1 Factor Could Really Drive Wells Fargo’s Earnings Higher

Wells Fargo (NYSE:WFC) has been on an impressive run recently. Shares of the megabank dipped all the way down to $21 in late October before rebounding. At Friday’s prices, they’re trading around $47, about where they sat in January 2020. Much of what has driven the stock back up toward its pre-pandemic levels appears connected to the bank’s progress on regulatory issues, as well as a big cost savings initiative that management has undertaken in order to get its efficiency more in line with its peers’.

But one seemingly overlooked factor is just how much money the bank could soon release from its reserves, which could really drive up earnings in the coming quarters.

Setting aside money for a rainy day.

Image source: Getty Images.

Day 1 CECL reserves

At the start of 2020, most large banks adopted the new current expected credit losses (CECL) accounting method, which drastically changed how lenders reserve money to cover loan losses. Under the old accounting regimen, banks would set aside those reserves based on events that led them to believe borrowers might not be able to meet their payment schedules or meet the terms of their loans. But under CECL, banks must be more forward-looking, and make reserves for losses as soon as the loans come onto the balance sheet. The result was that banks had to front-load their reserves.

This became deeply relevant when — just a few months after they made that change — the pandemic hit, forcing banks to reserve billions of dollars for potential loan losses, mostly due to the economic uncertainty brought on by the crisis. CECL likely magnified the size of those required reserve increases.

However, as we now know, loan losses were not nearly as steep as initially projected, largely thanks to measures like federal stimulus packages, loan deferrals, and other actions that helped bridge a lot of borrowers through the economic hardships of the crisis. Now, many banks are releasing large caches from their reserves, and most institutions may get their reserve levels down closer to the level they were at just after CECL was implemented — but before the pandemic rocked the U.S. economy.

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This could significantly benefit Wells Fargo because unlike most of its peers, which increased their reserves as a result of CECL, Wells Fargo’s total reserve levels — also referred to as the allowance for credit losses (ACL) — went in the opposite direction.

Bank Change in ACL Due to CECL Total ACL After CECL ACL as a Percentage of Loans After CECL
Wells Fargo ($1.3 billion) $9.1 billion 0.90%
Citigroup (NYSE:C) $4.1 billion $18.4 billion 2.55%
Bank of America (NYSE:BAC) $2.9 billion $12.4 billion 1.27%
JPMorgan Chase (NYSE:JPM) $4.3 billion $18.6 billion  1.8%

Source: Bank earnings materials

Upon CECL implementation, Wells Fargo saw its total ACL decrease by $1.3 billion, while most of its peers saw pretty sizable increases. Now, there were good reasons for this. CECL really forced banks to increase their reserves for credit card loans. Thus, JPMorgan and Citigroup, which both have large credit card portfolios, had to boost their reserves significantly to meet the new standard. Wells Fargo has the smallest credit card portfolio of this group.

Meanwhile, though it might sound counterintuitive, the big banks for the most part decreased the reserves they had set aside for commercial loans after implementing CECL. And Wells Fargo is one of the largest commercial lenders in the country, with the largest commercial loan portfolio among its big-bank peers.

Wells Fargo said that upon adoption of CECL, it decreased its ACL specifically for commercial loans by $2.9 billion to reflect “shorter contractual maturities given limitation to contractual terms.”

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Now, I do have some questions about Wells Fargo’s overall reduction in reserves. Bank of America — the other major commercial lender of this group — only lowered its reserves for commercial loans by $386 million upon implementation of CECL. While reserve calculations are quite complex, Wells Fargo’s commercial loan portfolio isn’t that much bigger than Bank of America’s, so it’s a little strange that it decreased its reserves for commercial loans by so much more.

Potential for huge releases

If we fast-forward to the present day, Wells Fargo’s ACL has increased quite a bit because of COVID-19 — from just 0.90% after the implementation of CECL to 2.09% at the end of 2021’s first quarter.

Total loan balances at Wells Fargo have dropped a lot over the past year, but the bank has not brought down its ACL in tandem with that decline. Net loan charge-offs — which reflect debt unlikely to be collected, and which are a good representation of actual loan losses — are at historic lows. Management noted on the bank’s first-quarter earnings call that there was still a significant amount of uncertainty baked into the ACL at the end of the quarter, but also said that credit quality was trending better than expected.

The bank did release more than $1.5 billion of reserves in the first quarter, but $757 million of that total was related to the bank’s sale of its student loan portfolio. At the end of the first quarter, Wells Fargo’s ACL sat at more than $18 billion. Remember, the bank’s day one CECL reserve number was $9.1 billion. Its target could be smaller now with the student loan book no longer part of the equation.

Now, I don’t think any bank expects to get back to its day one CECL reserve level any time soon, if ever, because banks always leave a little cushion to account for uncertainty. But most institutions seem to think they will get close to that day one level as long as nothing crazy happens and things keep trending positively.

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Again, I don’t know if I necessarily agree with Wells Fargo’s day one CECL number being as low as it was, but if the company is heading back toward that general vicinity and its credit quality continues to trend as it has, it looks like the bank has billions of dollars in reserves yet to release.

Huge potential for earnings

Once a bank accounts for net charge-offs and new provisions for loan growth, if there is any, reserve releases go back onto the income statement as a negative provision. Instead of eating into profits, they actually add to profits. Wells Fargo CEO Charlie Scharf recently said at a conference that people should expect to see a significant reserve release in the bank’s second-quarter results.

Let’s say the bank releases $5 billion or $6 billion or more over the next several quarters. That’s a lot of money returning to the bottom line. The bank only made $3.3 billion in net income in 2020, and even in years like 2018 and 2019, when it was making in excess of $20 billion, releases of that magnitude would still be significant, so they could really drive earnings higher this year.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.


View more information: https://www.fool.com/investing/2021/06/05/1-factor-could-really-drive-wells-fargos-earnings/

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