Wells Fargo’s Decision to Sell Its Auto Finance Unit In Puerto Rico Is A Step In The Right Direction
Wells Fargo (NYSE:WFC) is reportedly selling its auto finance business in Puerto Rico, Reliable Financial Services, to Banco Popular de Puerto Rico. The deal will result in $1.5 billion in auto loans and $340 million in commercial loans changing hands from Wells Fargo’s subsidiary to the Puerto Rican banking subsidiary of Popular, Inc. by the end of Q2 2018. Notably, the U.S. banking giant will book a loss, as the all-cash deal values the business at $1.7 billion – a discount of 4.5% to its current book value.
Despite this loss, we believe that Wells Fargo’s decision to sell Reliable is a good one, as the bank’s primary goal over the next several months is to ensure that it grows its core lending business without letting its balance sheet assets cross the $1.95 trillion mark. Reliable’s sale is the first of many similar disposals we expect Wells Fargo to undertake over coming months to reduce its portfolio of non-core lending units. Below, we explain why getting rid of the unit was an easy decision for Wells Fargo. You can also understand the impact of changes in auto lending metrics on Wells Fargo’s share price using our interactive model for the company.
We maintain a $65 price estimate for Wells Fargo’s shares, which is about 10% ahead of the current market price.
Balance Sheet Restrictions Due To Fed’s Enforcement Order
Earlier this month, the Federal Reserve passed an enforcement order against Wells Fargo prohibiting the banking giant from growing any further until it resolves all its internal governance issues. With the order capping the bank’s total balance sheet size at $1.95 trillion, the bank will have to strategically sell off some assets to accommodate growth in core loans and deposits in the near future.
Wells Fargo intends to make room for organic loan growth primarily by reducing its portfolio of trading assets and short-term investment securities. Additionally, it makes sense for the bank to focus its lending efforts on core retail and commercial lending operations, which will drive profits in the long run, while shrinking non-core lending units. We believe that Wells Fargo’s junior lien mortgage lending and auto lending units offer easy opportunities for the bank to clean up its balance sheet.
Why Auto Lending Isn’t A Great Growth Avenue For Wells Fargo
The spurt in sub-prime auto loans over 2014-15 has increased the overall risk associated with auto lending. This trend is evident from the fact that Wells Fargo’s auto loan charge-offs for 2017 represented more than 23% of the bank’s total charge-offs, although auto loans formed less than 6% of total loans
The higher risk level has, in turn, drastically reduced the effective yield for auto loans – in sharp contrast to the slight improvement in effective yield for Wells Fargo’s total loan portfolio. We define the effective yield of a loan category as the net interest yield less the net charge-off loan for that loan category. As effective interest income from auto loans is expected to decline even as total interest income improves sharply, we estimate the effective share of auto loans of the total adjusted interest income to fall to below 4% in 2018.
Finally, the Puerto Rican auto unit would have likely been hurt in particular by poor economic conditions in the U.S. territory. And the situation is only expected to get worse in the near future as the region reels under the devastation caused by Hurricane Maria. This could also explain why Wells Fargo agreed to a deal at a discount to book value.