Accounting Wells Fargo’s (WFC) Problems

by riskreversal November 17, 2016 12:00 pm • Trade Ideas

In the wake of the Wells Fargo’s (WFC) fraudulent account scandal, the company’s new (kind of old) President & CEO Tom Sloan issued a statement on their retail banking operations “as part of our ongoing commitment to transparency”.

Here were the low-lights (emphasis ours):

  • Consumer account opens were down 27% LM and 44% YoY primarily due to a full month impact of customer reaction to the sales practices settlement and reduced marketing activities
  • Customer-initiated account closures were up modestly, 3%, both LM and YoY
  • New credit card applications continued their downward trend with applications down 35% LM and 50% YoY primarily due to reduced marketing activities and a full month impact of customer reaction to the sales practices settlement

As far as the actions taken to remedy the fraud that took place for years in retail banking, possibly with senior management’s knowledge dating back to 2007, they may prove to just preliminary actions if Sloan, former CEO John Stumpf’s replacement was also aware of and slow to act to fix the illegal account openings in retail banking.  Also we learned last month on CNBC, that the former head of the retail baking group, Carrie Tolstedt, who booked $124 million in compensation for her oversight, reported to Sloan as recently as last November, when he was President and COO.

Without any particular insight into this situation, but based on nearly two decades of seeing business scandals play out in the financial markets, I’d be shocked if this story is done, and the stock’s 16% rally in a little more than a week since the election might provide a great near term opportunity for short entry, eyeing a re-tracement back to the mid $40s.

Obviously the ramp in interests rates has helped the one of the largest lenders in our country, but the presumption of a roll back in regulation is one that leaves us scratching our heads for a company like Wells, who clearly had a target on its back, and could be easy prey for the new administration that came in on a populist message. Also WFC’s largest shareholder, Warren Buffet was a big Clinton backer. I get the reasons for why investors are buying banks, I suspect they have run too far too fast for the reasons listed above, and WFC could simply be a good short candidate in a pairs trade vs a Citi or a BAC long… if one thought they could trade up to 1 price to book and WFC could see a move back towards 1 from 1.44x.

The stock bounced off of long term support at $45, seems like a fairly decent downside target on increased scrutiny in the near year:

[caption id="attachment_68246" align="aligncenter" width="600"]WFC 5yr chart from Bloomberg WFC 5yr chart from Bloomberg[/caption]

So what’s the trade?

The next identifiable catalyst is obviously the Fed’s Dec 14th meeting, followed by the company’s mid month Nov retail banking update, then the company’s Q4 results on Jan 13th then the Fed’s next rate meeting on Feb 2nd. Feb options will not be listed to Monday, and after Jan there is just April.

Gun to my head I target Jan earnings, with the stock at $52.50, the Jan 52.50 / 45 put spread is offered at $1.75.  This put spread breaks-even at $50.75, down 3.3%, is at the money, and offers profits of up to 5.75, or 3x premium at risk between 50.75 and 45, with max gain below.

I bring up the idea of waiting for Feb as the potential for an increase right after the Dec meeting (96% probability of a hike in Dec, but only a 16% chance of a consecutive one in Feb) could set the tone for banks stocks, if investors were to think the Fed was not about to embark on an aggressive rate hiking regime.

We’ll wait until Feb options are listing and may check back in with a specific trade idea.