Wells Fargo Exposing Itself To Potential Losses For Near-Term Gains By Expanding Auto Business
Wells Fargo (NYSE:WFC) is looking to grow its auto lending business again, after spending the last two years shrinking the unit. Wells Fargo slashed its auto loan portfolio over 2016-2017 primarily due to a sharp increase in charge-off rates from an increase in sub-prime auto lending. The U.S. banking giant continued to divest its auto loans early this year with the sale of its auto finance business in Puerto Rico (Reliable Financial Services) to Banco Popular de Puerto Rico.
However, the bank is now reversing this position, and will look to hand out more auto loans over coming months. As we detail in our interactive model for Wells Fargo, this is a risky move for the bank. Although faster growth in auto loans will help the bank report higher revenues over subsequent quarters, these gains will largely be offset by higher charge-off rates associated with these loans. More importantly, a larger auto loan portfolio could leave the bank vulnerable to millions of dollars in additional loan losses if economic conditions in the U.S. soften. This presents a sizable downside to our $65 price estimate for Wells Fargo’s shares, which is about 15% ahead of the current market price.
Wells Fargo Is Under A Lot Of Pressure From Investors And Regulators
Wells Fargo has been under significant scrutiny since late 2016, when its account opening scandal came to light – followed by a series of similar scandals.With the bank not demonstrating sufficient progress in fixing internal governance issues over 2017, the Federal Reserve passed an enforcement order against Wells Fargo this February prohibiting it from growing any further until it cleans up these issues – a move that will cap its total asset base at $1.95 billion, and weigh on total loan growth.
At the same time, investors have expressed dissatisfaction at Wells Fargo’s sub-par operating performance over recent quarters. Under these circumstances, the bank’s decision to look for growth in the auto lending business looks like a short-term way to boost revenues.
Boosting Auto Lending Looks Like A Quick-Fix Solution
The net interest yield on Wells Fargo’s auto loan portfolio was 100-150 basis points (1%-1.5%) higher than that for its total loan portfolio over 2015-2017. In other words, Wells Fargo earned an additional $1.00 – $1.50 for every $100 it loaned to customers for financing their auto purchases compared to other loan types. In view of the improving interest rate environment, this makes auto lending a good way for Wells Fargo to boost its revenues.
But auto loans come with higher charge-off rates than nearly all other loan categories (except card loans). And auto loan charge-off rates have risen steadily over recent years. 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. We define the effective yield of a loan category as the net interest yield less the net charge-off loan for that loan category.
This is in sharp contrast to the slight improvement in effective yield for Wells Fargo’s total loan portfolio over 2017 – a trend we believe will continue in 2018 due to higher interest rates as well as lower overall loan charge-off rates.
Taking all this into account, and keeping in mind the fact that Wells Fargo’s balance sheet restriction will mean growth in auto loans at the expense of growth in other lending categories, we estimate a marginal reduction in Wells Fargo’s EPS figure for the year from our original estimate of $4.64 to $4.61, as detailed below.
This small decrease in EPS works out to a decline in our price estimate for Wells Fargo by ~50 cents (using a P/E ratio of 14). While Wells Fargo is expected to tighten lending standards as it looks to grow auto lending, high charge-off rates will continue to weigh on revenue gains going forward. More importantly, an increase in the proportion of auto loans in the bank’s total loan portfolio could potentially lead to higher loan charge-offs over coming years if the ongoing trend of swelling auto loan charge-offs continues. This can meaningfully erode Wells Fargo’s profits – and presents a sizable downside to the bank’s share price estimate.
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