Wells Fargo Misjudged Risks of Energy Financing

Last year, after bank examiners marked many energy loans with tougher ratings than lenders thought necessary, the OCC was flooded with appeals, the person said. In September, regulators from the OCC, the Federal Reserve and the Federal Deposit Insurance Corp. met with dozens of energy bankers at Wells Fargo's office in Houston.

The disagreement centered on how to rate the risk of reserves-based loans. Banks insisted that, in a worst-case scenario, they'd be made whole by liquidating the properties. Regulators pushed lenders to focus instead on a borrower's ability to make enough money to repay the loan, according to the person familiar with the discussions. The agency reinforced its position with new guidelines published last month that instructed banks to consider a company's total debt and its ability to pay it back when gauging a loan's risk. Bill Grassano, an OCC spokesman, declined to comment.

"The regulators are taking a stronger stance on cash-flow protection rather than collateral coverage," said Julie Solar, a senior director of financial institution ratings at Fitch Ratings Ltd. "There were a lot of disagreements and a lot of appeals. There's a difference between the banks' view of the ultimate risk of loss and the regulators' view."

Downgrading Loans

The new guidelines mean banks will have to downgrade loans and set aside more cash to cover losses. Oil and gas producers owed Wells Fargo $9.6 billion at the end of 2015, about 55 percent of the bank's outstanding energy loans, company filings show. Most of that debt is backed by reserves, the bank has said.

"The tougher standard makes it more expensive for the banks to make loans to the energy business," said Buddy Clark, a partner with law firm Haynes & Boone in Houston. "But if the banks foreclosed now and tried to sell the properties, they'd have to take a loss. If it happens all at once, it'll be a disaster where all of these properties come on the market at the same time."

It's been a bruising reversal for Wells Fargo. Less than two years have passed since Mike Johnson, then head of commercial lending, told investors the energy business was "a major growth opportunity." The firm had expanded its energy team to 400 people, with offices in Calgary and Aberdeen, Scotland, and doubled its loan exposure to the industry, he said at the May 2014 event. Wells Fargo had also become the top energy investment bank and had acquired BNP Paribas SA's energy-lending group in 2012.

"We'd just gone through this very significant recession, and energy was one of the bright spots to invest in," said AlixPartners's Cassidy, who predicted an oil bust in 2013 and warned of the financing risks. "It solidified this thesis that oil was a recession-proof commodity. You had enormous growth in energy finance with people who hadn't ever seen one of these cycles before."

Spillover Risk

Even a total wipeout isn't likely to threaten Wells Fargo's stability. The reserves-based loans, though riskier than expected, will still pay off significantly better than unsecured bonds, where some investors have seen near-complete losses. And if oil prices rise, the collateral value and the cash flow of the borrowers will improve.

Wells Fargo stock, down 13 percent this year, has taken a beating because of energy exposure, but the concerns are overblown, said Tony Scherrer, director of research and portfolio manager for Smead Capital Management in Seattle, which has $2.4 billion in assets including more than 1.5 million Wells Fargo shares. 

"They got into energy late," Sherrer said. "They got excited about it. Was that a mistake? Maybe yes. But what's the actual exposure? It's actually pretty small."

The larger risk is spillover. After the 1980s oil bust, hundreds of lenders failed in oil-dependent states including Oklahoma and Texas as their economies tanked. U.S. oil companies have cut more than 100,000 workers since late 2014, and Oklahoma and Texas are already seeing a rise in credit-card delinquencies and auto-loan defaults. Banks are closely monitoring the housing market and commercial real estate in those regions for signs of cracks in larger parts of their loan portfolios.

Some lenders are pulling back. In 2014, two years after selling its energy unit to Wells Fargo, BNP Paribas, the largest French bank, decided to get back into reserves-based lending. In February, it announced it was abandoning the business for the second time in four years.