Big banks have less than a month to submit their capital plans to the Federal Reserve as part of their annual Comprehensive Capital Analysis and Review. Wells Fargo & Co (NYSE: WFC) is off to shaky start to 2018, and analysts say this year’s Fed stress test will be harder on Wells Fargo than most other banks.
In February, the Fed released the details of this year’s stress test scenarios. According to Bank of America analyst Erika Najarian, the 2018 severely adverse scenario is more severe than expected. This year’s severe scenario includes a rapid 51 percent drop in equity markets and ultimately a 65 percent overall stock market decline. Last year’s test included only a 50 percent decline in the stock market over four quarters.
For Wells Fargo investors, the more troubling aspect of the scenario is the steep, double-digit decline in the real estate market in only two quarters. Wells Fargo must prove that it can maintain adequate capital given a rapid stock market sell-off, a 23 percent decline in the home price index and a spike in mortgage rates to 6 percent. In last year’s severe scenario, mortgage rates peaked at just 4.6 percent.
“This does not only slow down mortgage revenues more, but also could imply steep mark-to-market losses on bank securities portfolios under stress,” Najarian says.
Of all the banks subject to CCAR, Wells Fargo has the second-highest portfolio exposure to residential mortgage-backed securities. Bank of America estimates RMBS represent about 59 percent of Wells Fargo’s total securities, second only to UBS Group ( UBS) at 69 percent.
This year’s stress test may limit Wells Fargo’s ability to boost its dividend and share buybacks in the near term. However, Najarian says the Trump administration will likely continue to ease the regulatory burden on banks, which could result in looser regulations by the time the 2019 CCAR rolls around.
Najarian says long-term Wells Fargo investors should remain patient.
“We believe WFC deserves to trade at a premium due to better earnings growth, but we are assuming WFC trades in line with peers due to a higher percentage of earnings from mortgage banking and accretable yield, as well as potentially greater regulatory scrutiny as the second largest US depository,” she says.
The Fed is expected to release CCAR results by June 30.
Bank of America has a “buy” rating and $69 price target for Wells Fargo stock.
Wayne Duggan is a freelance investment strategy reporter with a focus on energy and emerging market stocks. He has a degree in brain and cognitive sciences from the Massachusetts Institute of Technology and specializes in the psychological challenges of investing. He is a senior financial market reporter for Benzinga and has contributed financial market analysis to Motley Fool, Seeking Alpha and InvestorPlace. He is also the author of the book “Beating Wall Street With Common Sense,” which focuses on the practical strategies he has used to outperform the stock market. You can follow him on Twitter @DugganSense, check out his latest content at tradingcommonsense.com or email him at firstname.lastname@example.org.