Times Square was its usual jumble of tourists, traffic and passersby on a recent morning when a team of drummers suddenly appeared on a pedestrian plaza and began pounding out a rhythm on plastic garbage cans. As onlookers gathered, several dozen young adults clad in green and blue sweatshirts assembled and broke into a song-and-dance routine, performing “One” from the hit musical A Chorus Line. After ceding the plaza to a series of break-dancers, the group retook the “stage” and reprised the number, this time wearing bright red T-shirts and waving red and yellow streamers.
A flash mob orchestrated by New York City hipsters? A teaser for a new Broadway musical? No, this publicity stunt, aired on YouTube, was a bit of viral marketing by San Francisco–based Wells Fargo & Co. to promote the venerable banking brand’s arrival in the nation’s financial capital.
Over the past year, Wells has been overhauling thousands of East Coast branches of the former Wachovia Corp., the troubled bank it acquired at the height of the financial crisis, replacing the Wachovia name and blue-and-green logo with Wells’s brand and red and yellow colors. The deal gave Wells the largest branch network of any bank in the country — 6,300 outlets, about half of them in the eastern half of the U.S., where it had no previous presence — and some 70 million customers. For a company like Wells that has made an art form out of cross-selling financial products and services to its customers, this expansion is a potential gold mine — “one thrilling combination,” to quote the lyrics of “One.”
The Wachovia purchase will prove to be “the best acquisition, from both a financial and strategic standpoint, in the history of the banking industry and maybe one of the best in the history of corporate America,” predicts Richard Kovacevich, the former Wells chairman who, along with current chairman and CEO John Stumpf, orchestrated the deal.
Wells has a long way to go to fulfill Kovacevich’s vision, though. The acquisition of Wachovia has made Wells the fourth-largest bank in the country, with $1.25 trillion in assets, but it also saddled the company with tens of billions of dollars of bad home loans made by Golden West Financial Corp., a mortgage lender Wachovia bought in 2006 just as delinquencies were starting to rise on many of its notorious Pick-a-Pay loans, which allowed borrowers to defer part of their interest payments. Wells took a massive $40.9 billion write-down to cover losses on that mortgage book as well as other bad commercial real estate and consumer loans at Wachovia.
Even more daunting, Wells’s basic business model faces unprecedented challenges in today’s postcrisis environment. Consumers are continuing to pare their debts rather than take out new credit; companies have too much cash and too little confidence to want to borrow aggressively; sluggish growth and high unemployment look set to keep interest rates at historic lows for an indefinite period; and new financial regulations are forcing banks to hold more capital and reducing the fees they earn on some consumer activities, like debit cards. What’s more, unlike its megabank rivals Bank of America Corp., Citigroup and JPMorgan Chase & Co., Wells has almost no exposure to vibrant overseas markets. The bank gets fully 97 percent of its revenues from the U.S. economy. Its status as the country’s largest mortgage originator is a dubious honor at a time when the housing market is moribund. In this climate it’s not obvious that Wells can exploit its expanded network and generate growth.
The bank’s first-quarter results underscored the danger. Wells boosted net income by 48 percent from a year earlier, to $3.8 billion, but much of the gain reflected lower loan charge-offs and the release of earlier loan-loss reserves. Revenues slumped 6 percent, to $20.3 billion, an uncharacteristic decline for a bank with a high-octane sales culture. The company’s share price fell 5 percent in the two days following the April 20 announcement, to $28.54, even as the Dow Jones industrial average gained 2 percent. Two months later the price had slipped a further 4.5 percent, to $27.26.
Was the revenue decline a blip that will be reversed when the economy strengthens, or does Wells face more-serious problems? Lately, the bearish view has been winning the day among investors. “They’re saying, ‘Aha, look: They’ve gotten too big to grow, and the operating conditions going forward will be too difficult,’?” says John McDonald, an analyst with Sanford C. Bernstein & Co. in New York.
Stumpf insists that Wells’s best days are yet to come. There is ample room for growth in raising the product penetration rate among Wachovia’s old customer base, he contends. The acquisition has also given the bank significant new revenue streams in investment banking and wealth management, he notes. But it’s a telling sign of the times that Stumpf’s most significant initiative is a cost-cutting one. Last year he launched a program dubbed Project Compass that aims to streamline a host of back-office functions. The effort certainly makes sense for an institution with plenty of ?bloat from more than two decades of deal making. Wells’s efficiency ratio — operating expenses as a percentage of revenues — was 62.6 percent in the first quarter, compared with an average of 61.2 percent for a group of ten large banks and well above U.S. Bancorp’s 50.5 percent level.
“We’re going to have to tighten our belts to get more aligned with the revenue realities of today and what the future is going to look like,” Stumpf tells Institutional Investor in his modest but comfortable office on the 12th floor of Wells’s low-key headquarters in the Financial District of San Francisco. “We’re in a transition period right now. We’re going from consumers borrowing a lot and spending a lot to starting to save a lot. That’s actually a good long-term thing. But in the interim it will take us, as an industry and a company, a while to adjust.”
If there’s low-hanging expense fruit, analysts say, Stumpf should pluck it. Yet the focus on costs marks a significant departure from the no-holds-barred growth ethos of Kovacevich, whose constant refrain was, “No company ever cut its way to greatness.”
“For the better part of 25 years, Wells has had a very simple story: strong earnings powered by superior revenue growth,” says R. Scott Siefers, an analyst with Sandler O’Neill + Partners in New York. “There’s a concern out there that this could be a permanent shift in the story — one that makes Wells look more like every other bank.”
Still, many analysts remain confident in Wells’s earning power and believe the bank’s recent problems are temporary. Jason Goldberg, an analyst at Barclays Capital, has an overweight rating on the stock, with a $36 price target and a 2012 earnings estimate of $3.35 a share, compared with $2.21 a share last year. He notes that ?Wells is trading at a multiple of about 8 times projected 2012 earnings, a modest premium to Bank of America (less than 7 times) and JPMorgan Chase and Citigroup (both about 7.5), but well below regional banking leaders like SunTrust Banks (12) and KeyCorp (11). “Over the long haul, Wells is a bank that should work” from an investment perspective, says Goldberg.
Bringing Wells’s sales culture to the Wachovia franchise should boost revenues once the integration is complete. The average customer of the old Wells uses 6.2 products — such as checking and savings accounts, debit and credit cards, mortgage and consumer loans — compared with 5.2 for customers of the legacy Wachovia franchise. “It might not sound like a big difference,” Goldberg says, “but when you multiply it by 30 million customers, it’s a big number.” And that’s just the existing customer base. Wells has added 2 million customer households and $57 billion in deposits since the Wachovia deal, including an 8.5 percent net increase in checking accounts in Wachovia’s home state of North Carolina — a rare occurrence for a deal of such size.
The merger has also made Wells a bigger player in wholesale banking, capital markets businesses and wealth management. Those areas generated nearly 49 percent of the bank’s net income, excluding integration expenses, in the 12 months ended March 31. Before the deal those lines provided less than a third of earnings. “We’re almost the same size as consumer now,” says David Hoyt, head of the wholesale banking division, which includes commercial, corporate and investment banking.
Add it all up, and Stumpf insists there’s no need for an overhaul. Yes, there are revenue challenges. New government regulations meant to limit the amount banks can collect for account overdraft protection and debit card interchange fees have already begun to take a revenue bite — hence the focus on reducing expenses. That means unifying some systems and processes, eliminating redundancies and using some of the savings to reinvigorate revenue-producing activities. “If you’re past due on a credit card, auto loan and mortgage, you’re probably getting three different calls from us,” the CEO says. “Maybe that should be one call.”
The goal of the efficiency drive, he says, is to make Wells “more nimble and more relevant.” The company already is reducing its data warehouses from seven to three, and using that stored information more effectively is a part of Project Compass. “The magic of cross-sell is having one complete and correct view of the customer,” Stumpf says.
Bernstein’s McDonald applauds the cost-cutting effort but says it has affected investor perceptions. “Wells has never led with efficiencies and cost reductions as a value creator,” he says. “There’s a heresy angle that some people aren’t comfortable with.”
Stumpf, who was handpicked by Kovacevich for the CEO job because he embodied Wells’s sales culture, insists that the bank can regain its momentum. “I grew up in that same culture, and I still believe in it,” he says. “If you cut expenses to make your earnings number, where are you next year? You can’t cut your way to prosperity. It has to be about revenues.” Referring to Project Compass, he adds, “If we do this right, it will reduce expenses and accelerate our growth.”
ACHIEVING THAT GOAL WON’T BE EASY, but the indefatigable Stumpf has never shirked a tough task. The second of 11 children, he learned the value of hard work pitching in on the family dairy farm in Pierz, Minnesota, a rural community of 1,300 residents about 100 miles north of Minneapolis. His parents, Herb and Elvira, recall him as an orderly child who stacked his clothes neatly and always cleaned his plate at mealtimes. In high school “the first thing he’d do when he got into his car was check his hair,” his mother says.
Stumpf earned a bachelor’s degree in finance from St. Cloud State University, about 20 miles from home, helping pay his way through school by playing bass guitar for a rock band called Mason-Dixon Line. After graduating in 1976 he joined First Bank System (now U.S. Bancorp) in Minneapolis as a repo man, reclaiming cars from deadbeat borrowers. “There were situations that I wouldn’t want my children involved in,” says Stumpf. “But you learn a lot about negotiating — about how you need to treat people with dignity, even when they’re in tough situations. And when you collect bad loans, you sure learn a lot about making good ones.”
In 1982, having earned an MBA in finance at night school at the University of Minnesota, he jumped to Northwestern National Bank, a Minneapolis company that would later become part of ??Norwest Corp. He worked as a branch officer and then on commercial loan workouts before being named chief credit officer and head of auto finance in 1987.
Stumpf’s credit sense and easy way with people caught the eye of Kovacevich, then COO and head of retail banking, who had arrived at Norwest in 1986 from Citi. In 1989, Stumpf became CEO of Norwest’s Arizona operations. Two years later the company acquired United Banks of Colorado, which had been weakened by bad real estate loans, and Stumpf took the helm, demonstrating a knack for imparting the Norwest culture to new employees. From 1994 to 1998, with Kovacevich as CEO, Stumpf ran the company’s Texas operations, overseeing the acquisitions of 30 banks.
Norwest acquired Wells in 1998 and took its target’s name and headquarters. Stumpf first ran the combined company’s retail operations in the Southwest, then in 2000 was put in charge of ??Wells’s ten-state western banking group. Two years later he became head of all community banking, and in 2005 he was named chief operating officer.
Being CEO of a megabank has forced Stumpf into an industry leadership role. He’s met with President Barack Obama, held press conferences with other big-bank CEOs to defend their institutions’ role in the crisis and penned op-ed pieces about the importance of reviving the securitization market for mortgage loans. “I’m in contact with more constituents who in the past might not have been top of my radar: community activists, analysts, regulators. I spend more time with legislators,” Stumpf says. “I also try to talk with at least one customer and one team member every day, unannounced.”
The future looked bright when Stumpf succeeded Kovacevich as CEO in June 2007. Wells’s finely tuned retail machine had been on a tear, generating an annual return on equity in the 20 percent range between 1997 and 2006, compared with an average of 15 percent for the industry, according to Joseph Morford, an analyst with RBC Capital Markets. Then the subprime storm clouds burst.
The bank resisted the crisis better than most of its peers thanks to its sales culture and relative lack of exposure to subprime mortgages and investment banking. In 2007, while outfits like Citigroup and Morgan Stanley were hemorrhaging cash and running to sovereign wealth funds for capital, Wells grew revenues by 10.4 percent and contained its profit decline to just 4.3 percent despite a big increase in loan-loss provisions. That strength allowed Wells to pounce in the meltdown that followed Lehman Brothers Holdings’ bankruptcy. The bank acquired Wachovia for $15 billion in stock in October 2008, just days after Citi had announced its own plan to buy the bank. Wells’s clincher: It didn’t need any taxpayer assistance to complete its deal. Wells remained in the black in 2008 but saw its earnings plunge 67 percent, to $2.7 billion, because of the massive write-offs on Wachovia’s loans.
Today, Stumpf has plenty of reasons to focus on cost-cutting, only some of which stem from the economic environment. Wachovia and Wells were two of the biggest serial acquirers of the past 20 years. The combined entity is the result of jamming literally hundreds of companies together.
“We allowed ourselves to cover expense issues with growing revenues,” says Patricia Callahan, the executive vice president who heads up Project Compass. “We have 300 different management training programs delivered in various iterations around the company,” she adds. “At this point in the business cycle, when revenues aren’t so strong, we really ought to simplify things and pick maybe ten.”
Integration costs helped boost Wells’s noninterest expense tab 5 percent in the first quarter from a year earlier, to $12.7 billion. The company has hired more than 10,000 people to work on loan collections, loss-mitigation efforts and foreclosures, says chief risk officer Michael Loughlin, “and we’ll need to hire more.”
Tighter cost controls would certainly help the bottom line, and Wells has room to maneuver. Analysts say the $50.5 billion it spent in 2010 could fall to about $46 billion — about the combined level of expenses for premerger Wells and Wachovia. Timothy Sloan, who was named chief financial officer in February after the abrupt resignation of longtime CFO Howard Atkins, hints that the savings could be greater. He notes that first-quarter expenses included $472 million in litigation costs from “foreclosure-related matters” and $440 million in merger costs that will wind down when the Wachovia integration is complete. Throw in job cuts in the mortgage unit, now in progress because of a slowing origination market, and steady drops in the amount of foreclosed properties and other real estate owned, which must be maintained and marketed, and the $46 billion expense number “is in the realm” of possibility, Sloan says, “before you start to make some progress on Compass.” Analysts expect Wells to detail additional cost savings of roughly $1 billion later this summer.
Other costs loom. Wells will likely have to pay somewhere between $1 billion and $5 billion for its share of a settlement with state attorneys general and federal regulators of allegations of improper mortgage foreclosure practices. (Wells officials point out that the talks aim at a global settlement and that the bank has not been charged with foreclosing on anyone without proper cause.)
And then there are the new capital requirements. Wells’s tier-1 common-equity-to-asset ratio of 8.9 percent is up sharply from 3.1 percent two years earlier. By the new Basel III standards, executives calculate that Wells, with a 7.2 percent ratio, would rank above its peers because of its business mix. But questions remain about the specifics of the rules and whether regulators will consider Wells a “systemically important financial institution.” So-called SIFI banks will be required to retain an additional capital buffer of up to 2.5 percent of assets, and Wells is on the bubble. If the SIFI standard is global, then Wells, with its small international presence, is likely to be spared the full impact of the change. If the standard is country-specific, the bank will almost certainly face a hefty capital surcharge.
Notwithstanding these concerns, Stumpf and his colleagues are making considerable progress in streamlining the enlarged bank. Nearly three years on, the assimilation of Wachovia’s sprawling operations is approaching completion. The bank has changed over most redundant computer systems, and executives expect to finish the last of the market conversions, in the southeastern region of the country, this fall.
Credit quality is showing quarter-to-quarter improvement. Net charge-offs on loans were $3.2 billion in the first quarter, down $629 million from the previous quarter, while nonperforming assets dropped by $1.8 billion, to $30.6 billion. Although Wells still has work to do, “credit is really yesterday’s news,” says risk officer Loughlin.
With its ability to generate capital, Wells looks strong enough to handle what comes next. The company’s pretax, preprovision return on assets stood at 2.57 percent in the first quarter, second among large banks only to U.S. Bancorp’s 2.81 percent and well above the peer group average of 1.73 percent. “They still have plenty of earnings power,” says Sandler O’Neill’s Siefers.
As for excess capital, Wells cleared its late-winter stress test with flying colors and won government approval to boost its quarterly dividend to 12 cents, or 17 percent of earnings. The bank aims to increase that payout ratio to 30 percent, which analysts believe could take two years. The board also authorized the repurchase of as many as 200 million shares of stock.
To revive growth, Stumpf is betting on the bank’s big U.S. consumer business. In addition to its sprawling retail branch network, Wells has 2,000 mortgage or financial adviser shops and 12,000 ATMs. “Fifty percent of the Census households are within a two-mile radius of an ATM or a store,” says Carrie Tolstedt, head of retail banking.
Beyond traditional banking products such as loans and debit cards, executives see asset management, retirement planning and insurance sales as natural add-ons. Wells has the biggest bank-owned insurance brokerage, the No. 2 bank-owned mutual fund family and ranks No. 3 in retail brokerage. But although the company controls about 10 percent of the nation’s banking deposits, it only services about 2 percent of its wealth.
“With this notion of cross-sell, I like our chances,” says David Carroll, head of the wealth management and retirement unit and the only former Wachovia executive to land a spot as one of Stumpf’s direct reports.
The 5.2 million affluent customers served by Carroll’s group have an average of 9.82 financial products from Wells. “And if they have a banking relationship, it’s 11.65,” Carroll adds. “We don’t have to chase people who do nothing with Wells Fargo.” The wealth unit, which includes the bank’s retail brokerage arm, boosted net income by 20.2 percent in the first quarter from a year earlier, to $339 million; revenues were up 8.2 percent, at $3.15 billion.
Officials say the key to making the Wachovia marriage a long-term success lies in spreading the cross-selling gospel to the group’s newer employees. Although there was some initial resistance, employees of the former Wachovia — known as “the east” in management parlance — are embracing the Wells sales culture and showing their new masters a few things along the way.
Wells has sent staff teams into markets across the east and makes use of in-house blogs and social media to tutor employees on the thousands of ?little things that make up the company’s culture: Branches are called “stores,” employees are “team members,” and customers are “guests.” Banking is a team sport, and the team’s success is more important than individual achievement. Sell people only what they need, but work on building the relationships to make those sales when the time arrives. A key part of what makes Wells successful at cross-selling is the way it bundles products into packages, offering discounts — say, a quarter point off a home equity loan — to customers who do enough business with the bank. It sounds easy in principle but is difficult to execute.
Wells executives have picked up some good lessons about customer service, a Wachovia forte. Within months of the takeover, Wells adopted a unique hand signal that Wachovia branch employees had developed to alert colleagues to a dissatisfied customer. “If cross-sell is the engine, customer service is the fuel,” says retail banking head Tolstedt.
The company has executed the merger integration superbly, as evidenced by the new customers and deposits coming in the door. The kicker: Loan quality has proven better than anticipated. Wells expects actual losses on the Wachovia loan book to be $3.9 billion less than its $40.9 billion write-down.
Still, top-notch execution can’t make up for underlying weakness in Wells’s core markets. The group gets nearly two thirds of its revenues from retail banking, making it easily the biggest bet on the U.S. consumer among the megabanks. Tolstedt’s mammoth community banking division, which includes both the retail and mortgage units, saw revenues drop by $1.3 billion, or 9 percent, to $12.6 billion in the first quarter from the same period a year earlier. As a result, Wells’s first-quarter ROE was about 11.6 percent — not bad, relatively speaking, but not what investors have come to expect.
Wells is the nation’s top mortgage originator, with a 25 percent market share, and No. 2 in mortgage servicing, administering $2.3 trillion in home loans. “We’ve never seen someone who is this dominant in the mortgage market, ever,” says Guy Cecala, publisher of Inside Mortgage Finance, a trade publication.
That’s a mixed blessing at best given that the U.S. housing market is enduring its worst slump since the Great Depression. The impact on Wells’s top line has been dramatic. Revenues in the mortgage division dropped to $2 billion in the first quarter, a decline of $741 million, or 27 percent, from the preceding quarter. The company saw mortgage originations fall 34 percent from the previous quarter, to $84 billion, as rising interest rates and saturation cooled a red-hot refinancing market. About two thirds of originations in the last half of 2010 came from refinancings. “We’ve refinanced everyone who wanted to refinance,” Cecala says. The home purchase market, meanwhile, has turned down again in recent months, dashing hopes of a recovery. Sales of existing homes fell by 3.8 percent in May to an annual rate of 4.81 million, the lowest level in six months. Most analyst models predict a steady decline in Wells’s originations through the year, with a final tally estimated at about $250 billion, compared with $384 billion in 2010 and $416 billion in 2009. That meshes with Cecala’s projection of a $1 trillion overall origination market in each of the next two years. The number peaked at $4 trillion in 2003 and was $1.6 trillion in 2010.
Other parts of the retail business are also showing softness. Net interest income from lending activities, before provisions for loan losses, was off about $500 million, or 4.5 percent, in the first quarter from the previous year. Home equity, credit card and revolving loan balances all shrank, and yields were 6 basis points lower. Wells currently has about $100 billion sitting in low-rate but liquid securities or Federal Reserve funds, waiting for lending opportunities.
Fee income is also dropping. Account service charge revenue fell by $320 million, or 24 percent, in the first quarter from a year earlier, mostly as a result of the Fed’s Regulation E, which limits what banks can charge for overdraft protection and requires that customers opt in for the service. Pending regulations, notably the Dodd-Frank Wall Street Reform and Consumer Protection Act’s so-called Durbin amendment to slash debit card interchange fees, could present new challenges. The amendment would cost Wells $325 million a quarter after taxes in lost revenues, the company estimates. At the end of June, the Federal Reserve issued final rules capping the fees at 21 cents a transaction plus 5 basis points times the value of the purchase, up from an originally proposed 12 cents.
“What do we do to offset the loss of revenue?” says Stumpf. “Unfortunately, the consumer will pay,” most likely through monthly fees on heretofore free checking accounts. But even that won’t make up all of the gap and risks chasing away some customers.
Fortunately for Wells, the Wachovia deal brought new or expanded businesses in wholesale banking and wealth management to offset some of the consumer weakness.
The addition of investment banking, something Wells had long eschewed in contrast to most of its peers, is the most dramatic by-product of the acquisition. Kovacevich, who advises Wells today but holds no executive role, staunchly resisted any move into investment banking in the past but now defends it. “If we had tried to impose our culture on an investment bank we acquired, everyone would have left,” he says. Today, he adds, “the whole industry has changed. The worst offenders are gone, and they’ll be gone forever. The ones that are left are basically bank holding companies. Even if they wanted to, they wouldn’t be able to behave the way they did in the past.”
Wells Fargo Securities, the investment banking division, focuses mainly on arranging plain-vanilla financings for clients rather than proprietary trading and structured products. Although the company doesn’t break out earnings, executives say the securities arm has been profitable each quarter since the merger and grew revenues 44 percent in 2010. It ranked ninth by U.S. investment banking revenues, with $390 million, or 4.6 percent of the market, in the first quarter, according to data provider Dealogic. The unit ranked as the No. 1 underwriter of ??U.S. preferred securities and in the top ten in loan syndications and high-yield and municipal bond offerings last year. It recently landed a role as joint lead manager of a $1.5 billion senior debt offering by its biggest investor, Warren Buffett’s Berkshire Hathaway, which owns 6.48 percent of ?Wells.
“All of a sudden, we have a big reach and there aren’t as many competitors,” says wholesale banking head Hoyt. He predicts strong growth, noting that Wells has a full roster of big corporate clients and counts one in three midsize U.S. businesses among its customers. “We’re having great success taking that investment banking platform and serving our existing customers.” The wholesale banking division boosted net income by 33.5 percent in the first quarter, to $1.7 billion, even though revenues were flat.
Stumpf presides over a greatly expanded empire, but it remains to be seen whether he can restart the bank’s growth engine. Sandler O’Neill’s Siefers projects that quarterly revenues will be running at a rate of $21.6 billion by the end of 2012 — about where they were at the beginning of 2010. That’s a far cry from the heady expansion of the Kovacevich years.
Of course, today’s market conditions are much more challenging. But Stumpf doesn’t make any excuses for the bank’s performance. Asked whether the current economic and banking environment virtually guarantees he won’t be able to match his predecessor’s record, he laughs off the suggestion with a shrug. “Dick was the best our industry produced in a generation; he has no peer, in my mind,” he says. “Why not follow someone like that instead of someone who did a lousy job?”
Stumpf can only hope that a few years down the road, his successor will be able to say the same thing.
