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Wells Fargo's Harsh Penalty Could Be a Game Changer

By Matthew Frankel, CFP® - Updated Feb 5, 2018 at 11:32AM

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There were reasons to buy Wells Fargo in the wake of its scandals but perhaps not anymore.

Wells Fargo (WFC 1.52%) has had a rough couple of years. The bank has gone from one thought of as the most rock-solid and invincible of the largest U.S. banks to one plagued by a series of damaging scandals. However, as troubling as the scandals are, there were still some good reasons to be bullish on Wells Fargo in 2018.

That was before the Federal Reserve recently announced an unprecedented and severe penalty on the bank as punishment for its questionable sales practices and other bad behavior. In short, this action may have taken away the only reason left to buy the stock.

Gavel surrounded by money.

The Federal Reserve's penalty on Wells Fargo could potentially cost the bank billions. Image Source: Getty Images.

The Fed's harsh penalty on Wells Fargo

The Federal Reserve announced that it had decided to punish Wells Fargo for its "consumer abuses," such as the infamous fake-accounts scandal and other questionable practices that have come to light over the past year or so.

In its unprecedented action, the Fed is prohibiting Wells Fargo from growing any larger than its total assets at the end of 2017 until the bank makes "sufficient improvements."

In a statement, outgoing Federal Reserve Chair Janet Yellen said, "We cannot tolerate pervasive and persistent misconduct at any bank and the consumers harmed by Wells Fargo expect that robust and comprehensive reforms will be put in place to make certain that the abuses do not occur again... The enforcement action we are taking today will ensure that Wells Fargo will not expand until it is able to do so safely and with the protections needed to manage all of its risks and protect its customers."

Why it matters to investors

In many ways, Wells Fargo looked like a rather appealing bank investment until recently. Shares had dramatically underperformed peers, and the bank still had tremendous asset quality and was generating strong returns on equity.

However, the biggest reason to own Wells Fargo (or any other bank stock, for that matter) is that we're entering arguably the best growth environment for banks in decades. Tax reform will boost profits by billions of dollars, rising interest rates should lead to margin expansion, and there's a good chance that banking regulations will be rolled back over the next few years.

By restricting Wells Fargo's ability to grow, the Fed has effectively taken away this catalyst for growth. Sure, Wells will still benefit from lower tax rates and higher margins, but it won't be able to parlay these into growth. That's a big reason why so many analysts are downgrading the stock and why this could be the game-changing factor that scares away long-term-minded, value-seeking investors.

Is Wells Fargo still a good long-term investment?

It's difficult to say, and that's the problem. It's unclear when the Fed's growth-inhibiting action will be lifted. It could be later in 2018, sometime next year, or sometime further in the future. We just don't know the details of what would constitute "sufficient improvements" at this point.

At the very least, the Fed's penalty will remain in effect for most of 2018, and is especially troubling because it is happening during a time when banks should be focused on growth. Wells Fargo may be all right over the long run, but I'd stay away until there's more clarification about when the bank will be allowed to grow again, even at the newly depressed share price.

Matthew Frankel has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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