Will Warren Buffett Sell Wells Fargo?

After Berkshire Hathaway's (BRK.A -0.30%) most recent investor day, I think it's safe to say that no one really knows what Warren Buffett is thinking. The company and the "Oracle of Omaha" caught everyone off guard by revealing that it did not conduct any significant share repurchases in the first quarter -- that it sold its entire stake in four major airline companies, and grew its pile of cash and short-term investments to a whopping $137.2 billion.

Buffett's conservative gameplay in the first quarter begs another question: Will he make any moves on Wells Fargo (WFC -1.11%)? Buffett has owned the stock since 1990 and it's been widely considered one of his favorite banks. But in recent years, the legendary investor has blasted the bank for its phony-account scandal in 2016, in which bank employees created two million fake bank accounts. Buffett also recently reduced his stake in Wells Fargo by nearly 15% in the fourth quarter of 2019. As the coronavirus pandemic continues to hamper the economy and the bank continues to face regulatory scrutiny, will Buffett do anything?

Image source: Getty Images.

Outlook worsens for Wells Fargo

The big banks are all setting aside billions of dollars to prepare for loan losses resulting from social distancing measures that have essentially put the economy at a standstill. Those losses will eat into profits. The problem with Wells Fargo, as UBS analyst Saul Martinez said in a recent research note, is that it's difficult to see how the bank will generate any significant earnings in the second quarter.

After the phony account scandal in 2016, the Federal Reserve placed an asset cap on the bank, limiting Wells Fargo to $1.95 trillion in assets. The asset cap is measured on a two-quarter daily average basis and must be below $1.952 trillion at the end of the quarter, according to Wells Fargo CEO Charles Scharf. On March 31, the cap was at $1.943 trillion . 

So, Wells Fargo essentially has no more room to lend. That makes generating income particularly tough, because to generate any significant interest income while interest rates are at zero, banks need to lend a lot. The Fed has allowed Wells Fargo to make loans through the Paycheck Protection Program, but those will generate very little interest income and the bank must forfeit all fees it makes from the loans. 

Now, I don't think most banks are too concerned about lending right now because they have their hands full putting out fires from other existing loans and issuing PPP loans. But despite the effect of coronavirus, other large banks like JPMorgan Chase (JPM 0.15%) and Bank of America (BAC -1.07%) generated net interest income in the first quarter that was not too far off from what they produced in the first quarter of 2019.

Net interest income at Wells Fargo dropped by about a billion on a year-over-year basis. The bank also saw non-interest income drop significantly relative to its peers. This could be because of the asset cap, but Scharf said on the company's recent earnings call that the bank was "not looking for NII (net interest income) growth, and I'm sure it will be down by some amount," referring to net interest income from the first to second quarter .

Not enough reserves?

Potentially magnifying this problem is that Wells Fargo currently has set aside a much smaller allowance for credit losses than its peers, which represents the total amount of cash that companies set aside to cover loan losses. 

Sources: Company investor relations. As of Mar. 31, 2020.

As you can see above, Wells Fargo has set aside about $5 billion less than Bank of America and more than $10 billion less than JPMorgan and Citigroup (C -1.09%). Its coverage ratio -- a measure of total reserves to total loans expressed as a percentage -- is only 1.19%, again much smaller than its peers. The interesting thing is that during the first quarter, all banks adopted the new current expected credit losses (CECL) accounting method, which requires banks to forecast losses over the life of loans as soon as they are originated. While Bank of America, JPMorgan, and Citigroup all added to their reserves by about $3 billion or $4 billion as a result of CECL, Wells Fargo actually reduced its total reserves by about $1.3 billion because of CECL .

Wells Fargo CFO John Shrewsberry attributed the drop in reserves from CECL to the bank's loan mix -- Wells Fargo has a much smaller percentage of credit card loans than the other banks, historically one of the most risky loan categories. However, in his research note, Martinez said he thinks the bank will need to increase its reserves in the coming quarters due to some of its commercial exposure. Rising reserves and declining profits are never a good combination.

Will Buffett sell Wells Fargo?

Wells Fargo certainly faces some challenges ahead as it fights lower profits and regulatory restrictions dogging its business. But I still think it would be unlikely for Buffett to sell his entire stake in the bank, although he may continue to curb his position. After all, not all at the bank is bad. Wells Fargo has a high percentage of interest-bearing deposits that should continue to reprice down throughout the year as a result of the Fed's decision to rapidly drop rates to zero in March. That will reduce the bank's total funding costs and should help its margin a little bit. 

Additionally, management seemed confident in the bank's ability to keep paying its dividend. Its common equity tier 1 capital ratio (CET1), a measure of a bank's core capital to its risk-weighted assets, remained at 10.67% after the first quarter . As long as this ratio stays above 9%, the bank will likely not be limited in its ability to make capital distributions because it has more than $165 billion in retained earnings .

Perhaps the one benefit from the asset cap is that the bank is somewhat inhibited from increasing its risk-weighted assets, a big driver in significantly reducing many bank CET1s in the first quarter. "Based upon the assumptions that we've laid out in these very stressed environments, we do feel good about it (the dividend)," said Scharf. "But ultimately, the timing and the pace of the recovery is going to determine earnings capacity for everyone to be able to continue to support the level of dividends." (https://www.fool.com/earnings/call-transcripts/2020/04/14/wells-fargo-co-wfc-q1-2020-earnings-call-transcrip.aspx).

If Buffett sold his entire stake right now while Wells Fargo's stock is trading around $26 per share, he would lose a lot of his gains, and that seems unlikely given that he has owned the bank for three decades. Also, Buffett said at Berkshire's investor day that he does not see any special problems with the banks right now, meaning he likely expects them to recover to pre-coronavirus levels. I'm expecting Berkshire to hang on to at least some of its Wells Fargo stock for now.