Riding high The big winner from the financial crisis

Wells Fargo

Riding high      The big winner from the financial crisis

Sep 14th 2013  | SAN FRANCISCO |From the print edition

AS THE dust settles on an extraordinary period of financial tumult, which reached its zenith five years ago this week with the bankruptcy of Lehman Brothers, two banks vie for the title of the world’s biggest by market capitalisation. One is Wells Fargo, a San Francisco-based institution; the other is China’s state-owned ICBC. It says something about the state of global finance that both are largely domestic, conventional lenders, and that both are buoyed and buffeted by the policies of their respective governments.

Some of Wells’s success is serendipitous. The business model that it has refined since its merger with, and managerial takeover by, Minnesota-based Norwest in 1998 left it perfectly placed to benefit from the crisis and its aftermath. Wells went into the bust with a strong but limited franchise encompassing the western half of America and focused on the prosaic business of cross-selling multiple products from a “store” (Wells-speak for a branch). It did not have a big capital-markets business to blow it up. Simply by remaining solvent, a tribute to years of careful management, it was in a position to emerge from the turmoil with a business covering the other half of the country, too.

But Wells has also made plenty of savvy decisions. In August 2008 it decided not to buy Countrywide, which had been the country’s largest mortgage underwriter and, as Bank of America would discover, a sinkhole for bad loans and litigation. Two months later, as panic consumed the markets, it gazumped Citigroup to acquire Wachovia, which had been assembled over decades of costly and disruptive mergers. It may have been the best bank acquisition ever. In a single move, Wells doubled its branch count and added the eastern half of the country. As John Stumpf, the chief executive, likes to point out, a Wells branch or ATM is now within two miles of half of America’s homes and half of its firms.

Wells boasts a leading position in lending for small businesses, cars, energy and agriculture. It has a significant insurance operation and the third-largest network of stockbrokers in America, trailing only Merrill Lynch (Bank of America) and Morgan Stanley. To increase the success of its desultory credit-card operations, it need only entice more customers already using its multiple other services.

But the really big earner is mortgages. The bank has gathered a quarter of the American mortgage market. Last year it was responsible for originating close to a third of the country’s home loans. No lender has benefited more from the Federal Reserve’s ultra-low interest rates, which encouraged American homeowners to refinance in droves. Those policies have helped Wells to record 14 successive quarters of profit growth (see chart).

The refinancing wave helped in another way, too. Wachovia came with a nasty portfolio of mortgages that allowed clients to pick payments and interest rates in exchange for going ever more in debt. Wells was adroit at using the plunge in interest rates to curtail losses by putting homeowners onto new, cheaper loans.

As well as showing dexterity during the crisis, Wells also seems to be better at the nuts and bolts of banking. It does a good job of performing basic functions: opening an account can be an ordeal elsewhere but requires barely a pause at Wells. But why its customers are willing to provide it with vast amounts of deposits at almost no cost when better terms are available elsewhere is a bit of a mystery.

Dick Bove, an analyst at Rafferty Capital, says he initially accepted Wells’s explanation of its success as stemming from better treatment of customers—doughnuts for some, additional seating for others. His view changed when Wells took over his own Wachovia branch. Out went much of the service, including a branch manager at the front door who could resolve problems. In came desks filled with people selling products.

What Wells really excels at, Mr Bove concluded, is managing its employees well, providing the right incentives to enthuse them about pushing what the bank has to offer, particularly the mortgage and payroll-processing products that often lead individuals and businesses respectively to consolidate their banking activities.

Wells’s triumph is not an unequivocal one, however. Its run of profits growth is likely soon to end. The challenge for American banks at the moment is not the familiar threat of credit risk but the prospect of an end to ultra-loose monetary policy. The Fed is gearing up for a decision later this month on whether to slow the pace of its asset purchases; mortgage rates have already risen sharply in anticipation. That has all but ended the refinancing business. A reversal is unlikely unless the economy weakens, which would be positive for no person and no bank.

In response Wells has recently announced a series of redundancies, cutting at least 20% of the back-office staff who process mortgage applications. Further cuts would not be a surprise. This will mitigate the pain but not replace revenues. In its defence Wells notes it has 89 other businesses (which is true), and all have growth prospects (which may be true). But nothing comes close to mortgages.

Wells on notice

The firm faces other limitations, too. The Wachovia deal put it over America’s deposit cap, which (simplifying a little) limits banks to 10% of national deposits. That means a long history of acquisitions—numbering in excess of 12,000 entities, according to the bank’s archivist—is at an end. There are still large gaps Wells would like to fill in New England and around major cities, notably Chicago and Seattle. Recently, it has had to content itself with purchasing small loan portfolios from troubled European banks, an opportunistic but hardly sustainable approach.

A capricious regulatory environment is another source of vulnerability. A string of fines related to the mortgage crisis included a $175m settlement in July 2012 with the Department of Justice for charging higher interest rates to black and Hispanic customers. The case was tied to a statistical analysis of loan recipients, not the credit standards used by Wells. It loudly proclaimed its innocence but still paid up.

Its international presence is slim but a legacy franchise (from Wachovia) of correspondent banking is also vulnerable to murky regulations. Recent money-laundering prosecutions suggest American banks may be responsible not only for their customers but their customers’ customers as well. It is a stretch to believe that Wells can be effective at monitoring foreign institutions.

For all these concerns, Wells’s shares are down only a bit from their peak. Whatever the downside of being America’s leading franchise in a heavily regulated industry, the benefits are great, too.

Buttonwood

Squaring the circle    Financial markets are sending incoherent messages

Sep 7th 2013  |From the print edition

THE world’s financial markets have been marked by contradictions throughout 2013. Inflation has dropped but government bonds have suffered. Risk appetites have revived but emerging markets have underperformed.

Perhaps such anomalies are inevitable given the influence of central banks on market sentiment. Offered a choice of knowing in advance the growth and inflation numbers for 2014, or the precise details of Federal Reserve asset purchases next year, investors would probably opt for the latter. If fundamentals are not driving the markets, then fitting price movements into a coherent economic framework is inevitably harder.

More recent developments have at least had a familiar ring, as markets were once again affected by the curse of August. In the first half of last month, bonds suffered as yields rose sharply. In the second half, equities were hit by the prospect of Western military intervention in Syria. Fear of conflict in the Middle East has been a regular source of market worry over the past ten years, although the worst nightmare—a great disruption of oil supplies—has yet to be realised.

It is possible to explain some of the markets’ oddities. The divergence between the performance of developed and emerging markets has reflected trends in economic data. America’s economy seems to be strengthening and Europe is edging out of recession even as the numbers from the BRIC countries (Brazil, Russia, India and China) disappoint.

In 2008 and 2009 the question was whether emerging markets could decouple from the crisis in the developed world. Now the problem has reversed itself. The developing world has a much bigger impact on the global economy than it did during the storms of the late 1990s. Although it is optimistic about America, Morgan Stanley has revised down its forecasts for global growth this year from 3.1% to 2.9%, and from 3.9% to 3.5% in 2014.

Albert Edwards, a permanently bearish strategist at Société Générale, sees the recent turbulence in emerging markets as “leading to a renewed global recession, with waves of deflation flowing to the West from Asia as China is ultimately forced to devalue in the face of an unrelenting loss of competitiveness, most especially against its emerging-market rivals.”

But an emerging-market slowdown is not all bad news. The Economist’s all-items commodities index is 14.5% lower over the past 12 months, a development that is broadly positive for consumers in rich countries. The oil price is admittedly still well over $100 a barrel, in part because of Middle East tensions. But weak commodity prices are leading to lower headline inflation rates, giving central banks in the rich world plenty of scope to continue with their supportive monetary policies.

Normally, lower inflation is good news for government bonds. But Treasury bonds have had a bad run, with ten-year yields more than a percentage point above their levels at the start of 2013. Does the rise in yields stem from expectations of reduced asset purchases by the Fed, the process known as “tapering”? Perhaps, although analysis by Dhaval Joshi of BCA Research shows that bond yields have fallen fastest in recent years when the Fed has halted quantitative easing, not when it has been most active in buying.

Another possibility is that investors have become more optimistic about the global economy and have been switching from bonds into equities. But as has already been pointed out, global-growth forecasts are being lowered, not raised; and the copper price, seen as a barometer for the global economy, has been weak.

Price movements may have been driven by the desperation of investors as they shed losing positions. That was clearly the case with gold earlier this year; after a decade of steadily rising prices, there were a lot of stale positions to unwind. Similarly, the debt crisis forced many investors to seek the safety of government bonds and pin their hopes for excess returns on the emerging markets. The sell-off in both asset classes is probably the result of a radical rethink.

A bullish position in developed-market equities, particularly in America, now looks like the consensus bet. But that depends on the story of a rebounding economy holding up, along with corporate profits. Annual earnings-per-share growth at firms in the S&P 500 was just 3.9% in the second quarter. Yet analysts’ forecasts are for double-digit growth by the middle of next year, at a time when profits are already at a post-war high relative to GDP. Not so much a contradiction, more a case of wishful thinking.(Economist.com/blogs/buttonwood