Case 7 Wells Fargo's Remarkable Ascent John A. Pearce II, Steven T. Woods, and Richard B. Robinson Jr. 1 In a five-year period ending in 2013, Wells Fargo & Company, an American multinational banking and financial services holding company with operations worldwide, grew rapidly to become the largest bank in the United States as measured by market capitalization and the fourth largest bank based on assets. Its ascendance was rapid but never certain. 2 The December 2007 to June 2009 financial crisis in the United States changed the landscape of mortgage lending. Leading up to the recession, many banks issued subprime and adjustable-rate mortgages. With a greater availability of credit and the belief that housing prices never declined, customers were increasingly borrowing maximum amounts from banks to purchase homes, often with very small or no down payment. Seemingly, every applicant qualified. One analyst quipped that any mortgage applicant who could "show breath on a mirror" qualified for a loan. When the housing bubble burst and the financial crisis took hold in late 2007, many borrowers had trouble paying their mortgages, and a number of banks and financial institutions suffered such great losses that they were forced to merge to avoid bankruptcy. 3 One of the largest mergers in the banking industry involved San Francisco-based Wells Fargo's purchase of Wachovia Corporation for $15 billion in 2008. With this purchase, Wells Fargo became the third largest bank in the United States as measured8:45 Gmail X 524584085.pdf .. . by total deposits. The acquisition also created the largest corporate network of branch banks in the United States and added considerably to Wells Fargo's portfolio of mortgages. While the purchase of Wachovia involved sizable risks, Wells Fargo was eventually able to improve its newly combined mortgage business and become one of the top performing banks in the United States. 4 Wachovia became the target for a takeover by competitors, including Wells Fargo, when its financial performance plummeted because of its massive exposure to bad mortgage debt. The prelude to Wachovia's troubles occurred in 2006 when the company purchased the California-based mortgage lender Golden West Financial Corp. for $25.5 billion in order to expand its mortgage business. With housing sales booming in California and Florida at the time, Wachovia looked for growth in those markets through the purchase. However, in 2008, when the housing bubble started to burst, Wachovia's mortgage portfolio was exposed to reveal an extremely high risk level. 5 Because of the depth of Wachovia's financial trouble, it engaged in merger talks with Morgan Stanley. When the negotiations failed, the federal government moved in and pushed Citigroup to purchase the struggling company. A central element of the proposed government-brokered deal to have Citigroup acquire Wachovia was a provision that guaranteed that the government would absorb any loan losses that Citigroup might incur over a $42 billion cap. The proposed deal was praised by Citigroup investors, but was not favorable for taxpayers because it put their dollars at risk. 6 Although the deal was being negotiated for Citigroup to purchase Wachovia, Wells Fargo stepped in and successfully purchased Wachovia by offering a higher price. The acquisition added considerably to Wells Fargo's mortgage business, which in 2008 accounted for 11.2 percent of mortgages in the United States. Wachoviashareholders received 0.1991 share of Wells Fargo stock per one share of Wachovia stock, which put the value of Wachovia at $5.87 per share. When Wachovia purchased Golden West in 2006, the company's stock was at $59.39 per share. The drop in stock price marked a 90 percent decrease in market capitalization. 7 Unlike many of the large bank competitors that had bundled their loans into mortgage securities and then resold them to investors, Wachovia retained many of the mortgage loans. By keeping the loans it wrote, Wachovia had considerably lower returns than its largest competitors but much greater control over the majority of its mortgage-related investments. Consequently, Wells Fargo was able to restructure many of the Wachovia loans so that customers would not default. Wells Fargo also had more stringent credit standards for the mortgage loans that it approved, which decreased the number of risky loans it had issued that in turn led to a lower rate of foreclosures. 8 The financial crisis caused extreme economic stress on the U.S. market in 2007-2008, and declining interest rates beginning in 2009. Nevertheless, by adding 3,400 new retail branches to its network, Wells Fargo was able to achieve such high levels of market penetration and operational efficiencies that it was able to optimally benefit from any pockets or types of borrowing that occurred. Furthermore, complementing the U.S. federal government's tightening of the banking industry's standards for lending, Wells Fargo altered its operations to be a more "old-fashioned bank" by making loans that it would hold on its own books. This policy disciplined the company to improve its lending criteria and make less risky loans. 9 In addition to Wells Fargo's improvements in its mortgage business, the company also undertook changes in a number of other areas. Unfortunately, these changes would not be viewed as favorably. Customers who had free checking at Wachoviafaced a $7 monthly fee when their accounts converted to Wells Fargo, which they interpreted as a shortcoming of Wells Fargo. Customers also took issue with a declining level of customer service at Wells Fargo. This perception led J.D. Power and Associates to downgrade Wells Fargo's customer service rating to below average among its competitors. Even employees from Wachovia who were retained by Wells Fargo were disgruntled when they lost some of their paid holidays as a result of the merging of management philosophies. 10 Despite selected instances of employee and customer dissatisfaction, Wells Fargo thrived. Analysts Shayndi Raice and Nick Timiraos conducted an analysis of the company's mortgage loan business, which explored Wells Fargo's progress and provided details on its impressive inroads into the New York and San Francisco markets. They found that in 2012, Wells Fargo's mortgage business accounted for 28.8 percent of home loans issued nationwide, making it the largest lender in the country. Its portfolio of loans accounted for over $524 billion, the largest annual total ever for one bank. This amount was greater than the combined loans issued by the next five largest banks. A result was net income of $18.9 - billion for 2012, two times greater than Wells Fargo's profit in 2007.] 11 Contributing to Wells Fargo's comparative progress was the lack of success by its competitors. For example, shortly after its purchase of Countrywide Financial in 2008, Bank of America (BOA) was the largest lender. But with hundreds of thousands of defaulted loans, BOA's share of the mortgage business dropped from 21.6 percent in 2009 to 4.3 percent in 2012. Citigroup and Ally Financial also lost market share during this period, enabling Wells Fargo to take over as the nation's top lender. 12 The challenge for Wells Fargo in 2013, as Raice and Timiraos reported, was to maintain its success in mortgage lending. With interest rates rising andforecast to increase further in 2014, fewer loan initiations and fewer mortgage refinances were anticipated. Such declines would hurt Wells Fargo's profits, since more than 65 percent of its mortgage production in 2012 came from refinancing. 13 Therefore, Wells Fargo altered its plans. The company cultivated relationships with real-estate agents and developers in an effort to persuade them to use Wells Fargo as their preferred lender, enabling the bank to increase its mortgage loans in preferred markets. This move helped produce Wells Fargo's market share lead in mortgage loans in 2012. In that year, the bank issued over 20 percent of new home loans in both the New York and San Francisco markets, equaling the new home loan issuance of its two largest competitors combined. 14 Wells Fargo saw portfolio lending in New York, San Francisco, and other expensive markets as a way to access high net worth borrowers, who provided disproportionally high per capita profits for the bank. To make inroads against its competition, Wells Fargo studied the nuances of each market. For example, Raice and Timiraos reported that in San Francisco an industry-high percentage of young technology entrepreneurs were buying multimillion-dollar homes in 2013, when only months earlier they had been paying less than $3,000 a month in rent. When these buyers faced a monthly mortgage payment of $30,000 on their new homes, Wells Fargo could not utilize its previous approval process and standards to get their loans approved. Adopting an uncharacteristically aggressive posture, the bank revamped its approval standards to accommodate the changing competitive pressures. 15 With the anticipated loss in revenue from reduced refinancing activity, Wells Fargo pushed for new business in new markets. In 2001, Wells Fargo had 150 loan salespeople in San Francisco. But with its push for more mortgages in the Bay Area, Wells Fargo brought in an additional 450 salespeople tobring the total to 600 by 2013. 16 The New York market was far more complex than the one in San Francisco, as Raice and Timiraos reported. With a unique mix of co-op apartments and expensive condominiums, national mortgage lenders had difficulty gaining penetration in New York. In its specialized market segments, a lender had to assess the financial strength of the borrower and the building, adding to the complexity of the loan process. The makeup of the borrowers was also different in New York from other markets. Many high net worth mortgage applicants had resources committed to investments in unique business partnerships, had lower percentile incomes than their very high total assets might suggest, and were self-employed. 17 An indication of its success in working with real- estate agents and developers, in Raice and Timiraos's view, was that Wells Fargo became the preferred lender of Brown Harris Stevens and Halstead Property, two of the largest brokerages in New York City. Wells Fargo also created DE Capital as a joint venture with Douglas Elliman, the largest brokerage in New York City. The benefit was that 50 percent of Douglas Elliman clients applied for their mortgages through Wells Fargo. 18 Other tactics that led Wells Fargo to be successful in the New York market included creating a clearinghouse of information for New York loan officers. The database provided information on whether loans qualified for backing from Fannie, Freddie, and the Federal Housing Administration. If the loans were eligible for backing, the process for buyers to purchase units was accelerated for certain condo developments. 19 Wells Fargo overhauled its operations to reduce costs and improve the bank's technology. To cut costs in its branches, the bank improved its online and mobile banking operations. With its improved technology, customers needed less retail branch assistance, which decreased the need for retail534 of 788 branch employees. 20 With its dominance in the mortgage business, Wells Fargo doubled its return on assets between 2010 and 2013. Its profits for 2013 were projected to exceed 20 percent principally because of its increased effectiveness in generating profits from lending. Its mid-year price in 2013 was a historic high for the company of $43 a share. 21 While the large market share held by Wells Fargo was expected to decline as it increasingly shifted its focus on low-risk home buyers, the company's turnaround strategy had enabled it to thrive following the financial crisis in 2008. By 2013, Wells Fargo seemed well positioned to continue to strengthen its profitable operations. 1Dunn, A. 2012. "1 Year in, Change Visible at Wells Fargo." Charlotte Observer, October 13. 2Raice, S., and N. Timiraos. 2013. "Mortgage Gamble Pays Off for Wells." Wall Street Journal, April 3: A.1