Wells Fargo Reports a Rare Disappointing Quarter

By John Maxfield Markets Fool.com

Storm clouds hung over Wells Fargo's fourth-quarter earnings. Image source: iStock/Thinkstock.

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It's been a long time since Wells Fargo (NYSE: WFC) has reported disappointing earnings, but that was the case(link opens PDF) on Friday. Net income at the nation's third biggest bank by assets fell in the fourth quarter of last year to $4.9 billion, down from $5.2 billion in the year-ago period.

Bucking the trend

Wells Fargo's downbeat earnings come amid a swell in profits at other banks. Earnings at JPMorgan Chase and Bank of America(NYSE: BAC) rose in the last three months of 2016 on a year-over-year basis, fueled by higher trading and net interest income. In Bank of America's case, it was the best fourth-quarter performance that it's reported in a decade.

Wells Fargo didn't benefit as much from these trends. It doesn't operate a sizable trading operation like JPMorgan Chase and Bank of America do, thus its revenue wasn't fueled to the same extent by the elevated activity in the markets following the presidential election. And unlike Bank of America, which has positioned its balance sheet to gain from higher interest rates, Wells Fargo was prepared for rates to stay "lower for longer."

It was the latter that took a significant bite out of Wells Fargo's earnings last quarter. The California-based bank suffered a $592 million loss due to the impact of elevated interest rates and currency movements on its hedging results, what it refers to as "net hedge ineffectiveness accounting loss." This accounts for a majority of the $818 million decline in Wells Fargo's noninterest income in the final three months of last year.

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Data source: Wells Fargo. Chart by author.

Fake-account scandal

The fake-account scandal that engulfed Wells Fargo beginning in September didn't help, either. Thousands of employees in its branches sought to meet their sales quotas over the years by opening millions of accounts for customers without the authority to do so. Wells Fargo was fined $185 million by regulators and has since been subject to a number of additional regulatory constraints.

Its once-heralded chairman and CEO John Stumpf stepped down in the scandal's wake. The bank has had to eliminate sales goals in its branches and change its compensation structure for branch employees. And it's been accused in multiple media reports of retaliating against whistleblowers who tried to bring the misdeeds to the attention of supervisors and executives, including Stumpf.

Since then, Wells Fargo has seen its new account openings plummet. Data released by the bank in December showed that new checking account openings at Wells Fargo dropped 41% in November, while consumer credit card applications plunged 45%. As the scandal unfolds, moreover, Wells Fargo is likely to see its noninterest expenses increase as it defends itself against government and shareholder lawsuits.

It should come as little surprise, in turn, that Wells Fargo's profitability has been materially affected. Its return on assets last quarter came in at 1.08%, down from 1.24% in the year-ago period. This still exceeds the 1% threshold that analysts and investors expect from big banks, but it's a far cry from the days when Wells Fargo was among the most profitable banks in the country.

Things are still looking up

Despite Wells Fargo's struggles, it still stands to benefit from ongoing trends in the bank industry. In the first case, credit quality remains strong, as the balance sheets of businesses and individuals are healthier than they've been in years. This enabled Wells Fargo to reduce its loan loss provision in the fourth quarter by $26 million, or 3%.

The incoming presidential administration's vow to ease regulations in the bank industry by "dismantling" Dodd-Frank would also help. Depending on what shape the reforms take, they could free Wells Fargo and other banks up to operate with more leverage, squeeze more juice out their asset portfolios, reduce compliance costs, and return more capital to shareholders. All of these changes would boost profitability in the industry.

A continued uptick in interest rates would also help over the long run, despite the fact that Wells Fargo has wagered that rates will remain low. The Federal Reserve increased the fed funds rate by 25 basis points in December and signaled that it could do so three more times this year. Higher interest rates translate into higher loan prices, which, all else equal, translate into higher revenue for banks.

Finally, it's worth noting that Warren Buffett, a bank investor without equal, continues to have confidence in Wells Fargo, the second-largest holding in Berkshire Hathaway's common stock portfolio. Buffett has said in the past, and reiterated the sentiment recently, that the $1.9 trillion bank would the one he'd choose if he had to invest his wealth into only a single company. Given the source, that's high praise.

In sum, while it will take a year or more for Wells Fargo to put its fake-account scandal in the rearview mirror, it's only a matter of time before it does so. At that point, it'd be surprising if the bank didn't reclaim its position at the apex of the bank industry.

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John Maxfield owns shares of Bank of America and Wells Fargo. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.