DBRS Comments on Wells Fargo & Company 2Q12 Earnings - Senior at AA Unchanged

DBRS, Inc. (DBRS) has today commented that its ratings for Wells Fargo & Company (Wells Fargo or the Company), including its Issuer & Senior Debt rating of AA, are unchanged following the release of the Company’s 2Q12 results. The trend on all ratings is Stable. Wells Fargo reported record earnings of $4.6 billion in the quarter, a 17.0% increase from 2Q11 and an 8.8% increase from 1Q12. DBRS sees this as a continuing differentiator for the Company from many of its competitors with general earnings resilience, business diversity, and generally strong performance across much of its franchise in a difficult operating environment that has pressured industry fees, net interest income, and margins. Of particular note, Wells Fargo’s core net revenue strengthened as its DBRS adjusted income before tax and provisions (IBPT) of $8.9 billion increased 21% from 2Q11’s $7.3 billion and increased 6.9% from 1Q12. Importantly to its rating level, capital and asset quality levels improved in 2Q12 while the Company grew average deposits and loans while maintaining significant liquidity. DBRS’s ratings for Wells Fargo continue to be underpinned by its strong, broadly diversified franchise, predictable recurring earnings, consistent management and business strategy, good credit quality, strong capital levels, and ample liquidity.

On July 12, 2012, the U.S. Department of Justice (DOJ) announced an agreement with Wells Fargo requiring it to pay a $125 million settlement to borrowers primarily relating to claims of borrower discrimination in brokered mortgages between 2004 and 2009, which the Company denies. The DOJ settlement also requires Wells Fargo to provide $50 million in community improvement programs in 7 MSAs. Indeed, the Company’s 2Q12 financials reflected some elevated charges to account for the DOJ settlement. The Company has also independently decided to discontinue brokered wholesale mortgage originations that currently represent 5% of Well Fargo’s home mortgage funded volume. DBRS perceives these events as an unfortunate example of reputational risk facing the Company but notes that the financial impact is relatively immaterial and the event has no current rating implications.

Company-wide net revenues were $21.3 billion, down 1.6% from 1Q12 and up 4.4% from 2Q11. The linked quarter revenue decline reflected lower trading and equity investment gains that were only partially offset by modestly higher net interest income. Net income, at $4.6 billion for the quarter, benefited from noninterest expenses that were almost 5%, or $596 million lower than 1Q12 and 0.6%, or $78 million, lower than 2Q11. The lower noninterest income from the trading and equity investment gains mentioned above (and largely offset by lower expenses) masked a strong performance in many fee areas including mortgage, trust and investment and account service charges.

Importantly, Wells Fargo achieved positive operating leverage compared to both the sequential and year-ago quarters as adjusted expense declines of 1.8% y-o-y and 5.7% q-o-q were readily exceeded by adjusted revenue growth of 6.7% y-o-y and -0.8% q-o-q, respectively. The $596 million decline in expenses over the quarter was primarily driven by lower employee expense while expenses included some charges related to the DOJ settlement. While expenses declined strongly and efficiency improved, the Company guided its Project Compass target to exceed its targeted $11.25 billion expense run rate by 4Q12 (from $12.4 billion in 2Q12), adjusting higher for a stronger than anticipated level of revenue growth than previous guidance. DBRS sees the expense initiative as important for continuing to generate positive operating leverage in the currently difficult operating environment.

The allowance for credit losses declined $483 million to $18.6 billion, marking the ninth consecutive quarterly decline and included a $400 million reserve release as net charge-offs decreased $195 million, or 8.1% in the quarter. Asset quality metrics generally indicated improvement, including 90+ day accruing and 30 to 89 day past due consumer loans, while PCI loans continued to perform better than expected. Mortgage repurchase reserves rose 22%, or $320 million, in the quarter to $1.8 billion as $669 million in additions were only partially offset by the $349 million in losses that rose 12% from $312 million in 1Q12. The Company sees increased future expected demands for loans sold between 2006 and 2008 as reflecting conforming practices between the GSEs. DBRS notes positively that the number of unresolved repurchase loan demands and loan balances continue to decline.

Nonperforming assets decreased $1.76 billion, or 6.6%, from 1Q12 to $24.9 billion and accounted for 3.21% of total loans down from 3.48% in the prior quarter. Despite further declines in the Company-wide allowance for loan losses, Wells Fargo’s reserves remain adequate in DBRS’s view barring a significant decline in national real estate values. The Company’s allowance for credit losses was $18.6 billion at quarter-end, representing 2.41% of loans and 91% of nonaccrual loans.

End of period gross loans were up $8.7 billion, or 1.1% over the quarter, and core loans grew a more robust $13.8 billion (excluding the $5.1 billion reduction in the liquidating portfolios). The quarter included the addition of $6.9 billion in U.S. and foreign loans from the purchase of BNP Paribas’ energy lending business and WestLB’s subscription finance loans, which accounted for 50% of the core loan growth while organic growth accounted for the other half.

From DBRS’s perspective, the Company remains relatively well-positioned to cope with regulatory and legislative changes. In DBRS’s view, Wells Fargo’s sound funding and liquidity profile, along with solid capital levels, afford it greater flexibility, relative to many banks, to manage through the evolving regulatory environment. Average deposits grew 1% from 1Q12 to $924 billion with average core deposits up $10.2 billion, or 1.1%, while average total deposit funding cost fell one basis point (bps) to 19 bps, and the Company continued to record cross-sell improvement both in the East and West. With regards to liquidity, the Company’s cash, Fed funds, and short-term investment position was a substantial $91 billion at quarter-end. The AFS securities portfolio contracted 1.5%, or $3.4 billion q-o-q, and the yield grew 13 basis points (bps) as the balances from lower-yielding short-term government or government agency securities that were called were reinvested into primarily high quality municipal securities. At the same time, Wells Fargo reduced long-term debt by $4.8 billion as $12.4 billion in maturities and redemptions (including Trups and sub debt) more than offset the $7.6 billion in issuance.

Wells Fargo maintains a comfortable capital cushion and ample loss absorption capacity. The Company had a 2Q12 estimated Tier 1 ratio of 11.68% (down 10 bps) and a Tier 1 Common ratio of 10.08%, up 10 bps or $2.2 billion. The Company also reported an estimated Basel III Tier 1 Common ratio of 7.78%, which puts it well on the way toward compliance when the final guidelines are announced given the rate of organic capital generation. DBRS notes that organic capital growth took place in the quarter despite paying $0.22 per share in dividends, repurchasing of 53 million common shares, and paying down debt as denoted above.

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

The principal applicable methodology is the Global Methodology for Rating Banks and Banking Organizations. Other methodologies used include the DBRS Criteria – Intrinsic and Support Assessments. Both can be found on the DBRS website under Methodologies.

The sources of information used for this rating includes company documents and SNL Financial. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

Lead Analyst: William Schwartz
Approver: Alan G. Reid
Initial Rating Date: 10 December 1999
Most Recent Rating Update: 1 June 2012

For additional information on this rating, please refer to the linking document under Related Research.