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Wells Fargo: Fed Overreacts On Dividend Cut – Seeking Alpha

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- Hirdetés -

After the Fed stress test results were released, Wells Fargo (WFC) has fallen close to the pandemic lows due to how the Fed implemented dividend payout restrictions. The stock didn’t fall due to the actual weakness in the business or any dire outcome from the stress test. My investment thesis remains very bullish on the large financial being able to survive the virus crisis and eventually thrive under efficiency plans of the new CEO.

- Hirdetés -

Image Source: Wells Fargo website

Fed Stress Test Results

Every year since the 2008 financial crisis, the large financial institutions such as Wells Fargo have to conduct a stress test per the Dodd-Frank Act. The test is done to determine the resiliency of financial institutions under severely adverse economic scenarios to ensure banks have enough capital to survive the next financial crisis.

Whether good or bad, this stress test was designed prior to the pre-COVID-19 market crash. The Fed outlined these key macroeconomic metrics under the severely adverse scenario:

Source: Wells Fargo 2020 Stress Test Results

Despite the dire economic period faced by the U.S. economy due to COVID-19, the country hasn’t even seen all these dire economic scenarios occur. The unemployment rate surged far above 10%, but the rate is already down to 11%. At the same time, the Dow Jones average is nearly flat for the year, while the scenario predicts a 50% decline. Due to the improving stock markets and economy, home prices appear nowhere near crashing by 28%.

In essence, the Fed outlined an economic scenario the U.S. has already overcome during the COVID-19 shutdown despite a very dire position in mid-April. Yet, the Fed stress results have Wells Fargo generating far better capital ratios than the regulatory minimum requirements.

Source: Wells Fargo 2020 Stress Test Results

Wells Fargo is projected to absorb $49.9 billion in provisions for credit losses. The losses are offset by only $26.9 billion in pre-provision net revenue. Yet, the large financial is projected to end Q1’22 with a CET1 ratio of 9.6%, which is far above the regulatory minimum of 4.5%.

The company hasn’t even implemented plans to improve the banks efficiency ratios to improve profits. According to Bloomberg Law, Wells Fargo still has the same employee levels as 2010, while other large banks have cut large amounts of employees to improve efficiency.

About That Dividend

The most negative part of the Fed stress test results weren’t the actual results, but the move by the Fed to alter the requirements for large financials paying dividends due to a panic by the government organization. Investors shouldn’t value the stock based on short-term dividend payout cuts.

In essence, the Fed was pressured to cut capital returns by the large banks despite the excess capital in the banking system. The banks are now limited on capital returns based on income over the last four quarters as follows:

  • Suspending share buybacks.
  • Capping dividend payments to Q2 levels.
  • Allowing dividends according to formula based on recent income.

Analysts projected that only Wells Fargo and Goldman Sachs (GS) amongst the large financials will have to cut dividends. All of the banks had already eliminated stock buybacks to conserve capital and take advantage of the flexibility of this capital return version.

The disturbing part of the projected dividend cut by Wells Fargo due to weak income over the Q2/Q3 period is that the company was already projected to have substantial capital even while paying the existing dividend. In fact, the only reason the capital ratio declines during the period is the dividend payout.

Source: Wells Fargo 2020 Stress Test Results

The capital actions of 1.9% amount to nearly the same amount as the PPNR. Wells Fargo currently pays a $2.04 annual dividend amounting to an $8 billion annual payout or ~$18 billion over a nine-quarter period under the stress test. In reality, the large bank would only save about half of this dividend payout via the proposed Fed cap.

With the company projected to only earn $1 per share this year and projecting substantial credit provisions in Q2, the earnings estimates could fall further. The company could be forced to cut the dividend by 50% or more due to limited net income during the virus crisis, yet the Common Equity Tier 1 ratio was 8.8% at the low.

Assuming Wells Fargo cuts the dividend by 50%, the capital ratio ends the stress test period above 10.5%. In essence, the large financial has plenty of capital to continue paying the dividend at the current 8% rate.

Takeaway

The key investor takeaway is that Wells Fargo flew past the Fed stress test. Despite the requirement by the Fed to restrict dividend payouts, the large bank is in solid shape. Investors should focus on the future where the new CEO improves the efficiency ratio to industry levels. The large bank generated over $4 in profits last year, and the improved efficiency ratio in the future will only boost out year EPS estimates far above the normalized 2019 levels. Wells Fargo remains a Strong Buy at the lows here.

Disclosure: I am/we are long WFC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.

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