DBRS Comments on Wells Fargo & Company 4Q10 Earnings - Senior at AA, Unchanged

DBRS has today commented on the 4Q10 operating performance and earnings of Wells Fargo & Company (Wells Fargo or the Company). The Company again reported record earnings on solid net income and revenues of $3.4 billion and $21.5 billion, respectively.

The Company’s quarterly financial performance reflected resilient revenue generation, improved credit quality, and modest loan growth despite persistent economic and regulatory headwinds. Moreover, liquidity and capital strengthened over the quarter. The increased earnings over the quarter occurred as the $655 million increase in non-interest income and $456 million decline in loan loss provision more than offset the $1.1 billion rise in expenses and $35 million decline in net interest income. Revenue grew across most business lines while 18 businesses produced double-digit (annualized) revenue growth. Those businesses were responsible for over 60% of the Company’s total revenue in the quarter. The Community Banking (excluding a $400 million charitable contribution) and Wholesale Banking segments turned in strong financial performances over the quarter while the Wealth, Brokerage and Retirement segment’s lower securities gains and other fees over the quarter constrained net income. Income before provisions and taxes (IBPT) was roughly flat with the prior quarter at $8.6 billion (excluding the $400 million charitable contribution) but was 13% lower compared to $9.8 billion in 4Q09 primarily reflecting lower mortgage servicing income, the lower level of loan balances, repositioning of the securities portfolio, Reg E and overdraft policy change impact, and higher collection and foreclosure expenses compared to the prior year quarter.

Despite the significant industry headwinds, DBRS continues to view the Company as well positioned to ride out a challenging operating environment and earn its way through the challenges. The Company’s balance sheet has strong levels of core deposit funding, ample liquidity and closely-managed risk exposures backed by solid capital levels. Lastly, the Wachovia integration appears to proceeding smoothly having already substantially achieved the expected cost saves without notable disruptions while experiencing lower than expected credit costs. DBRS also sees strong potential revenue opportunities from legacy Wachovia’s customer base, which are just beginning to be realized. Wells Fargo’s strong, broadly diversified franchise; its predictable, recurring earnings; consistent management and business strategy; strong capital levels and ample liquidity are commensurate with its Issuer & Senior Debt ratings at AA and Stable trend. DBRS, therefore, sees this quarter’s operating performance as consistent with Wells Fargo’s rating levels, which remain unchanged.

Net interest margin (NIM) of 4.16%, down 9 basis points (bps) from 3Q10, was primarily due to a 1.7% increase in earning assets at a 14bp overall lower yield. This marks the first quarter of sequential average earning asset growth for Wells Fargo since 4Q09 as it purchased investment securities and retained cash from the continuing deposit inflows, as higher yielding (and higher credit cost) non-strategic loans continued to run off. One-third of the NIM decline (3bp) was due to the decline in purchased credit impaired (PCI) resolution income compared to 3Q10.

Wells Fargo’s confidence in credit quality improvement continued as its credit reserve allowance declined $909 million (3.7%) in the quarter to $23.5 billion (including the reserve for unfunded commitments) as most credit metrics improved. 4Q10 net charge-offs (NCOs) declined 6.3% ($256 million) to $3.8 billion, or 2.02% of average loans (annualized), compared with $4.1 billion, and 2.14%, in 3Q10. Commercial net charge-offs fell 10%, or $111 million over the quarter, however, consumer charge-offs were down a more modest 4.8%, or $145 million.

Total nonaccrual loans decreased for the first time since 2Q07, falling $2.1 billion (7.3%) in the quarter to $26.2 billion (3.47% of total loans) at December 31, 2010 from $28.3 billion (3.76% of total loans) at September 30, 2010, and inflows decreased in every portfolio segment except Wells Fargo Finance, which increased 3%. The Company has written down its nonaccruals by approximately $6.6 billion, or 25%, to date. Commercial nonaccrual loans (which can be lumpy) fell 10.2%, or $1.29 billion, while consumer nonaccruals decreased 4.9%, or $770 million, both after peaking in the prior quarter. Foreclosed assets (non-GNMA) declined 2.3% to $4.5 billion in the quarter, but may rise given the 4Q10 industry foreclosure slowdown due to regulatory concerns. DBRS is mindful that the Company has approximately $10 billion in accruing consumer troubled debt restructurings (TDRs) of which a material portion may return to non-accrual and produce elevated losses. DBRS also expects nonperforming assets (especially consumer) to remain elevated well into 2011 due to stubbornly elevated unemployment levels and a struggling residential housing market, while the Company intends to continue its focus on loan modifications and workouts.

Positively, and looking forward, accruing loans 90+ days past due (excluding PCI and guaranteed/insured loans) declined 12.4% over the quarter to $3.8 billion, continuing the double-digit declining pace of the past four quarters. The Company’s $3.0 billion loan loss provision in the quarter, $456 million (13.2%) less than 3Q10, was $850 million below net loan charge-offs as the Company reiterated its comfort with reserve levels given current indications and expects further reserve release absent any significant economic deterioration. Other indicators of credit quality improvement included a 5% decline in 30 day past due loans in the consumer portfolio and continued better than expected performance in the PCI portfolio.

Loan loss reserves (excluding the reserve for unfunded commitments) totaled $23.0 billion (3.04% of total loans) at 4Q10 compared with $23.9 billion (3.18% of total loans) at 3Q10. The loan loss reserve now covers 88% of nonaccrual loans and 71% of nonperforming assets (54% of NPAs including accruing TDRs) both increasing over the quarter from 85% and 69%, respectively. DBRS notes that although reserve levels do not fully cover NPAs, the fourth quarter $5.2 billion buffer between provisions and IBPT, reflects its significant earnings power and provides considerable downside credit protection for the Company.

Wells Fargo disclosed a repurchase reserve of $1.3 billion (down $42 million in the quarter) against $2.9 billion in current original loan balance demands ($894 million or 23% lower than 3Q10). DBRS believes this to be an adequate coverage rate given the current trend of declining claims. DBRS views this dynamic situation with caution, however, as the rate of repurchase and severity rates could increase in the future. In addition, while Wells Fargo has a relatively small amount of (non-WFC) private label securitizations, losses could increase if investor behavior or legal precedents change.

Although generally a strong net revenue generator, DBRS sees the Company’s revenues as somewhat constrained in recent quarters primarily due to the difficulty in generating earning assets and elevated expenses given the current economic and regulatory environment. At the same time, however, Wells Fargo’s financial performance has reflected earnings resilience in rebounding non-interest income and the Wachovia franchise’s embedded growth potential. Outstanding end-of-period loans increased 0.5%, or $3.6 billion, over the quarter, as the active loan portfolio grew 1.5%, or $9.6 billion, and outstripped the 4.9%, or $6 billion, decrease in the non-strategic portfolios (certain home equity, indirect auto, debt consolidation, Pick-a-Pay, and Commercial / CRE PCI loans). Positively, 11 different business lines experienced loan growth in 4Q10 including mortgage, auto, commercial, CRE and asset-based finance.

Net interest income declined slightly to $11.06 billion in the quarter from $11.1 billion; however, it would have increased $68 million if the $103 million decrease in PCI loan resolution income were excluded. The 9 bps decline in net interest margin over the quarter to a best of class 4.16% was also primarily due to the aforesaid increase in lower-yielding average earning assets. Average non-interest bearing deposits grew an impressive 7.1% while average total deposits increased 2.7% over the quarter as Wells Fargo continues to generate organic growth from its customer base. The favorable customer shift away from time deposits into savings and checking accounts also continues unabated. Deposits are supportive to NIM with lower rate checking and savings accounts accounting for 90% of average core deposits while average core deposits funded 105% of loans for 4Q10. Interest-bearing deposits had a 4bp lower yield at 41bp for quarter, which declines to a mere 30bp when the funding is blended together with non-interest bearing deposits.

Non-interest income of $10.4 billion was up 6.7%, or $655 million, compared to the prior quarter with increases in very strong mortgage banking, trust and investment fees, insurance and trading revenues only partially offset by declines in deposit service charges (due to Reg E), and operating leases. The impact of Reg E and related overdraft policy changes was $431 million in 4Q10, a $51 million increase from 3Q10 and consistent with management’s previously communicated expectations although the number is expected to decline in 2011. Mortgage banking revenues increased $258 million, or 10%, in the quarter as low interest rates precipitated $128 billion in mortgage originations, up 27% from the prior quarter and a still robust $73 billion application pipeline (although down from $101 billion in 3Q10) which bodes well for 1Q11 originations. The strong mortgage banking performance more than offset the $276 million net decline in MSR-related items and fees, $200 million in volume-related expenses and $94 million net increase to the repurchase reserve.

Non-interest expense was up 8.9% ($1.1 billion) to $13.3 billion compared with $12.3 billion in 3Q10 primarily from the aforesaid $400 million charitable contribution (3 years funding for its Foundation), $200 million in seasonally higher expenses, the higher mortgage volume-related expenses, and elevated foreclosure ($86 million) costs. The efficiency ratio for the fourth quarter, therefore, deteriorated to 62.1% from 58.7% at 3Q10 and was further elevated relative to 56.5% at 4Q09. Wells Fargo is currently reviewing its expense base for streamlining and process improvement cost reductions but is also confident that integration and workout costs will decline over time.

According to DBRS, the Company’s financial fundamentals and capital position are sound and supportive of the Company’s rating level and Stable trend. Reflecting its capital strength, the Company’s estimated Tier 1 capital ratio improved 35 bps to 11.25% and Tier 1 Common Capital ratio grew 36 bps (all organically generated) to 8.37% in the fourth quarter. All regulatory ratios continue to be far above the well-capitalized levels and the Company has estimated a preliminary (as of 12/31/10) Basel III Tier 1 Common calculation of 6.9% indicating a smooth transition to the proposed capital guideline. Wells Fargo also continued to maintain a high level of liquidity with over $72 billion in average FedFunds, repos and other short-term investments in 4Q10.

Currently, Wells Fargo is one of the 19 banks subject to a second round of Federal Reserve stress tests to ensure capital adequacy. The stress tests will test a bank’s ability to absorb losses over the next two years under at least two scenarios (baseline and adverse) and will take the proposed Basel III capital requirements into account. Test results will also determine whether an institution may resume capital distributions (stock dividends and/or repurchases). The stress test results are expected to be communicated to BHCs (not publicly) no later than March 21, 2011. Given its strong earnings, capitalization and capital generation capacity, DBRS expects a positive result.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The applicable methodologies are Global Methodology for Rating Banks and Banking Organizations, Enhanced Methodology for Bank Ratings – Intrinsic and Support Assessments, Rating Bank Subordinated Debt and Hybrid Instruments with Discretionary Payments, and Rating Bank Preferred Shares and Equivalent Hybrids which can be found on the DBRS website under Methodologies.

The sources of information used for this rating include the company documents, the Federal Deposit Insurance Corporation and SNL Financial. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

Lead Analyst: William Schwartz
Initial Rating Date: 10 December 1999
Most Recent Rating Update: 10 February 2010

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