I've spent most of my waking hours over the past five years immersed in banking. I've read dozens of books, talked to numerous high-level executives at many of the nation's biggest banks, and spent countless hours wading through the impenetrable financial documents that banks file each quarter with the Securities and Exchange Commission.
From this, I learned that not all banks and bankers are bad, as many Americans are inclined to believe in light of the abuses that took place in the industry over the past few decades. One bank I always cited as a positive example was Wells Fargo (NYSE:WFC).
But my opinion on Wells Fargo has changed in the wake of its fake-account scandal. I no longer feel comfortable supporting a bank that appears to have treated its employees, not to mention its customers, the way it did. I will reconsider this after Wells Fargo Chairman and CEO John Stumpf is fired or resigns.
Why I was a believer in Wells Fargo
Let me be clear about one thing: I don't think Wells Fargo's stock is a dud. I own it. Warren Buffett owns it. And I suspect it will continue to provide decent returns for investors in the future.
The most impressive thing about Wells Fargo is that, unlike so many of its peers, it's been able to maintain its discipline through thick and thin. Banking, like most industries, is cyclical. When the economy is roaring ahead, banks make a ton of money. The demand for loans soars, and defaults on those loans plunge. But when the economy takes a turn for the worse, these trends reverse course with vigor.
You can get a sense for this by looking at what happened to Bank of America (NYSE:BAC) in the 2008 financial crisis. "In the boom we pushed cards through the branches and in mass mailings," Bank of America Chairman and CEO Brian Moynihan told Fortune's Shawn Tully in 2011. "To drive growth we gave cards to people who couldn't afford them." This decision went on to cost Bank of America upwards of $60 billion in losses when all was said and done.
The key to running a great bank, then, is to navigate through these cycles. This is particularly important when you consider that most banks are leveraged by a factor of 10-to-1, which makes running a bank akin to tap-dancing on a pin top. You want to take advantage of a cycle's upswing but not overdo it by giving loans to anyone and everyone with a pulse. You then want to take advantage of the downswing, as your less prudent peers retreat and retrench to lick their wounds.
The bank that has done this best through the years is M&T Bank (NYSE:MTB), a regional lender based in upstate New York that's run by the indomitable Robert Wilmers. M&T Bank has produced one of the best returns in the bank industry, if not the best, since Wilmers took over in 1983. And it's done so in large part by acquiring competitors for pennies on the dollar during downturns in the credit cycle. Most recently, M&T Bank purchased its downstate rival Hudson City Bancorp four years ago for a substantial discount to book value. (Regulators approved the deal last year.)
Dimon and Buffett on banking
You don't have to take my word for the fact that this is how banking works. "No one has the right to not assume that the business cycle will turn," implored Jamie Dimon, the chairman and CEO of JPMorgan Chase, in the lead-up to the last crisis. "Every five years or so, you have got to assume that something bad will happen."
And here's Buffett writing on this point in his 1990 letter to shareholders:
The banking business is no favorite of ours. When assets are 20 times equity -- a common ratio in this industry -- mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the institutional imperative: the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so.
The irony is that Buffett wrote this in the course of explaining why Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) acquired 10% of Wells Fargo's outstanding common stock in 1989 and 1990. And at least up until the fake-account scandal hit last month, Buffett has been vindicated. As Stumpf and his predecessor, Richard Kovacevich. wrote in their 2007 shareholder letter, which would have been drafted in early 2008, just before the financial crisis struck with full force:
Our company maintained its credit risk discipline reasonably well during the years of excessive risk taking in our industry. Unlike many of our competitors, we did not make option adjustable-rate mortgages (ARMs) -- consistent with our responsible lending principles. We did not make negative-amortization ARMs. We offered in only a very few instances, below certain credit scores, stated-income mortgages and low- and no-documentation mortgages. Because of our prudent lending to customers with less than prime credit and our decision not to make negative amortization loans, we estimate we lost between two and four percent in mortgage origination market share from 2004 to 2006. That translates into losing between $60 billion and $120 billion in mortgage originations in 2006 alone. We're glad we did. Such lending would have been economically unsound and not right for many borrowers.
By avoiding the worst corners of the subprime-mortgage market, Wells Fargo, like M&T Bank, found itself in an enviable position in the aftermath of the crisis. Its chairman at the time, Kovacevich, was even considering rejecting TARP money from the government, until then-Treasury Secretary Hank Paulson forced the bank to take it by threatening to have regulators deem it capital-deficient if it didn't. But even before Wells Fargo received the government's infusion of capital, it was strong enough in October 2008 to acquire larger rival Wachovia. The deal was consummated at a 70% discount to book value.
How Wells Fargo achieved this
What is it about Wells Fargo that enabled it to perform so well through the second-worst economic downturn since the Great Depression?
Part of it is culture. "When Berkshire bought Wells Fargo, the world was unglued in a real estate lending-driven banking panic," Berkshire Hathaway Vice Chairman Charlie Munger said earlier this year. "We knew their bank lending officers weren't ordinary. They grew up in the garment district as cynics and were careful and better [than others]." Just like Buffett and Dimon, in other words, Wells Fargo's risk-management team has demonstrated throughout the years that it understands how important it is to maintain credit discipline throughout all stages of the credit cycle, not just after everything has come crashing down.
But -- and this is an important point -- another reason Wells Fargo has been able to navigate through the unpredictable vicissitudes of the credit cycle is that it operates so efficiently. Most banks spend 60% or more of their net revenue on operating expenses. Wells Fargo, by contrast, tends to come in comfortably below 60%. Its efficiency ratio in the latest quarter, for instance, was only 58%. Because this translates into fatter profits for the California-based bank, it also means that there's less pressure on it to reach for yield in its asset portfolio by underwriting unacceptably risky loans.
What we're starting to discover, however, is that Wells Fargo's efficiency ratio may have been artificially inflated by the overly aggressive sales tactics that caused 5,300 of its branch-based employees to open millions of fake deposit and credit card accounts for unwitting customers. This factors into the efficiency ratio because selling additional financial products to customers, whether they want them or not, boosts the bank's revenue. And revenue is the denominator in the efficiency ratio. Thus, higher revenue translates into a lower efficiency ratio.
Wells Fargo will tell you that the 2 million or so fake accounts the bank's employees opened didn't actually generate that much revenue. The figure they've provided is $2.6 million, which was how much it refunded to customers "for any fees associated with products customers received that they may not have requested." That's not even a rounding error when you consider that Wells Fargo earns $5.5 billion or more a quarter.
The last straw
But the problem with this explanation is that it ignores the much larger amount of revenue that Wells Fargo has earned through the years from accounts that were lawfully opened but shouldn't have been. We now know that Wells Fargo's employees were pushed incredibly hard to cross-sell things such as credit cards and additional deposit accounts to customers who had no need for them.
Take this exchange between Robert Smith, the co-host of NPR's Planet Money podcast, and a former Wells Fargo employee named Ashley:
Smith: Ashley remembers one day when a man comes into the bank branch.
Ashley: He was elderly. He had a cane. He was on his own. The teller had sent him over to me the first day I met him because he was overdraft. And he couldn't understand why he was negative. And he was saying, "All I want is to buy a newspaper. Why can't I buy my newspaper?"
Smith: Ashley pulls up his account on her computer. And she notices something really strange. This man was living off Social Security. He got around $1,100 a month, and yet ...
Ashley: Well, he had accrued, I think, over $200 in overdrafts. And when I looked at his accounts, he had six different accounts. He had no understanding of the accounts he had. He just said, "Oh, this nice lady explained to me that I needed this new account package," like it wasn't an option for him. I felt so terrible for this man.
Ashley voided as many fees as she could, given the authorization she had, but then transferred money from her own account to cover the rest of them. And that isn't even the worst part. Ashley was later fired by Wells Fargo for failing to cross-sell enough financial products. And the bank took it one step further by making it impossible for her to ever get another job in the bank industry.
Here's Planet Money's Smith and co-host Chris Arnold:
Arnold: As far as Ashley, she started to refuse to meet her quota. She was just saying, "Look, I can't ethically do this." She was calling the Wells Fargo ethics line trying to explain this, but eventually Wells Fargo fired her.
Smith: Ashley tried to get another job in banking, but she found that she never made it very far past the initial interviews. She suspected that Wells Fargo had put some sort of black mark on her record somewhere. And it turns out that is exactly the case. Wells Fargo wasn't joking around when they said they would make it hard for her to find work again.
Arnold: No. Wells Fargo wrote her up on what's called a U5 document. It's like a report card for bankers, basically. We tracked it down, and we asked Ashley to read what it said.
Ashley: "Failure to perform job duties."
Smith: Any bank, any bank that Ashley applies to will see this line -- "failed to do job duties."
Arnold: The form does not mention that those job duties were the sales goals that everyone we spoke to said were unrealistic and that are at the center of a series of ongoing investigations at the state and federal level.
Smith: It just says "failed to do job duties." It was the first time Ashley had seen it in print.
Ashley: It's like having a black cloud that's kind of looming behind you. And I'm always trying to get in front of the cloud, out of the cloud, into the sunshine, but it's always there.
And, to be clear, this isn't an isolated incident. There are many reports from other employees saying essentially these very same things. One employee was even fired after sending an email to John Stumpf about the creation of fake accounts.
Look, I'm very pro-bank. And I think most bankers are good, decent people. But this is unacceptable.
It's time for Stumpf to go.