. The bank successfully completed a number of acquisitions during 1968 as well. The Bank of Pasadena, First National Bank of Azusa, Azusa Valley Savings Bank, and Sonoma Mortgage Corporation were all integrated into Wells Fargo’s operations.
• 1970 to 1980:
  • Between 1970 and 1975, Wells Fargo’s domestic profits rose faster than those of any other U.S. bank. Wells Fargo’s loans to businesses increased dramatically after 1971. To meet the demand for credit, the bank frequently borrowed short-term from the Federal Reserve to lend at higher rates of interest to businesses and individuals.
  • In 1973, a tighter monetary policy made borrowing short-term from the fed to lend to businesses and individuals at higher rates, less profitable. Around this time, new interest limits were introduced on passbook savings, and Wells Fargo was the first to begin paying the higher rate. The bank attracted many new customers as a result, enabling it to substantially increase its market share in California’s competitive banking climate. With its increased deposits, Wells Fargo was then able to reduce its borrowings from the Federal Reserve, and the premium it paid for deposits was more than made up for by the savings in interest payments. In 1975, the rest of the California banks instituted a 5% passbook savings rate, but they failed to recapture their market share.
  • In 1973, Wells Fargo decided to go after the medium-sized corporate and consumer loan businesses, where interest rates were higher. Slowly, Wells Fargo eliminated its excess debt, and by 1974, its balance sheet showed a much healthier bank. Wells Fargo’s real estate lending also bolstered the bottom line. The bank focused on California’s flourishing home and apartment mortgage business and left risky commercial developments to other banks.
  • While Wells Fargo’s domestic operations did well in the early 1970s, its international operations performed poorly. The bank’s 25% holding in Allgemeine Deutsche Credit-Anstalt, a West Germany bank, cost Wells Fargo $4 million due to bad real estate loans. Another joint banking venture, the Western American Bank, which was formed in London in 1968 with several other American banks, was hard hit by the recession of 1974 and failed. Unfavorable exchange rates hit Wells Fargo for another $2 million in 1975. In response, the bank slowed its overseas expansion program and concentrated on developing overseas branches of its own rather than tying itself to the fortunes of other banks.
  • Wells Fargo’s investment services became a leader during the late 1970s. According to Institutional Investor, Wells Fargo garnered more new accounts from the 350 largest pension funds between 1975 and 1980 than any other money manager. The bank’s aggressive marketing of its services included seminars explaining modern portfolio theory. Wells Fargo’s early success, particularly with indexing—weighting investments to match the weightings of the S&P 500—brought many new clients aboard.
  • In 1978, Wells Fargo secured a major legal victory that would guarantee its long-term prosperity in its home market of California. After eight years of litigation in both federal and state courts, the Supreme Court of California ruled in Wells Fargo’s favor and upheld the constitutionality of California’s statutory nonjudicial foreclosure procedure against a due process challenge. Thus, Wells Fargo could continue to provide credit to borrowers at very affordable rates (nonjudicial foreclosure is relatively swift and inexpensive).
  • By the end of the 1970s, Wells Fargo’s overall growth had slowed somewhat. Earnings were only up 12% in 1979, compared with an average of 19% between 1973 and 1978.
• 1980 to 1990:
  • The early 1980s saw a sharp decline in Wells Fargo’s performance as the company struggled with a high volume of problem loans. The bank reacted by scaling down its operations overseas and concentrating on the California market.
  • In 1983, under new management (namely, Carl Reichardt and Paul Hazen), the bank relentlessly reduced costs, eliminating 100 branches and cutting 3,000 jobs. The bank also closed down its European offices at a time when most banks were expanding their overseas networks.
  • Rather than taking advantage of banking deregulation, which was enticing other banks into all sorts of new financial ventures, management kept things simple and focused on California. Wells Fargo beefed up its retail network through improved services such as an extensive automated teller machine network, and through active marketing of those services.
  • In 1986, Wells Fargo purchased rival Crocker National Bank from Britain’s Midland Bank for about $1.1 billion. The acquisition was touted as a brilliant maneuver by Wells Fargo. Not only did Wells Fargo double its branch network in southern California and increase its consumer loan portfolio by 85%, but the bank did it at an unheard-of price, paying about 127% of book value at a time when American banks were generally going for 190%. In addition, Midland kept about $3.5 billion in loans of dubious value. Crocker doubled the strength of Wells Fargo’s primary market, making Wells Fargo the tenth largest bank in the United States. Furthermore, the integration of Crocker’s operations into Wells Fargo’s went considerably smoother than expected. In the 18 months after the Crocker acquisition, 5,700 jobs were trimmed from the banks’ combined staff, 120 redundant branches closed, and costs were cut considerably.
  • Before and after the acquisition, the bank aggressively cut costs and eliminated unprofitable portions of Wells Fargo’s business. During the three years before the acquisition, Wells Fargo sold its realty-services subsidiary, its residential-mortgage service operation, and its corporate trust and agency businesses. Over 70 domestic bank branches and 15 foreign branches were also closed during this period. In 1987, Wells Fargo set aside large reserves to cover potential losses on its Latin American loans, most notably to Brazil and Mexico. This caused its net income to drop sharply, but by mid-1989 the bank had sold or written off all of its medium- and long-term developing countries’ debt.
  • Concentrating on California was a very successful strategy for Wells Fargo. In May 1988, Wells Fargo acquired Barclays Bank of California from Barclays plc. In the late 1980s, the company considered expanding into Texas, where it made an unsuccessful bid for Dallas’s First Republic Corporation in 1988. In early 1989, Wells Fargo expanded into full-service brokerage and launched a joint venture with the Japanese company Nikko Securities called Wells Fargo Nikko Investment Advisors. Also in 1989, the company divested itself of its last international offices, further tightening its focus on domestic commercial and consumer banking activities.
  • In 1989, Wells Fargo obtained another important legal victory from the California Courts of Appeal. The court held that Wells Fargo was not subject to tort liability for breach of the implied covenant of good faith and fair dealing just because it had taken a “hard line” approach in workout negotiations with its borrowers and refused to modify or forbear enforcing the terms of the relevant promissory notes. The borrowers had narrowly avoided foreclosure only by liquidating a large amount of assets at fire sale prices to raise cash and pay off their loans in full. By barring recovery against Wells Fargo for the losses incurred by borrowers as a result of its hardball tactics, the court enabled Wells Fargo to continue providing credit at low interest rates, secure in the knowledge that it could aggressively pursue defaulting borrowers without risking tort liability.
• 1990 to 1995:
  • The early 1990s were marred by recession. The bank, was still loaded with debt, including relatively risky real estate loans, in the late 1980s. However, the bank had greatly improved its loan-loss ratio since the early 1980s. Wells continued to improve its health and to thrive during the early 1990s. Much of that growth was attributable to gains in the California market. Despite an ailing regional economy during the early 1990s, Wells Fargo posted healthy gains in that core market. Wells slashed its labor force—by more than 500 workers in 1993 alone—and boosted cash flow with technical innovations.
    • Wells Fargo launched its personal computer banking service in 1989 and was the first bank to introduce access to banking accounts on the web in 1995.
  • After dipping in 1991, Wells’ net income surged to $283 million in 1992 before climbing briskly to $841 million in 1994. At the end of 1994, after 12 years of service during which Wells Fargo & Co. investors enjoyed a 1,781% return, Carl Reichardt stepped aside as head of the company. He was succeeded by Paul Hazen. Wells Fargo Bank entered 1995 as the second largest bank in California and the seventh largest in the United States, with $51 billion in assets. Under Hazen, the bank continued to improve its loan portfolio, boost service offerings, and cut operating costs. During 1995, Wells Fargo Nikko Investment Advisors was sold to Barclays PLC for $440 million.
  • During 1995, Wells Fargo initiated discussions to merge with American Express. This merger would have been notable, since both companies were founded by the same people, Wells and Fargo. It was thought that this merger could give Wells a more global presence. However, egos clashed within the companies as to who would run the combined firm. One issue centered around technology. Even though American Express was going through a very expensive and ambitious technological upgrade, it still would have lagged greatly behind Wells Fargo’s systems, posing tremendous integration risk. Also, there would have been regulatory issues, especially since American Express owned an insurance company, Investors Diversified Services (doing business as American Express Financial Advisors), and this would have had to have been divested. In the end, it was decided not to go through with the merger.
• 1996 to 2008:
  • In 1995, Wells Fargo began pursuing a hostile takeover of First Interstate Bancorp, a Los Angeles-based bank holding company with $58 billion in assets and 1,133 offices in California and 12 other western states. Wells Fargo had long been interested in acquiring First Interstate and made a hostile bid for First Interstate in October 1995 initially valued at $10.8 billion. Other banks came forward as potential “white knights”, including Norwest Corporation, Bank One Corporation, and First Bank System. The latter made a serious bid for First Interstate, with the two banks reaching a formal merger agreement in November valued initially at $10.3 billion. But, First Bank ran into regulatory difficulties with the way it had structured its offer and was forced to bow out of the takeover battle in mid-January 1996. Talks between Wells Fargo and First Interstate then led within days to a merger agreement.  In January 1996, Wells Fargo announced the acquisition of First Interstate Bancorp for $11.6 billion. The newly enlarged Wells Fargo had assets of about $116 billion, loans of $72 billion, and deposits of $89 billion. It ranked as the ninth largest bank in the United States.
    • Wells Fargo aimed to generate $800 million in annual operational savings out of the combined bank within 18 months, and immediately upon completion of the takeover announced a workforce reduction of 16 percent, or 7,200 positions, by the end of 1996. The merger, however, quickly turned disastrous as efforts to consolidate operations, which were placed on an ambitious timetable, led to major problems. Computer system glitches led to lost customer deposits and bounced checks. Branch closures led to long lines at the remaining branches. There was also a culture clash between the two banks and their customers. Wells Fargo had been at the forefront of high-tech banking, emphasizing ATMs and online banking, as well as the small-staffed supermarket branches, at the expense of traditional branch banking. By contrast, First Interstate had emphasized personalized relationship banking, and its customers were used to dealing with tellers and bankers not machines. This led to a mass exodus of First Interstate management talent and to the alienation of numerous customers, many of whom took their banking business elsewhere.
  • The financial performance of Wells Fargo, as well as its stock price, suffered from this botched merger with First Interstate Bancorp, leaving the bank vulnerable to being taken over itself as banking consolidation continued unabated. In 1998, Wells Fargo entered into a friendly merger agreement with Norwest Corporation of Minneapolis. The deal was completed in November of that year and was valued at $31.7 billion. Although Norwest was the nominal survivor, the merged company retained the Wells Fargo name because of the latter’s greater public recognition and the former’s regional connotations. The merged company remained based in San Francisco based on the bank’s $54 billion in deposits in California versus $13 billion in Minnesota. The head of Wells Fargo, Paul Hazen, was named chairman of the new company, while the head of Norwest, Richard Kovacevich, became president and CEO. However, Wells Fargo retains Norwest’s pre-1998 stock price history, and all SEC filings before 1998 are listed under Norwest, not Wells Fargo.
    • The new Wells Fargo started off as the nation’s seventh largest bank with $196 billion in assets, $130 billion in deposits, and 15 million retail banking, finance, and mortgage customers. The banking operation included more than 2,850 branches in 21 states from Ohio to California. Norwest Mortgage had 824 offices in 50 states, while Norwest Financial had nearly 1,350 offices in 47 states, ten provinces of Canada, the Caribbean, Latin America, and elsewhere.
    • The integration of Norwest and Wells Fargo proceeded much more smoothly than the combination of Wells Fargo and First Interstate. A key reason was that the process was allowed to progress at a much slower and more manageable pace than the First Interstate Bancorp merger. The plan allowed for two to three years to complete the integration, while the cost-cutting goal was a more modest $650 million in annual savings within three years. Rather than the mass layoffs that were typical of many mergers, Wells Fargo announced a workforce reduction of only 4,000 to 5,000 employees over a two-year period.
  • Continuing the Norwest tradition of making numerous smaller acquisitions each year.
    • Wells Fargo acquired 13 companies during 1999 with total assets of $2.4 billion. The largest of these was the February purchase of Brownsville, Texas-based Mercantile Financial Enterprises, Inc., which had $779 million in assets.
    • The acquisition pace picked up in 2000 with Wells Fargo expanding its retail banking into two more states: Michigan, through the buyout of Michigan Financial Corporation ($975 million in assets), and Alaska, through the purchase of National Bank of Alaska, with $3 billion of assets. In 2000, Wells Fargo also acquired First Commerce Bancshares, Inc. of Lincoln, Nebraska, which had $2.9 billion in assets, and a Seattle-based regional brokerage firm, Ragen MacKenzie Group Incorporated. In October 2000, Wells Fargo made its largest deal since the Norwest-Wells Fargo merger when it paid nearly $3 billion in stock for First Security Corporation, a $23 billion bank holding company based in Salt Lake City, Utah, and operating in seven western states. Wells Fargo thereby became the largest banking franchise in terms of deposits in New Mexico, Nevada, Idaho, and Utah; as well as the largest banking franchise in the West overall. Following completion of the First Security acquisition, Wells Fargo had total assets of $263 billion with some 140,000 employees.
    • In 2001, Wells Fargo acquired H.D. Vest Financial Services for $128 million, but sold it in 2015 for $580 million.
    • There was speculation that the next ‘stage’ for Wells Fargo might involve a major merger with an eastern bank that would create a nationwide retail bank.
    • In January 2007, Wells Fargo acquired Placer Sierra Bank.
    • In May 2007, Wells Fargo acquired Greater Bay Bancorp, which had $7.4 billion in assets, in a $1.5 billion transaction.
    • In June 2007, Wells Fargo acquired CIT’s construction unit.
    • In January 2008, Wells Fargo acquired United Bancorporation of Wyoming.
    • In August 2008, Wells Fargo acquired Century Bancshares of Texas.
  • In June 2007, John Stumpf was named Chief Executive Officer of the company and Richard Kovacevich remained as chairman.
• 2008 to Present:
  • In September 2008, during the financial panic, Wells Fargo made a bid to purchase the troubled Wachovia Corporation. Although at first inclined to accept a September 29 agreement brokered by the Federal Deposit Insurance Corporation to sell its banking operations to Citigroup for $2.2 billion, on October 3, Wachovia accepted Wells Fargo’s offer to buy all of the financial institution for $15.1 billion.
    • In October 2008, the transaction was temporarily blocked after a Citigroup lawsuit alleging they had an exclusivity agreement. The injunction was overturned, followed by Citigroup and Wells Fargo entering into negotiations brokered by the FDIC to reach an amicable solution to the impasse. Those negotiations failed.  Ultimately, Citigroup did not block the merger, but indicated they would seek damages of $60 billion for breach of an alleged exclusivity agreement with Wachovia.
    • The Wachovia merger created a coast-to-coast super-bank with $1.4 trillion in assets and 48 million customers, and expanded Wells Fargo’s operations into nine Eastern and Southern states. There would be big overlaps in operations only in California and Texas, much less so in Nevada, Arizona, and Colorado. In contrast, the Citigroup deal would have resulted in a substantial overlap, since both banks’ operations were heavily concentrated in the East and Southeast. The proposed merger was approved by the Federal Reserve as a $12.2 billion all-stock transaction on October 12 in an unusual Sunday order. The acquisition was completed on January 1, 2009.
  • In October 2008, Wells Fargo was the recipient of $25B of the Emergency Economic Stabilization Act Federal bail-out in the form of a preferred stock purchase.
    • Tests by the Federal government revealed that Wells Fargo needed an additional $13.7 billion in order to remain well capitalized if the economy were to deteriorate further under stress test scenarios.
    • On May 11, 2009 Wells Fargo announced an additional stock offering which was completed on May 13, 2009 raising $8.6 billion in capital. The remaining $4.9 billion in capital was planned to be raised through earnings.
    • On Dec. 23, 2009, Wells Fargo redeemed the $25 billion of series D preferred stock issued to the U.S. Treasury under the Troubled Asset Relief Program’s Capital Purchase Program. As part of the redemption of the preferred stock, Wells Fargo also paid accrued dividends of $131.9 million, bringing the total dividends paid to the U.S. Treasury and U.S. taxpayers to $1.441 billion since the preferred stock was issued in October 2008.
  • In 2009, Wells Fargo Securities was established to house Wells Fargo’s new capital markets group which it obtained during the Wachovia acquisition. Prior to that point, Wells Fargo had little to no participation in investment banking activities, though Wachovia had a well established investment banking practice which it operated under the Wachovia Securities banner.
    • Wachovia’s institutional capital markets and investment banking business arose from the merger of Wachovia and First Union. First Union had bought Bowles Hollowell Connor & Co. on April 30, 1998 adding to its merger and acquisition, high yield, leveraged finance, equity underwriting, private placement, loan syndication, risk management, and public finance capabilities.
    • Legacy components of Wells Fargo Securities include Wachovia Securities, Bowles Hollowell Connor & Co., Barrington Associates, Halsey, Stuart & Co., Leopold Cahn & Co., Bache & Co. and Prudential Securities, and the investment banking arm of Citadel LLC.

Past Performance

Financial Performance

• 2016 Annual Report:
  • Revenue of $88.3 billion, up 3% from 2015. The increase in revenue for 2016 compared with 2015 was predominantly due to an increase in net interest income, reflecting increases in interest income from loans and trading assets, partially offset by higher long-term debt and deposit interest expense.

Balance Sheet & Liquidity

• 2016 Annual Report:
  • Our balance sheet grew 8% in 2016 to $1.9 trillion, as we increased our liquidity position, held more capital and continued to experience solid credit quality.
  • Our loan portfolio increased $51.0 billion from December 31, 2015, predominantly due to growth in commercial and industrial, real estate mortgage, credit card, automobile, and lease financing loans within the commercial loan portfolio segment, which included $27.9 billion of commercial and industrial loans and capital leases acquired from GE Capital in 2016. We have grown loans on a year-over-year basis for 22 consecutive quarters.
  • We further strengthened our liquidity position in 2016 in advance of the increase on January 1, 2017, to the minimum liquidity coverage ratio (LCR) regulatory requirement.
  • We grew our investment securities portfolio by $60.4 billion in 2016.
  • Our federal funds sold, securities purchased under resale agreements and other short-term investments (collectively referred to as federal funds sold and other short-term investments elsewhere in this Report) decreased by $4.1 billion, or 2%, during 2016.
  • Deposits at December 31, 2016, were up $82.8 billion, or 7%, from 2015. This increase reflected growth across our commercial and consumer businesses. Our average deposit cost increased 3 basis points from a year ago driven by commercial deposit pricing. We grew our primary consumer checking customers (i.e., customers who actively use their checking account with transactions such as debit card purchases, online bill payments, and direct deposit) by 3.0%.

Credit Quality

• 2016 Annual Report:
  • Performance in several of our commercial and consumer loan portfolios remained near historically low loss levels.
  • Net charge-offs of $3.5 billion were 0.37% of average loans, compared with $2.9 billion and 0.33%, respectively, from a year ago.
  • Net losses in our commercial portfolio were $1.1 billion, or 22 basis points of average loans, in 2016, compared with $387 million, or 9 basis points, in 2015, driven by higher losses in our oil and gas portfolio.
  • Our commercial real estate portfolios were in a net recovery position for each quarter of the last four years, reflecting our conservative risk discipline and improved market conditions.
  • Net consumer losses declined to 53 basis points in 2016 from 55 basis points in 2015.
  • Losses on our consumer real estate portfolios declined $330 million, or 52%, from a year ago.
  • As of December 31, 2016, approximately 73% of our real estate 1-4 family first lien mortgage portfolio was originated after 2008, when new underwriting standards were implemented.
  • The allowance for credit losses of $12.5 billion at December 31, 2016, was up slightly compared with the prior year.
  • Our provision for credit losses in 2016 was $3.8 billion compared with $2.4 billion a year ago reflecting a build of $250 million in the allowance for credit losses, compared with a release of $450 million in 2015. The build in 2016 was primarily due to deterioration in the oil and gas portfolio, while the release in 2015 was due to strong underlying credit performance and improvement in the housing market.
  • Nonperforming assets (NPAs) at the end of 2016 were down $1.4 billion, or 11%, from the end of 2015. Nonaccrual loans declined $998 million from the prior year end while foreclosed assets were down $447 million from 2015.

Capital:

• 2016 Annual Report:
  • Our capital levels remained strong in 2016 with total equity increasing to $200.5 billion at December 31, 2016, up $6.6 billion from the prior year.
  • Returned $12.5 billion in capital to our shareholders through increased common stock dividends and additional net share repurchases.
  • Net payout ratio (which is the ratio of (i) common stock dividends and share repurchases less issuances and stock compensation-related items, divided by (ii) net income applicable to common stock) was 61%.
  • During 2016 we increased our quarterly common stock dividend from $0.375 to $0.38 per share.
  • In 2016, our common shares outstanding declined by 76.0 million shares as we continued to reduce our common share count through the repurchase of 159.6 million common shares during the year. We also entered into a $750 million forward repurchase contract with an unrelated third party in fourth quarter 2016 that settled in first quarter 2017 for 14.7 million shares. In addition, we entered into a $750 million forward repurchase contract with an unrelated third party in January 2017 that is expected to settle in second quarter 2017 for approximately 14 million shares. We expect our share count to continue to decline in 2017 as a result of anticipated net share repurchases.
  • We believe an important measure of our capital strength is the Common Equity Tier 1 ratio on a fully phased-in basis, which was 10.77% as of both December 31, 2016 and 2015. Likewise, our other regulatory capital ratios remained strong.

Net Interest Income:

• Net interest income and the net interest margin in any one period can be significantly affected by a variety of factors including:
  • The mix and overall size of our earning assets portfolio and the cost of funding those assets.
  • In addition, some variable sources of interest income, such as resolutions from purchased credit-impaired (PCI) loans, loan fees and collection of interest on nonaccrual loans, can vary from period to period.
  • Net interest income and net interest margin growth has been challenged during the prolonged low interest rate environment as higher yielding loans and securities have run off and have been replaced with lower yielding assets.
• Net interest income on a taxable-equivalent basis was $49.0 billion in 2016, compared with $46.4 billion in 2015, and $44.4 billion in 2014. The net interest margin was 2.86% in 2016, down 9 basis points from 2.95% in 2015, which was down 16 basis points from 3.11% in 2014. The increase in net interest income for 2016, compared with 2015, resulted from growth in loans, including the GE Capital business acquisitions that closed in 2016, investment securities, trading balances, and the net benefit of higher interest rates, partially offset by an increase in funding interest expense from growth and repricing of wholesale and other business deposits, short-term borrowings, and long-term debt.
• The decline in net interest margin in 2016, compared with 2015, was primarily due to growth and repricing of long-term debt balances, and growth in deposits. This was partially offset by growth and repricing of loans and investment securities. The growth in customer-driven deposits and funding balances during 2016 kept cash, federal funds sold, and other short-term investments elevated, which diluted net interest margin but was essentially neutral to net interest income.
• Average earning assets increased $139.0 billion in 2016 from a year ago, as average loans increased $64.5 billion, average investment securities increased $30.1 billion, and average trading assets increased $21.7 billion in 2016, compared with a year ago. In addition, average federal funds sold and other short-term investments increased $20.9 billion in 2016, compared with a year ago.
• Deposits are an important low-cost source of funding and affect both net interest income and the net interest margin. Deposits include noninterest-bearing deposits, interest-bearing checking, market rate and other savings, savings certificates, other time deposits, and deposits in foreign offices. Average deposits increased to $1.3 trillion in 2016, compared with $1.2 trillion in 2015, and represented 132% of average loans compared with 135% a year ago. Average deposits decreased to 73% of average earning assets in 2016, compared with 76% a year ago as the growth in total loans outpaced deposit growth.

Non-Interest Income:

• The decline in non-interest income in 2016 compared with 2015 was largely driven by lower net gains from equity investments, lower mortgage banking, and lower insurance income due to the divestiture of our crop insurance business.
• Service charges on deposit accounts were $5.4 billion in 2016, up from $5.2 billion in 2015 due to higher overdraft fee revenue driven by growth in transaction volume, account growth and higher fees from commercial products and re-pricing.
• Brokerage advisory, commissions and other fees are received for providing full-service and discount brokerage services predominantly to retail brokerage clients. Income from these brokerage-related activities include asset-based fees for advisory accounts, which are based on the market value of the client’s assets, and transactional commissions based on the number and size of transactions executed at the client’s direction. These fees decreased to $9.2 billion in 2016, from $9.4 billion in 2015, which increased slightly compared with 2014. The decrease in these fees for 2016 was predominantly due to lower transactional commission revenue. The increase in 2015 was primarily due to growth in asset-based fees driven by higher average advisory account assets in 2015 than 2014. Retail brokerage client assets totaled $1.49 trillion at December 31, 2016, compared with $1.39 trillion and $1.42 trillion at December 31, 2015 and 2014, respectively, with all retail brokerage services provided by our Wealth and Investment Management (WIM) operating segment.
• We earn trust and investment management fees from managing and administering assets, including mutual funds, institutional separate accounts, corporate trust, personal trust, employee benefit trust and agency assets. Trust and investment management fee income is primarily from client assets under management (AUM) for which the fees are determined based on a tiered scale relative to the market value of the AUM. AUM consists of assets for which we have investment management discretion. Our AUM totaled $652.2 billion at December 31, 2016, compared with $653.4 billion and $661.6 billion at December 31, 2015 and 2014, respectively, with substantially all of our AUM managed by our WIM operating segment.
• In addition to AUM we have client assets under administration (AUA) that earn various administrative fees which are generally based on the extent of the services provided to administer the account. Our AUA totaled $1.6 trillion at December 31, 2016, compared with $1.4 trillion and $1.5 trillion at December 31, 2015 and 2014, respectively. Trust and investment management fees of $3.3 billion in 2016 decreased due to a shift of assets into lower yielding products, compared with 2015. Trust and investment management fees of $3.4 billion in 2015 remained stable compared with 2014.
• We earn investment banking fees from underwriting debt and equity securities, arranging loan syndications, and performing other related advisory services. Investment banking fees of $1.7 billion in 2016 increased from $1.6 billion in 2015, due to higher loan syndications and advisory fees, partially offset by lower equity originations. Investment banking fees in 2015 decreased compared with 2014 due to reductions in equity capital markets and loan syndications, partially offset by increased fees in advisory services and investment-grade debt origination.
• Card fees were $3.9 billion in 2016, compared with $3.7 billion in 2015 and $3.4 billion in 2014. Card fees increased in 2016 and 2015 predominantly due to increased purchase activity.
• Other fees of $3.7 billion in 2016 decreased compared with 2015 predominantly driven by lower commercial real estate brokerage commissions and all other fees. Other fees in 2015 were unchanged compared with 2014 as a decline in charges and fees on loans was offset by an increase in commercial real estate brokerage commissions. Commercial real estate brokerage commissions decreased to $494 million in 2016 compared with $618 million in 2015 and $469 million in 2014. The decrease in 2016 was driven by lower sales and other property-related activities including financing and advisory services.
• Mortgage banking income, consisting of net servicing income and net gains on loan origination/sales activities, totaled $6.1 billion in 2016, compared with $6.5 billion in 2015 and $6.4 billion in 2014. In addition to servicing fees, net mortgage loan servicing income includes amortization of commercial mortgage servicing rights (MSRs), changes in the fair value of residential MSRs during the period, as well as changes in the value of derivatives (economic hedges) used to hedge the residential MSRs.
• Net gains on mortgage loan origination/sales activities was $4.3 billion in 2016, compared with $4.1 billion in 2015 and $3.0 billion in 2014. The increase in 2016 compared with 2015 was predominantly driven by increased origination volumes, partially offset by lower margins. The increase in 2015 from 2014 was primarily driven by increased origination volumes and margins. Mortgage loan originations were $249 billion in 2016, compared with $213 billion for 2015 and $175 billion for 2014.
• Mortgage applications were $347 billion in 2016, compared with $311 billion in 2015 and $262 billion in 2014. The 1-4 family first mortgage unclosed pipeline was $30 billion at December 31, 2016, compared with $29 billion at December 31, 2015 and $26 billion at December 31, 2014.
• Net gains from trading activities, which reflect unrealized changes in fair value of our trading positions and realized gains and losses, were $834 million in 2016, $614 million in 2015 and $1.2 billion in 2014. The increase in 2016 compared with 2015 was predominantly driven by higher deferred compensation gains (offset in employee benefits expense) and higher customer accommodation trading activity within our capital markets business reflecting higher fixed income trading gains.
• Net gains on debt and equity securities totaled $1.8 billion for 2016 and $3.2 billion and $3.0 billion for 2015 and 2014, respectively, after other-than-temporary impairment (OTTI) write-downs of $642 million, $559 million and $322 million, respectively, for the same periods. The decrease in net gains on debt and equity securities in 2016 compared with 2015 reflected lower net gains from equity investments as our portfolio benefited from strong public and private equity markets in 2015.
• Lease income was $1.9 billion in 2016 compared with $621 million in 2015 and $526 million in 2014. The increase in 2016 was largely driven by the GE Capital business acquisitions, and the increase in 2015 was driven by higher gains on early leveraged lease terminations and higher rail car lease income.
• All other income was $702 million for 2016 compared with $(115) million in 2015 and $456 million in 2014. All other income includes ineffectiveness recognized on derivatives that qualify for hedge accounting, the results of certain economic hedges, losses on low income housing tax credit investments, foreign currency adjustments and income from investments accounted for under the equity method, any of which can cause decreases and net losses in other income. The increase in other income in 2016 compared with 2015 was driven by a $374 million pre-tax gain from the sale of our crop insurance business in first quarter 2016, a $290 million gain from the sale of our health benefit services business in second quarter 2016, and our proportionate share of earnings from a merchant services joint venture that was deconsolidated in 2015, partially offset by changes in ineffectiveness recognized on interest rate swaps used to hedge our exposure to interest rate risk on long-term debt and cross-currency swaps, cross-currency interest rate swaps and forward contracts used to hedge our exposure to foreign currency risk and interest rate risk involving non-U.S. dollar denominated long-term debt.

Non-Interest Expense:

• Non-interest expense was $52.4 billion in 2016, up 5% from $50.0 billion in 2015, which was up 2% from $49.0 billion in 2014. The increase in 2016, compared with 2015, was driven predominantly by higher personnel expenses, operating lease expense, outside professional services and contract services, and FDIC and other deposit assessments, partially offset by lower insurance, operating losses, foreclosed assets expense, outside data processing, postage, stationery and supplies, and telecommunications expense. The increase in 2015 from 2014 was driven by higher personnel expenses and operating losses, partially offset by lower travel and entertainment expense and foreclosed assets expense.
• Personnel expenses, which include salaries, commissions, incentive compensation and employee benefits, were up $1.2 billion, or 4% in 2016, compared with 2015, due to annual salary increases, staffing growth driven by the GE Capital business acquisitions and investments in technology and risk management, higher deferred compensation expense (offset in trading revenue) and increased employee benefits. Personnel expenses were up 2% in 2015, compared with 2014, due to annual salary increases, staffing growth across various businesses, and higher revenue-related incentive compensation.
• FDIC and other deposit assessments were up 20% in 2016, compared with 2015, due to an increase in deposit assessments as a result of a temporary surcharge which became effective on July 1, 2016.
• Outside professional services expense was up 18% and contract services expense was up 23% in 2016, compared with 2015, driven by continued investments in our products, technology and service delivery, as well as costs to meet heightened regulatory expectations and evolving cybersecurity risk.
• Operating losses were down 14% in 2016, compared with 2015, predominantly due to lower litigation expense for various legal matters. Operating losses were up 50% in 2015, compared with 2014, predominantly due to higher litigation expense for various legal matters.
• Operating lease expense was up $1.1 billion in 2016, compared with 2015, primarily due to depreciation expense on the leased assets acquired from GE Capital. Operating lease expense was up $58 million in 2015, compared with 2014, due to higher depreciation expense driven by rail car fleet growth.
• Outside data processing expense was down 10% in 2016, compared with 2015, due to lower card-related processing expense and the deconsolidation of our merchant services joint venture in fourth quarter 2015, partially offset by increased data processing expense related to the GE Capital business acquisitions. Outside data processing expense was down 5% in 2015, compared with 2014, due to lower processing fees and association dues, as well as the deconsolidation of our merchant services joint venture in fourth quarter 2015.
• Travel and entertainment expense remained relatively stable in 2016, compared with 2015, and was down 23% in 2015, compared with 2014, driven by travel expense reduction initiatives.
• Postage, stationery and supplies expense was down 11% in 2016, compared with 2015, driven by lower postage and mail services expense. Postage, stationery and supplies expense was down 4% in 2015, compared with 2014, driven by lower stationery and supplies expense.
• Telecommunications expense was down 13% in 2016, compared with 2015, and down 3% in 2015, compared with 2014, in each case driven by lower telephone and data rates.
• Foreclosed assets expense was down 47% in 2016, compared with 2015, driven by lower operating expense and write-downs, partially offset by lower gains on sales of foreclosed properties. Foreclosed assets expense was down 35% in 2015, compared with 2014, driven by higher gains on sales of foreclosed properties, lower write-downs and lower operating expense.
• Insurance expense was down 60% in 2016, compared with 2015, due to the sale of our crop insurance business in first quarter 2016 and the sale of our Warranty Solutions business in third quarter 2015.
• All other noninterest expense was up 9% in 2016, compared with 2015, driven by higher insurance premium payments. All other noninterest expense in 2016 included a $107 million contribution to the Wells Fargo Foundation, compared with a $126 million contribution in 2015.
• Our full year 2016 efficiency ratio was 59.3%, compared with 58.1% in both 2015 and 2014. The Company expects the efficiency ratio to remain at an elevated level.

SAFE?

Durability

• Geoff Gannon e-mail: S. banks are very durable businesses with high customer retention allowing them to retain most of their key deposit accounts from year-to-year.  If you keep your money in high interest paying accounts then you are bad for the banking industry, but in the U.S., Americans keep almost all their savings in: 1) Equity in their home, 2) Mutual funds, and 3) Promises from the government (social security, etc). So, Americans don’t really put money in the bank to save for retirement. They use their bank account for transactions. Businesses use them the same way.  Hence, U.S. households and businesses are generally indifferent to interest payments on the money they use month-to-month. In other countries, interest payments on savings accounts may be important, but in the U.S., this is rarely the case.
• Geoff Gannon e-mail: Its possible banks could change for the worse, but banks changing for the better is much more likely. Traffic to branches has been declining by huge numbers from year-to-year. If banks can just have the number of customer visits to a given branch drop by 4% a year while deposits at that branch rise by 4% a year, after not that many years, banks will be able to greatly reduce salary and rent relative to deposits. Salary and rent at branches is a big part of a bank’s expense line per dollar of deposits.  Hence, technology could really save banks a ton of money if it allows them to cut the number of branches. Mobile banking should be great for the giant, nationwide banks and even good for regional banks. The economies of scale of running one website are a lot better than the economies of running hundreds of branches.

Moat

• Competitive advantage is built on a huge base of low cost deposits ($1.2T or 10.8% of all U.S. bank deposits), cross-selling of products, conservative lending practices, customer switching costs, and economies of scale.
• ​A key part of its strategy and moat is to cross-sell products to current customers in order to increase fee income (avg 6.25 products per customer).
• Business has an exceptionally strong branch network (vast and dense) allowing it to maintain the top share in one-third of its markets and an oligopolistic position as second- or third-largest player in another third.
• Wells Fargo has been considered the strongest among the big banks in the United States due to:
  • Its ability to recover from the financial crisis (2008 ROA / ROE = 0.44% / 0.97%; 2009 ROA / ROE 0.97% / 9.9%).
  • Its low-risk business model:
    • Wells Fargo (WFC) is less exposed to the risky investment banking and trading business than its peers JPMorgan Chase (JPM), Citigroup (C), and Bank of America (BAC). While JPMorgan Chase and Citigroup derive 15%–20% of their non-interest income from trading activities, this income constitutes less than 1% of Wells Fargo’s income.
    • On June 29, 2016, the Federal Reserve approved Wells Fargo’s capital plans after it found that Wells Fargo could keep lending in a severe economic downturn. This clears the way for Wells Fargo to rewards its investors through dividends and share repurchases.
  • Its consistent financial performance (positive net income every year since 1980).

Key Risks

Investment banking.

• For virtually all of its existence, Wells Fargo has focused on traditional banking — taking deposits and lending money. This changed during the financial crisis, as a result of its acquisition of Wachovia. The deal not only transformed Wells Fargo from a large regional bank into the nation’s largest retail banking franchise based on branch count, it also gave the company a turnkey investment bank. As CEO Tim Sloan explained:
  • “When we put Wells Fargo and Wachovia together we saw an absolutely terrific opportunity to be able to grow that business primarily, one, because of the quality of the people that we inherited when we put Wells Fargo and Wachovia together so it’s all about the people and the culture from my perspective, and then two, about a strategy which is not dependent upon using your balance sheet to be able to buy business, but it’s dependent upon the broadening of those relationships with your existing customers.”
• One of the problems associated with investment banking, and particularly in today’s heightened regulatory environment, is that certain investment banking activities can weigh heavily on the parent company’s valuation and profitability. High-risk trading operations are the principal culprit. It’s easy to appreciate why this is when you consider that JPMorgan Chase lost more than $6 billion in one fell swoop four years ago after a London-based trader made a wrong-way bet on derivatives tied to the health of the U.S. economy. Fears that this can happen to any bank with large trading operations weigh on a bank’s valuation.  Fortunately, according to Sloan, Wells Fargo isn’t interested in taking its investment banking operations too far in this direction. As he explained in a response to a question about the types of investment banking products that it offers:
  • “It’s kind of the base level of products and services that you’d imagine. It’s bringing folks to market in terms of both investment grade and high yield bonds. It’s equities. It’s [advising on mergers and acquisitions]. It’s just kind of basic and then providing other types of risk management products whether it’s interest rate or derivative-type products to our customer base.”
• Although Wells Fargo got into investment banking by way of an acquisition, it disclaims any interest in purchasing additional companies to grow this corner of its business. It’s focused instead on organic growth. One benefit to growing organically is that it allows Wells Fargo to deepen its relationships with existing clients. Another benefit is that growing organically better enables Wells Fargo to control risk, as history is littered with examples of banks that have unwittingly assumed expensive liabilities by acquiring less conservative competitors — look no further than Bank of America’s 2008 purchase of Countrywide Financial.  Sloan was clear that Wells Fargo is focused on avoiding this:
  • “There’ve been many, many opportunities that we’ve had post-crisis to look at different acquisition opportunities just given some of the carnage that’s gone on in the industry. And that just doesn’t make sense for us. Growing our businesses organically is always the number one strategy, particularly in this business because it gets down to the people and you want to make sure that you have the right people that are not only running the businesses that are out there, working with our clients, and also working very well as a team with our corporate bankers, our real estate bankers, and commercial bankers.”
  • “The likelihood that we would ever make an acquisition in investment banking is very, very remote. We don’t think that we need to do it.”
• In short, Wells Fargo wants to have its cake and eat it too — that is, to offer its clients the benefits of an investment bank while simultaneously controlling the risk associated with introducing investment banking products into its otherwise traditionally focused business model. According to Jon Weiss, the head of the investment banking Wells Fargo Securities arm, “”We are not talking about a massive investment in a new business,” he said. “To the extent that we are growing, we are going to do it the Wells Fargo way – with discipline.”
• Wells Fargo Securities accounts for roughly 6% of overall revenue and bank reps said it would likely stay in that range. The group has about 4,500 industry and product investment bankers, sales and trading professionals research and analysts and support staff.  More than 90% of its revenue comes from the United States, and 95% of its team members are based in the US.  The investment bank derives roughly 60% of its revenue from origination and 40% from trading; fixed income represents about 28% of that, compared to 13% from equity trading.  Sales and trading is focused on distributing and making markets in securities issued by clients, rather than trading for the sake of trading, Jon Weiss (the head of the investment banking Wells Fargo Securities arm) said.  In origination, real estate is the bank’s largest sector, accounting for 28% of revenue, followed by consumer, healthcare and gaming at 19%.  As it builds into new segments, Weiss said, Wells would focus on hiring people, rather than paying a premium to buy a business.  He said building as it goes gives Wells the freedom to design and scale new businesses based on current client needs, consistent with the new regulatory framework.  That also allows the bank to avoid the legacy issues that plagued JP Morgan and Bank of America, he said.  For his part, CEO Sloan, said the times have simply changed.  “People have realized that you can’t prostitute your balance sheet to get a fee.”

Community Banking Improper Sales Practices

• On September 8, 2016, announced settlements with the Consumer Financial Protection Bureau (CFPB), the Office of the Comptroller of the Currency (OCC) and the Office of the Los Angeles City Attorney regarding allegations that some retail customers received products and services they did not request. Actions taken were as follows:
  • Reached out to 40 million retail and 3 million small business customers through statement messaging, other mailings and online communications, including over 168,000 potentially unauthorized credit card customers called as of December 31, 2016.
  • Established a Sales Practices Consent Order Program Office in October 2016, reporting directly to our Chief Risk Officer, which coordinates actions being taken across the Company to meet the requirements of the consent orders that were issued as part of the settlements in September.
  • Submitted our reimbursement and redress plans in response to the consent orders to the OCC and CFPB in December 2016.
  • Refunded a total of $3.2 million to customers for potentially unauthorized accounts that incurred fees and charges, including the addition of consumer and small business unsecured line of credit accounts, for the period of May 2011 through June 2015.
• The Board also conducted and independent investigation into improper sales practices in the company’s Community Banking division. It issued a report on its findings root causes on April 10, 2017.  The report assessed how issues of corporate structure and culture as well as individual actions contributed to harm to customers and Wells Fargo’s brand and reputation.
• Root Causes / Corresponding Actions:
  • Sales Culture: Community Banking became more and more a sales culture focused on growth in the number of products sold each year.  Focus on growth prompted low quality sales and improper and unethical behavior.  Senior leaders failed to see problems as systemic.
    • Changed Senior Management in Community Banking
    • Eliminated product sales goals & discontinued cross-sell metric
    • Reviewed claims of retaliation to whistleblowers
  • Incentives: Sales model meant management had to exert extreme pressure on employees to meet its targets.  Team members who reached targets were praised & rewarded (compensation schemes) while those who failed were in many cases fired.
    • Introduced new compensation and performance management programs
    • Established stronger controls to monitor for unintended behavior
  • Senior Management Oversight: Senior management championed the decentralized business model, cross-selling, and the sales culture.  It either ignored the problems or was too slow to react.
    • Former CEO was removed.
  • Decentralized Organization Structure: Decentralization led to duplication of risk management and human resources functions in the organization and issues staying within the business units.
    • Changed reporting lines for control function groups, including human resources (includes compensation and employee relations) to report into their central control groups rather than the lines of business they support
    • Changed reporting lines for risk team members to report into central Corporate Risk group
    • Created a new Office of Ethics, Oversight, and Integrity
  • Control Function Oversight: Even when senior executives came to recognize that sales practice issues within the Community Bank were a serious problem or were not being addressed timely and sufficiently, control functions relied on [Community Bank senior leaders] to carry out corrective actions.
    • Improvements to enterprise risk management practices and controls including: automated e-mails to customers when new accounts have been opened, improved multi-factor authentication to protect customer info, reviewing complaints to identify ways to improve sales practices, added risk professionals as second line of defense.
  • Management Reporting to the Board: Sales practice problems were not being reported to the Board in a timely fashion.  When reports were made, they contained inadequate and inaccurate information.  They did not learn until 2016, the number of employees terminated for sales practice violations (~5,300).
    • The Board is requiring increased and more focused management reporting relating to conduct risk management.
  • Board Oversight and Performance: The Board should have moved toward the centralization of the risk function sooner.  The Board should have insisted on better reports.  The Board should have pushed harder for change in management of Community Banking.
    • Board separated the roles of Chairman and CEO, elected an independent Chairman and Vice Chair.
    • Board amended its By-Laws to require the Chairman and Vice Chair roles to be held by independent directors.
    • Board changed compensation plan to hold executives accountable for sales culture, management oversight, and control function oversight.

Potential changes in the mortgage market.

• Wells Fargo notes its mortgage business is a key part of its overall success, and to a large extent, it relies on government-sponsored enterprises Fannie Mae and Freddie Mac to repurchase most of the loans it extends to customers. As the largest mortgage originator and servicer in the U.S., Wells Fargo is particularly sensitive to changes in the mortgage market, and government efforts to wind down Fannie Mae and Freddie Mac could potentially transform the industry in a way that would require a swift and strong response from the bank.
• Wells Fargo could have to repurchase bad mortgage loans from the various entities to which it sells those mortgages. Moreover, Wells Fargo notes the risk of losing servicing revenue, which becomes increasingly important as more borrowers hold onto their mortgages for a longer period of time rather than quickly refinancing them. Wells Fargo hopes the multibillion-dollar settlements that the industry has reached to settle allegations of improper mortgage practices will prove to be the end of a difficult time for the industry, but it doesn’t guarantee further problems won’t turn up.

Regulatory uncertainty.

• Huge changes in the regulatory framework have forced Wells Fargo to adapt, as its status among the largest bank holding companies have put it in the crosshairs of regulators looking to impose tougher standards on the banking industry. Wells Fargo identifies several regulatory efforts as potentially problematic, including the ongoing implementation of Dodd-Frank Act reforms, Basel capital and liquidity standards, and Federal Reserve supplemental capital rules and guidelines.
• In particular, a proposal to boost supplementary leverage ratio requirements to 5% to 6% by 2018 is projected to force the eight banks it would affect, including Wells Fargo, to hold an extra $68 billion in capital. Those provisions aren’t guaranteed to become final rules, but the regulatory environment nevertheless points to greater scrutiny in the future for Wells Fargo and its peers.
  • Equity/Assets = 10.5% (vs 8.5% pre-crisis).
  • Tier 1 Capital ratio = 12.6%.

Changing economic conditions.

• If the U.S. economy weakens in key areas like employment and housing, it would potentially hurt key banking businesses. Loan losses are at historically low levels with rising home prices and stronger employment conditions having helped Wells Fargo reduce its allowances for credit losses, and generally improved the quality of its loan portfolio. If home prices start to fall, or unemployment bounces back, then Wells Fargo could have to add to loss provisions, cutting earnings.
• At the same time, though, economic strength has its own dangers. As the economy accelerates, the Federal Reserve is more likely to increase interest rates, and the resulting flattening of the yield curve would hurt Wells Fargo’s net interest margins and therefore pressure the profits of its core banking business (over the short-term). Rising rates in response to economic strength would also continue to hurt refinancing volume, which relies on falling rates to entice borrowers into giving up their old mortgages. The current pace of growth has given Wells Fargo almost a Goldilocks scenario, but a move in either direction could upset that delicate balance.

GOOD?

Profitability

• Profitability is well above industry averages (10Y avg ROA is 1.28% vs industry avg of 0.89%).
• 20Y median ROA = 1.5%, currently 1.2%.  Should be able to get back to 1.5% level in the future.
  • BAC 20Y median ROA = 1.0%.
  • C 20Y median ROA = 1.1%.
• 20Y median ROE = 14.3%, currently 10.4%.  Going forward might expect to see ROE range of 13-15% if leverage restrictions are reduced.
• 20Y cumulative loan losses / cumulative earning assets = 0.70%.
  • BAC 0.73%.
  • C 0.91%.

Growth

• Wells’ deposit base has grown at 7.6% per annum over the last 5 years vs. 5.9% for all U.S. banks.  Future growth should slow, but the business should continue to outperform.
• Book value per share is up >8x in the last 20 years.
  • USB’s Book Value per Share is up ~6x in the last 20 years.
  • PNC’s Book Value per Share is up ~5x in the last 20 years.
  • JPM’s Book Value per Share is up ~4x in the last 20 years.
  • BAC’s Book Value per Share is up ~2x in the last 20 years.
  • Citigroup’s Book Value per Share is down ~15% in the last 20 years.

Management

• ​Despite recent aggressive sales practices, management is well above average.  Conservative underwriting is engrained in the corporate culture and past capital allocation has been very good (consistent dividends, timely buybacks, fantastic acquisition of Wachovia resulting in >50% of net earnings returned to shareholders).
  • The company’s current dividend yield is >2.8% and should continue to rise in coming years.
  • The company has bought back an average of $7B worth of stock in each of the last 3 years.
  • In the last 20 years, share count is up 3.4x vs Total Equity up 32.9x.
• Tim Sloan became CEO and a member of the Board of Directors in October 2016, when he succeeded John Stumpf (who retired in the wake of the scandal in which bank employees opened credit cards and deposit accounts without customers’ permission). Stephen Sanger, a board member, will now serve as chairman, dividing up the two roles that had been held by Stumpf.
  • Sloan had previously been chief operating officer (COO) and president. In that role, he was responsible for the operations of the company’s four main business groups:  Community Banking, Consumer Lending, Wealth and Investment Management, and Wholesale Banking.
  • He led the company’s Wholesale Banking business beginning in 2014 — overseeing approximately 50 different businesses, including Capital Markets, Commercial (middle market) Banking, Commercial Real Estate, Asset Backed Finance, Equipment Finance, Corporate Banking, Insurance, International, Investment Banking, and Treasury Management.
  • Prior to leading Wholesale Banking, he served as Wells Fargo’s chief financial officer, responsible for financial management functions including controllers, financial reporting, asset liability management, treasury, investor relations, and investment portfolios.
  • From September 2010 to February 2011, Tim served as chief administrative officer and managed Corporate Communications, Corporate Social Responsibility, Enterprise Marketing, Government Relations, and Corporate Human Resources.
  • From 1991 to 2010, Tim held various leadership roles in Wholesale Banking, including head of Commercial Banking, Real Estate, and Specialized Financial Services. Prior to joining Wells Fargo in the Loan Adjustment Group in 1987, he worked for Continental Illinois Bank in Chicago.
  • Tim earned his B.A. in economics and history and his M.B.A. in finance and accounting, both from the University of Michigan–Ann Arbor.
  • Sloan purchased $2.0MM of stock on the open market on 17-APR-2017. In total, Sloan owns ~700k shares worth ~$38MM.

Predictability

• Despite the financial crisis, the business has been highly predictable (revenue is R2 is 4th decile and earnings 2nd or 3rd decile relative to the market).

Stock Performance

• In the last 20 years, average stock price is up 3.6x (6.6% per annum).
  • USB is up 3.3x (+6.1% per annum).
  • PNC is up 2.2x (+4.0% per annum).
  • JPM is up 2.1x (+3.9% per annum).
  • BAC is up 0.0x (0% per annum).
  • C is down to 0.64x (-2% per annum).

Other

• Berkshire Hathaway is Wells Fargo’s largest shareholder.
  • As of 31-MAR-2017, Well’s had an estimated 4,996.73 MM shares outstanding.
  • Berkshire held 497,165,023 shares (9.95% of shares outstanding) as of 12-APR-2017 following the sale of a total of 7,134,447 shares over the period of 10-APR-2017 to 12-APR-2017.
  • My guess is that the sale by Berkshire reflects the company’s need to stay below the Wells Fargo’s 10% ownership threshold.
  • The following from the 2016 10-K may also be relevant: “We also entered into a $750 million forward purchase contract with an unrelated third party in fourth quarter 2016 that settled in first quarter 2017 for 14.7 million shares. In addition, we entered into a $750 million forward repurchase contract with an unrelated third party in January 2017 that is expected to settle in second quarter 2017 for approximately 14 million shares.”

CHEAP?

Valuation Keys / Assumptions

• Interest rates.
  • The median interest rate cycle time (trough to peak) over the last 5 cycles has been 33 years. The average interest rate cycle time over the last 5 cycles has been 31 years.  ASSUME a full cycle will take 32 years and it will take 16 years from the trough of the cycle to meet the average interest rate for that cycle.
    • In 2014, the FFR reached 0.09%, which I assume is the bottom of the cycle and suggests, we are 2 years into an interest rate recovery upwards (ie. Reach mid-point in 14 years / 2030).

Period	Up or Down		Length
1798 to 1825	DOWN	for	27	years
1825 to 1861	UP	for	36	years
1861 to 1898	DOWN	for	37	years
1898 to 1920	UP	for	22	years
1920 to 1946	DOWN	for	26	years
1946 to 1981	UP	for	35	years
1981 to 2014	DOWN	for	33	years
2014 to…	UP	for	32	years
NOTE: Average cycle is 31 years; median cycle is 33 years.

• Since 1900, yields have ranged from <2% to >15%, with an average of 4.9%. In the last 38 years, the median Fed Fund Rate (FFR) was 5.1% with the high reaching 16.39% in 1981.  ASSUME that at the mid-point of the interest rate cycle, rates will reach 4.9%.
  • For 2016, the average FFR was 0.39%, so for a medium case valuation, the FFR would move up ~4.5% before reaching its mid-point value.
  • For the low case, assume the FFR will not move up at all (ie. Rate will stay at 0.39% for the foreseeable future).
  • For the high case, assume the FFR will again reach it’s 1981 high of ~16% (ie. Rate will climb 7.6% from 0.39% to reach mid-point of ~8%).
• Interest-earning assets:
  • From 1979 to 2016, the median ratio of Average Loans to Average Deposits for WFC was 95%.
  • CAGR’s in U.S. Deposits (40Y/30Y/20Y/10Y/5Y) = 6.9%/5.8%/6.8%/6.4%/5.9%.
  • CAGR’s in WFC Deposits (40Y/30Y/20Y/10Y/5Y) = 13.1%/14.7%/18.7%/15.5%/7.9%.
  • So, Wells Fargo’s historical deposit growth rate has always exceeded the rate of U.S. Deposits; this is due in part to a number of acquisitions over the years including First Interstate Bancorp in the early 90’s, Norwest in the mid 90’s, and Wachovia during the Financial Crisis of 2008. However, even outside of the M&A activity, Wells Fargo’s deposit growth rate has exceeded that of U.S. Deposits (including the last 5 years).
  • ASSUME that over the long-term, deposit growth should mimic nominal GDP growth rate. So, U.S. deposit growth of 4-5% per annum seems reasonable (call it 4.5%) is achievable and that Wells Fargo’s growth rate will at least match that rate.  Hence, loan growth rates will match deposit growth rates at 4.5% per annum.
  • ASSUME current interest-earning asset mix will remain the same moving forward (ie. commercial loans at 29% of total, consumer loans at 27%, investment securities at 21%, short-term investments at 17%, trading assets at 5%, and other assets at 2%).
  • ASSUME the yield on interest-earning assets will match their historical values relative to the FFR.
    • Commercial loan yields at 3.0% to 4.0% > FFR.
    • Consumer loan yields at 4.5% to 5.5% > FFR.
    • Investment Security yields at 2.5% to 4.5% > FFR.
    • Short-Term Investment yields at 0% > FFR.
    • Trading Asset yields at 1.0% to 2.0% > FFR.
    • Other yields at 2.0% to 3.0% > FFR.
    • Weighted Average Yield of Interest-Earning Assets at 2.8% to 3.8%.
  • Net loan charge-offs:
    • ASSUME net loan charge-offs will match their historical levels (38 year P25/P50/P75 net charge-offs / average loans = 0.56%/0.81%/1.11%).
    • For the low case, net loan charge-offs assumed to be at their historically high levels. For medium case, they are at their historical P50, and for the high case, they are maintained at the P25 level.
  • Non-Interest Income:
    • Assume Non-Interest Income grows at 2.0% per annum from its current level.
  • Non-Interest Expense:
    • Assume Non-Interest Expense grows at 1.0% per annum from its current level as net branch closures (reduction in employees, leases) partially offset increasing salaries and IT expenditures.
    • Tax Rate:
      • Assume tax rate at historical median level of 33%.
    • P/E Ratio:
      • Use historical median P/E ratio (14.5) as a guideline. Assume P/E ratio of 13 for the low case, 14 for the medium case, and 15 for the high case.
    • Shares Outstanding:
      • Assume net buybacks will continue, reducing share count on average by 2.6% per annum.

Valuation Calculation

• LOW & MEDIUM CASE – Normalized Spread on Forward Interest-Earning Assets:
  • 2030 Interest-Earning Assets / Total Funding Sources ~$3.168T.
  • 2030 Total Interest Income ~$84B for low case; ~$245B for medium case.
  • 2030 Total Interest Expense ~$5B for low case; ~$137B for medium case.
  • 2030 Net Interest Income ~$79B for low case; ~$107B for medium case.
  • 2030 Normalized Loan Net Charge-Offs ~$19.5B for low case; ~$14B for medium case.
  • 2030 Non-Interest Income for low & medium cases ~$53B.
  • 2030 Non-Interest Expense for low & medium cases ~$60B.
  • 2030 Pre-Tax Earnings ~$53B for low case; ~$86B for medium case.
  • 2030 Net Income ~$35B for low case; ~$58B for medium case.
  • 2030 Share Count for low & medium cases ~3,456MM.
  • 2030 Per Share Price ~$133 for low case; ~$234 for medium case.
  • 2030 Pre-Dividend Return ~6.7% for low case; ~11.1% for medium case.
  • 2030 Total Annualized Return; ~9.5% for low case; ~13.9% for medium case.
• MEDIUM CASE – Quick & Dirty Estimate:
  • 8% forward dividend yield + 2.6% net buybacks + 4.5% deposit / loan growth rate + 2% reduction in branch count per year = 11.9% per annum
  • Downfalls of this method: It oversimplifies the effect of the branch count reductions and neglects changes to interest rates.
• MEDIUM CASE – Normalized ROA:
  • Normalized ROA is 1.5%.  Total Assets $1.930T.  Normalized earnings = ~$29B.  
  • Estimated fair market cap (at 14x) = $405.3B.  
  • Share count as of 1Q2017 was 4,996.73 MM.  Estimated fair price of $81/share (33% discount).
  • Downfalls of this method: Oversimplifies changes to interest rates & asset mix, neglects branch count reductions and deposit growth, and doesn’t estimate an annualized return.
• MEDIUM CASE – Normalized Yield on Average Earning Assets:
  • 20Y normalized spread on Net Interest Income / Earning Assets – Interest Expense / Earning Assets is 3.06%.  
  • Total earning assets are $1.711T.  Thus, normalized earnings = 1.711T*.0306*(1-Tax rate of 33%) = $35B.  
  • Share count as of 1Q2017 was 4,996.73 MM.  Estimated fair price of $101/share (46% discount).
  • Downfalls of this method: Oversimplifies changes to interest rates & asset mix, neglects branch count reductions and deposit growth, and doesn’t estimate an annualized return.

Mis-Pricing

• Interest rates almost have to rise in the next few years because we are at historically low levels.  Net interest margins (NIM) of major banks (measured as the spread between the interest income received by banks and the interest paid out to customers on deposits as a percentage of their interest-earning assets) have been at historical lows as the Federal Reserve has maintained near-zero policy rates (since the financial crisis of 2008 hit).
  • Low interest rates lead to lower net interest income for banks because banks typically lend long and borrow short; ie. The maturity of a bank’s loan portfolio typically exceeds the average maturity of its deposits. So, when interest rates begin to decline, funding costs fall faster than net interest income, leading to higher margins.
  • Net interest margins fall when interest rates remain lower for a longer time and loans are repaid or renewed. As the yield curve steepens, these margins grow, thereby improving profitability for banks.
  • Banks with more commercial loans, which often have floating rates that rise with the Federal Reserve’s rate, will profit most from higher interest rates. Rates on mortgages, however, are often fixed for many years.
  • Major banks with high interest-related income—such as Wells Fargo (WFC), Bank of America (BAC), JPMorgan Chase (JPM), and Citigroup (C)—have been struggling with compressed margins.
  • Banks with large bases of non-interest bearing deposits, earn a larger spread on the loans linked to those deposits.
• Branch closings.
  • Traffic to branches is declining. Wells Fargo should be able to greatly reduce branch costs per dollar of deposits.
• Reputational Harm.
  • Investors may be over-estimating the impact (loss of depositors) as a result of the aggressive sales practices.

PORTFOLIO MANAGEMENT

• I currently own shares in WFC.
• The investment is a hedge against most other investment types that suffer when interest rates rise.
• I would consider selling the position if: 1) I discovered a flaw in my thesis that led me to no longer be comfortable with the risks associated with the investment (eg. Expanding rapidly into investment banking or a decline in the conservatism of underwriting), 2) My estimate of the forward return dropping below 6% per annum, or 3) Finding a much more attractive investment that I wanted to switch the position for.