I think many investors have been willing to give Wells Fargo (NYSE:WFC) the benefit of the doubt over the past few years. After its phony-account scandal in 2016, the bank agreed to pay a massive $3 billion settlement. Then the Federal Reserve placed a $1.95 trillion asset cap on the bank. Then the coronavirus pandemic hit.

While the company's stock price continued to fall, many saw it as an opportunity to get in on a bank with a strong business model that's too big to fail. The upside seemed enormous, and still could be.

But after a disastrous second quarter resulting in a $2.4 billion loss and an 80% reduction in the quarterly dividend, it's hard to make excuses for Wells Fargo's worst quarter since the Great Recession.

Wells Fargo

Image source: Wells Fargo.

An enormous unexpected credit provision

Wells Fargo's $2.4 billion loss ($0.66 per share) was far worse than most analysts expected. I'll give the bank a pass for its drop in revenue, which declined $3.7 billion from the second quarter of 2019. After all, the asset cap prevents Wells Fargo from expanding its balance sheet, which is the main way to counter smaller loan spreads resulting from the Fed dropping interest rates to zero.

What's hard to excuse is the absurdly high $9.5 billion provision expense (cash that banks set aside to cover potential loan losses) that Wells Fargo took in the second quarter, which is more than double what it took in the first quarter.

Bank Q2 Credit Provision
JPMorgan Chase (NYSE:JPM) $10.5 billion
Bank of America (NYSE:BAC) $5.1 billion
Citigroup (NYSE:C) $7.9 billion
Wells Fargo $9.5 billion

As you can see above, other large banks took big provisions as well. But Wells Fargo is much smaller than JPMorgan Chase in terms of total assets. Furthermore, it has a much smaller credit card loan book, which tends to have higher losses, than both JPMorgan and Citigroup. In terms of commercial and credit-card loan exposure, its loan book is much more similar to that of Bank of America, which only took a $5.1 billion quarterly credit provision.

Bad loan projecting in Q1

The pain for Wells Fargo came from its commercial loan portfolio. The bank boosted reserves to account for potential commercial losses by nearly $6.4 billion in the quarter. Commercial loans are facing enormous pressure since the pandemic not only vastly reduces foot traffic at businesses and in public, but also changes the potential value and demand for some buildings, not to mention hurting the oil and gas industry. In its earnings presentation, Wells Fargo projects that commercial real estate prices will fall somewhere in the low- to mid-teen percentages. 

I don't have an issue with the bank provisioning conservatively, but the reason it had to take such a big provision in the second quarter is that it did such a poor job of properly projecting losses and economic conditions in the first quarter.

 Bank Q1 Allowance for Credit Losses  Coverage Ratio 
Wells Fargo $12.0 billion 1.19%
Bank of America $17.1 billion 1.51%
Citigroup $22.6 billion 2.91%
JPMorgan Chase $25.4 billion 2.32%

Source: Company SEC filings.

As you can see above, Wells Fargo set aside far less cash to cover total potential loan losses than its peers, not just from a total cash perspective, but also as a percentage of total loans (coverage ratio), which is a better comparison.

The way Wells Fargo calculated its allowance for credit losses in the first quarter of the year seemed more hopeful than conservative. Many banks in the first quarter, including Wells Fargo, adopted a new accounting method called the current expected credit losses (CECL) method, which essentially requires banks to forecast losses on the life of a loan as soon as that loan is originated and added to the balance sheet.

While many banks ended up significantly increasing their total reserves to account for this new methodology, Wells Fargo said CECL actually decreased its total reserves by $1.3 billion. So, even when the bank took a $3.8 billion credit provision in the first quarter to account for potential loan losses from the coronavirus pandemic, it only ended up increasing its reserves to cover potential losses from commercial and industrial loans by $630 million in the first quarter, a modest number considering economic conditions.

The bank also ended up decreasing its reserves to cover potential losses on commercial real estate and commercial real estate construction loans in the first quarter by $388 million and more than a $1 billion, respectively. I know accounting policies are complex, but this makes very little sense to me. When the first quarter ended, many states had already begun to implement shelter-in-place orders, and many banks were already bracing for huge losses. Seems like an odd time to decrease reserves for these commercial categories.

CEO Charlie Scharf said on the company's earnings call that "our view of the length and severity of the economic downturn has deteriorated considerably from the assumptions used last quarter, which drove the $8.4 billion addition to our credit loss reserve in the second quarter." He also acknowledged that "we are extremely disappointed in both our second-quarter results," and that despite the pandemic, "our franchise should perform better."

Scharf was brought in to clean up Wells Fargo after the bank's phony-accounts scandal. He has decades of experience in executive roles at financial institutions, previously serving as the CEO of Visa and the Bank of New York Mellon, and holding other various leadership roles at Citigroup and JPMorgan. He is a protege of JPMorgan Chase CEO Jamie Dimon. So it's concerning to see someone with so much experience allow the company to use such upbeat and ultimately wrong assumptions. Isn't a big rule in banking to always be conservative and prepare for the worst?

Wells Fargo has never really been known to have credit problems; even in the Great Recession, the bank performed reasonably well compared to others. Now would be the worst time for the bank to add another issue to its list.

Management needs to do better

To Scharf's credit, he did basically acknowledge the bank messed up. Also, the bank's allowance for credit losses as a percentage of total loans is now in a much better place at 2.19%, up a whole percentage point from Q1.  Scharf is also in the process of revamping senior leadership and said the bank needs to cut $10 billion in expenses.

All of this should greatly help the company if executed properly, but the second quarter did not reflect well on Scharf or the rest of Wells Fargo's management team, and now leadership must do better.