What Wells Fargo’s Credit Freeze Tells Us About Earnings Season

Since the pandemic started twisting consumer finances, I have been watching the credit markets especially closely for the faintest hint of strain. I’m evidently not alone.

This week’s news that Wells Fargo & Co. (NYSE:WFC) is terminating all consumer credit lines raised plenty of eyebrows across Wall Street, especially with an earnings report right around the corner. The timing feels a little too coincidental and, if my intuition is right, investors could be in for a stormy summer.

Pulling The Plug on $25 Billion

Reading between the lines, pulling the plug on existing lines of credit means Wells Fargo is effectively closing the books on as much as $25 billion in consumer debt. For you and me, that would be a huge amount of money, and it’s going to be a headache for people who relied on keeping that money available.

But in the grand scheme of things, that money only represents 6% of the bank’s consumer loan book. Furthermore, it’s not like Wells Fargo is writing off all that credit. New borrowing is frozen but existing balances roll over onto a fixed-rate repayment plan.

Of course, bankers rarely exit a once-successful business unless they either can generate higher returns on capital elsewhere or they see borrowers struggling to make their payments. Wells Fargo has effectively made the first argument here.

The underwriters aren’t talking about increased risk or higher default rates. But the executives aren’t convincing when they talk about “simplifying” their product offerings here.

Pushing consumers who once relied on these credit lines into more traditional loans or credit cards probably won’t generate higher profits per dollar of capital. The risk-adjusted interest charges are at best comparable.

And that tells me the underwriters probably flashed a warning signal. We saw something similar a year ago when Wells Fargo and peers like JPMorgan Chase & Co. (NYSE:JPM) stopped taking applications for home equity lines of credit.

At the time, the motive clearly revolved around protecting the banks from extending too much credit in a deteriorating economic environment. It was a risk reduction measure, not any kind of operational pivot.

Maybe Wells Fargo remains confident that U.S. consumers have weathered the lockdowns and can pay the bills as government support recedes. If so, I wish they’d tell us.

Because the alternative is that they’re cutting risk because they see increasing strain ahead. Bankers hate getting caught in an economic storm so much they’ve practically learned to predict the weather.

A Warning Ahead of Earnings

Watching them, we can pick up on their cues and protect ourselves. That’s where the timing of this announcement comes in.

Remember, the big banks are reporting their quarterly numbers next week, kicking off a critical earnings season. We’re already anticipating a significant year-over-year drop in revenue across the group.

Trading fees are down because the market has calmed down a lot in the past 12 months. Interest income has cratered and won’t recover until the Fed can start tightening rates again.

On paper, the banks have come a long way back from last year’s lows, but they still have a long way to go before they can show shareholders anything like the money that they made in 2019.

But that longer-term erosion is already factored into the stocks at these levels. The only question is whether the recovery will play out as fast as everyone on Wall Street currently expects.

If so, great. Bank stocks can rally and start the season off in a bullish direction.

However, if guidance is too weak to hit our standing targets, the bears go on the offensive. And after the first headline miss, investors will start second-guessing all assumptions looking for a reason to sell.

Any deterioration in credit quality or uptick in loss reserves would qualify as a sign that not everything is perfect in the banking environment. It would even cast a shadow on other sectors. 

Can the retailers muddle through if U.S. households need to tighten their budgets? Will auto sales trends continue? You see the logic. Without access to credit, the consumer boom we’re enjoying now might not last long.

I’m hoping Wells Fargo and its peers will surprise to the upside. But we’re planning for the worst, just in case. My Value Authority is only buying the highest-quality banks that never got into the riskier areas of the credit market.

As a bonus, these stocks are relatively defensive. They pay much higher cash dividends than the big banks. They’ll ride out any market storm in strength.

And if the skies get cloudy this earnings season, opportunistic options strategies are the perfect way to not only take shelter but make money on the downpour. 

My High Octane, 2-Digit Trader and Triple-Digit Trader portfolios have all been raking in cash buying puts, sometimes against stocks like Wells Fargo.