Below is an excerpt from our sell report for Wells Fargo. Many commentators have missed the real significance of the bank scandal, we think, which is about managerial negligence and a weak commitment to its fiduciary obligations to the shareholder owners of the bank. Wells Fargo’s management imposed unreasonable sales targets on employees and then failed to grasp the consequence, which was the widespread opening of fake accounts, even as management pocketed “performance” compensation for (falsely) reaching cross-selling goals.
On September 8 enforcement actions against Wells Fargo was were made public by the Office of the Comptroller of the Currency, the Consumer Financial Protection Bureau and the Los Angeles City Attorney, which collectively fined the bank $185m. The government agencies alleged that Wells Fargo engaged in “widespread illegal activity” and said that employees had opened as many as two million checking, savings and credit card accounts without customers’ knowledge.
Shortly after the announcement of the fine, the US Justice Department announced that it was in the early stages of investigating Wells Fargo for criminal and/or civil violations in relation to the illegal account openings.
According to the CFPB, the fraud didn’t just amount merely to opening fake accounts, but “[b]ank employees temporarily funded newly-opened accounts by transferring funds from consumers’ existing accounts in order to obtain financial compensation for meeting sales targets ” [emphasis added].
The magnitude of Wells Fargo’s fine is a pittance compared to the bank’s $22bn in net profit last year; similarly the 5,300 employees already fired due to the illegal account openings is small relative to the bank’s 200,000 workforce. The political and regulatory blowback from the scandal could be more serious, however. Most worrisome for shareholders are the defects that the scandal reveals in Wells’ corporate culture, its internal controls, and future business strategy. The illicit account openings and money transfers raise a general question about the security of Wells Fargo’s accounts and its compliance with money laundering and ‘know your customer’ rules, and an abandonment of aggressive cross-selling practices would leave Wells without its signature business strategy of the past fifteen years, without a visible alternative.
Longtime sell-side bank analyst Dick Bove points out that if Wells employees opened half a million fraudulent credit card accounts to meet sales targets, then what does this say about the loan officers’ credit underwriting standards—not to mention the accuracy of management’s grasp of its loan book’s quality?
The response of Wells’ senior management to the scandal has been largely evasive and unconvincing both in its account of the origins of the illegal cross-selling and its purported remedies (see, e.g., Lucy Kellaway, “Wells Fargo’s wagonload of insincere regrets,” Financial Times, Monday 19 September 2016).
In April of 2016 Wells’ longtime head of retail banking, Carrie Tolstedt, announced her retirement. At this time Wells knew of the regulatory investigations into its cross-selling practices. Nevertheless, Tolstedt was feted by the bank at her retirement and received substantial additional stock options as compensation. In the press release announcing her retirement, Wells CEO John Stumpf stated, “A trusted colleague and dear friend, Carrie Tolstedt has been one of our most valuable Wells Fargo leaders, a standard-bearer of our culture, a champion for our customers, and a role model for responsible, principled and inclusive leadership,”
Tolstedt worked at the bank for 27 years and headed its retail division since 2008. Fortune magazine reports that
Tolstedt was regularly praised for her unit’s ability to get customers to open numerous accounts. For a number of years, Wells Fargo’s proxy statement, which details executive pay, cited high “cross-selling ratios” as a reason that Tolstedt had earned her roughly $9 million in annual pay. For instance, in Wells Fargo’s 2015 proxy statement, the company said that its compensation committee had authorized Tolstedt’s $7.3 million stock and cash bonus that year, because “under her leadership, Community Banking achieved a number of strategic objectives, including continued strong cross-sell ratios, record deposit levels, and continued success of mobile banking initiatives” (Stephen Gandel, Fortune, “Wells Fargo Exec Who Headed Phony Accounts Unit Collected $125 Million” September 19, 2016).
Tolstedt’s performance compensation for achieving inflated and partially fraudulent cross-selling numbers suggests that senior management is better at running the bank to reward themselves, rather than the bank’s shareholder owners.
John Stumpf will testify before the US Senate this week in order to answer questions about the scandal; Stumpf already has refused to identify any senior executives who are responsible for the individual “bankers, managers and managers of managers” to whom the bank has attributed blame, and he refused to name the most senior employee let go thus far.
According to the Journal, Wells’ dedicated focus on cross-selling banking products to Mainstreet customers dates to the late 1980s when then-CEO Richard Kovacevich brought the strategy from the acquired bank Norwest Corp. In 1999 the bank reported that its retail customers on average held three accounts and that it hoped to increase that number to eight. This program was known internally to employees as the “Gr-eight” initiative; Kovacevich picked eight as a target because it rhymed with “great.”
Currently Wells reports that its average Mainstreet customer owns over 6 products from the bank. Not only does this figure trounce the industry average, but Wells, unlike other banks, reports this figure explicitly in its quarterly earnings.
Some analysts have compared the Wells scandal to JP Morgan’s “London Whale trade,” which resulted in huge losses and fines over the bank’s failure to oversee its derivative trading risk, but ultimately proved navigable for Morgan. But the Wells’ scandal seems more serious, because it cuts to the heart of Wells’ carefully crafted image as the plainspoken, ethical alternative to rapacious Wall Street banking. At Morgan, by contrast, everyone knew that the bank had a big, aggressive, and lucrative tradition operation, which was one reason why you owned it. If Wells’ corrects the incentives and culture that led to the problem, then it will presumably have to give up its marquee business strategy.
Regulators will now probably scrutinize all retail banks, whereas previously they had focused upon those banks with rarified trading and securitization practices that are far removed from the ordinary public’s everyday concerns.
Wells pays a handsome +3% dividend yield, which is safe and sustainable, due to its relatively low payout ratio of about 36%. This fact alone will probably lead many shareholders to ignore the scandal and hold on to the stock, or even to buy its recent sell-off.
Nevertheless, on balance the uncertainty about Wells’ future retail strategy, risks of further regulatory and criminal action, and an apparently dysfunctional corporate culture coupled with managerial negligence makes selling more reasonable.