Wells Fargo: Fed Lawsuit Loser

NEW YORK ( TheStreet) -- Wells Fargo ( WFC) was the loser among the largest U.S. financial companies on Tuesday, with shares sliding 2% to close at $35.22.

David A. Montoya, Inspector General of the Department of Housing and Urban Development announced that the federal government had filed a civil fraud lawsuit against Wells Fargo's main banking subsidiary Wells Fargo Bank, NA, seeking damages "for more than 10 years of misconduct in connection with WELLS FARGO's participation in the Federal Housing Administration ("FHA") Direct Endorsement Lender Program."

U.S. Attorney Preet Bharara was typically colorful, saying that "yet another major bank has engaged in a longstanding and reckless trifecta of deficient training, deficient underwriting and deficient disclosure, all while relying on the convenient backstop of government insurance," and that "Wells Fargo's bonus incentive plan - rewarding employees based on the sheer number of loans approved - was an accelerant to a fire already burning, as quality repeatedly took a back seat to quantity."

Bharara added that "even after concerns were raised internally at the bank, Wells Fargo began self-reporting bad loans in a significant way, as required, only after this Office issued a subpoena last year."

Wells Fargo said in a statement that "many of the issues in the lawsuit had been previously addressed with HUD," and that the bank "is the leading FHA lender and has acted as a prudent and responsible lender with FHA delinquency rates that have been as low as half the industry average." The company also said it would "present facts to vigorously defend itself against this action."

The Dow Jones Industrial Average and the S&P 500 ( SPX.X) both saw 1% declines, and the NASDAQ Composite dipped 1.5%, as investors continued to wait for Spain to request a European bailout.

Among the large-cap stock losers was Johnson & Johnson ( JNJ), which was downgraded by Goldman Sachs analyst Jami Rubin to a "Sell" rating from a neutral rating, because of "limited upside to our price target (7% total annual return for JNJ including dividends vs. our coverage group average of 14%)."

Rubin's 12-month price target for JNJ is $72. The analyst said that "although JNJ has potential for improved growth, we believe this is already captured in valuation," and that the company is "lacking transformational pipeline opportunities and less inclined to do shareholder-friendly capital allocation."

Rubin's downgrade to a "Sell" rating seems particularly harsh, because Goldman Sachs ( GS) and JPMorgan Chase structured Johnson & Johnson's huge acquisition of Synthes in June.

Turning back to financials, some day traders may have been scratching their heads earlier on Tuesday when trades of the Financial Select Sector SPDR ( XLF) were apparently misquoted, according to a MarketWatch report.

The reported quoted Eric Hunsader -- founder of market research firm Nanex -- as saying that an XLF trade that was apparently mispriced at 16.4940 "should probably be 16.0494," and that "another example was 16.4540 instead of 16.0454."

The Financial Select Sector SPDR ended the trading session at $15.94, down 1% for the session.

The KBW Bank Index ( I:BKX) was down 1% to close at 50.85, with all but two of the 24 index components showing declines for the day.

In his firm's third-quarter bank earnings preview, Oppenheimer analyst Terry McEvoy said that "the general upward move in the equity markets, more favorable housing trends and a resurgence in acquisition activity late in the quarter contributed to the solid performance" of financial stocks, but "with earnings beginning to flatten out, near-term loan growth expectations overly aggressive, and the negative margin trajectory, we have a more balanced view of the regional banks today with higher mortgage and asset management revenue and a drop in environmental costs providing some near-term relief."

With steadily improving credit quality, most banks have seen their earnings boosted over the past two years through the continued release of loan loss reserves. McEvoy said that "consensus estimates show the top 100 regional and small banks have finally hit their earnings wall as the benefits of lower provisions for reserves have now passed. Earnings for these banks are expected to be flat from the prior quarter and show a 5.7% increase from 3Q11."

Wells Fargo


Wells Fargo's shares have now returned 30% year-to-date, following a 10% decline during 2011.

The shares trade for 2.1 times tangible book value, according to Thomson Reuters Bank Insight, and for 10 times the consensus 2013 earnings estimate of $3.67, among analysts polled by Thomson Reuters. The consensus 2012 EPS estimate is $3.33.

Wells Fargo's shares trade at much higher to book value than the other three members of the "big four" U.S. banking club, reflecting the firm's stronger and more consistent earnings. According to Thomson Reuters Banking Insight, the company's return on average assets for the 12-month period ended June 30 was 1.30%, while its return on average tangible common equity was 15.86%.

The company will report its third-quarter results on Friday, with a consensus EPS estimate of 87 cents a share, increasing from 82 cents in the second quarter, and 72 cents during the third quarter of 2011.

With the mortgage refinancing wave continuing, analysts expect another solid quarter for Wells Fargo's mortgage production and gains on sale of new loans, but the company has already signaled that it will report a major narrowing of its net interest margin, which is the spread between a bank's average yield from loans and investments and its average cost for deposits and borrowings.

At a conference on Sept. 11, Wells Fargo Wells Fargo CFO Tim Sloan said that although the company achieved a "stable" net interest margin during the second quarter, in part because of "a 7 basis point linked quarter benefit from higher variable items," the margin for the third quarter "could be similar to what we experienced in the third quarter of last year when our net interest margin was down 17 basis points."

According to Guggenheim Securities analyst Marty Mosby, among the largest U.S. bank holding companies, "Wells Fargo has the most margin compression today expected over the next year," as the company has a large percentage of assets with original maturities of greater than three years, that are "repricing down now, lower than they were three years ago."

Oppenheimer analyst Chris Kotowski rates Wells Fargo "Outperform" with a 12-18 month price target of $40, saying on Sept. 25 that "we think deposit growth will help offset some of the margin contraction and mortgage banking revenue has been very strong and is likely to continue to be so for the back half of the year."

"With WFC, the risk to the downside is always on the expense side, and the company has had to pull back on some of the earlier promises made to get its quarterly expenses in the $11B range," Kotowski said, adding that "while we are modeling $11.8B in expenses for this quarter and $11.5B for next, we realize that is nudging up against the guidance and that if Wells misses, it is the likeliest to be there."

SunTrust


SunTrust ( STI) was the winner among the largest U.S. banks on Tuesday, with shares rising 2% to close at $30.10.

SunTrust's shares have been quite volatile over the past few sessions. The Atlanta Lender will announce its third-quarter results on Oct. 22, with the consensus among analysts being a profit of $1.78 a share (including several extraordinary items), increasing from 50 cents the previous quarter, and 39 cents a year earlier.

SunTrust's shares have risen 19% since the company announced on Sept. 6 that it would end its investment in Coca Cola ( KO), in order to shore up its capital ratios, because the Federal Reserve's proposed capital rules will increase the risk weighting of banks' equity investments.

The company accelerated two forward purchase agreements to sell its Coke shares, while also transferring $3 billion in portfolio loans to held-for-sale, and said that the moves, along with other actions, would lead to a pretax third-quarter gain of $1.9 billion, or $1.2 billion after taxes.

The company also announced it would transfer roughly $3 billion in loans to held-for-sale, including performing student loans and nonperforming residential mortgage and commercial real estate loans, resulting in pre-tax charges of $250 million, and that "in light of ongoing discussions with Fannie Mae ( FNMA) and Freddie Mac ( FMCC)," it expected "to record an estimated $375 million mortgage repurchase provision during the quarter."

The shares have now returned 72% year-to-date, following a 40% decline during 2011, and trade for 1.2 times their reported June 30 tangible book value of $26.02, and for 11 times the consensus 2013 EPS of $2.78. The consensus 2012 EPS estimate $3.27.

KBW analyst Jefferson Harralson rates SunTrust "Outperform," with a price target of $34, and estimates that the company "to report a 3Q12 GAAP number of $2.04," but that after adjusting for the one-time items, the company will have a third-quarter operating loss of 20 cents a share.

Harralson expects investors to look beyond the extraordinary items and focus on SunTrust's net interest margin, which expects to be flat from the third quarter, and "loan growth (which we estimate at 5% annualized)."

With mortgage putback exposure "mostly ring fenced," Harralson said that "investors should now look to the efficiency ratio and profitability statistics as the next large earnings lever. Management has been consistent in saying it can get to a 60% or below efficiency. If STI could show expense progress in this difficult quarter, investors could be heartened that a 60% efficiency ratio is possible."

A bank's efficiency ratio is, essentially, the number of pennies of overhear expenses it incurs, for each dollar of revenue.

STI Chart STI data by YCharts

Interested in more on SunTrust? See TheStreet Ratings' report card for this stock.

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-- Written by Philip van Doorn in Jupiter, Fla.

>Contact by Email.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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