DBRS Comments on Wells Fargo & Company’s 4Q12 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 4Q12 results. The trend on all ratings is Stable.

Wells Fargo reported record earnings of $5.1 billion in the quarter, a 23.9% increase from 4Q11 and a 3.1% increase from 3Q12. DBRS sees the financial results as reflecting another quarter of strong performance for the Company including robust loan and deposit growth, continued improving credit quality and a fortified balance sheet with declining long-term debt. Reflecting the flexibility in its business model and the scale of its mortgage business, Wells Fargo elected to retain $9.7 billion of its conforming first mortgage production (vs. $9.8 billion in 3Q12) on balance sheet as an alternative to buying MBS in the quarter, but expects to retain only an additional $2 to $3 billion of originations that settle in 1Q13. Noteworthy was a very strong mortgage banking quarter at $3.1 billion in revenue, very welcome in a weak growth environment, but not necessarily sustainable. While originations and pipeline declined during the quarter, they remained robust at $125 billion and $81 billion, respectively. DBRS notes that gain on sale margins continue to track at high levels. Evidencing franchise strength, the Company continued to record higher cross-sell metrics.

Positively, Wells Fargo’s core net revenue strengthened, as its DBRS-calculated adjusted income before tax and provisions (IBPT) of $9.3 billion increased 19% from 4Q11’s $7.8 billion and 4.0% from 3Q12. The IBPT calculation excluded $715 million in equity investment gains from revenue and the $644 million in foreclosure settlement costs and the $250 million Wells Fargo Foundation contribution from expenses. Importantly to its rating level, capital and adjusted asset quality levels improved in 4Q12, while the Company continued to improve its funding and liquidity profile. 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.

Company-wide DBRS-adjusted net revenues were $21.3 billion, up 1.2% from 3Q12 and up 4.7% from 4Q11. The linked quarter revenue increase reflected the strong mortgage banking quarter while net interest income was roughly flat. End of period gross loans were up $17 billion, or 2.2% over the quarter, and core loans grew a more robust $21 billion (excluding a $4.1 billion reduction in the liquidating portfolios) which stabilized net interest income. Loan growth for the quarter included the addition of the aforementioned $9.7 billion in retained residential mortgage loans accounting for 46% of the core loan growth. Like most banks, the Company’s net interest margin (NIM) remained pressured declining 10 basis points (bps) to 3.56%. Specifically, strong deposit inflows were invested in short-term investments, accounting for 8 bps of the decline while balance sheet repricing contributed another 5 bps that were only partially offset by 3 bps of variable income.

Wells Fargo achieved positive operating leverage compared to both the sequential and year-ago quarters as a DBRS-adjusted expense decreases of 4.0% YoY and a 0.9% QoQ were readily exceeded by adjusted revenue growth of 4.7% YoY and 1.2% QoQ, respectively. Adjusted for the aforementioned foreclosure settlement and the Foundation contribution, expenses declined $110 million over the quarter and $506 million over the year with the largest decline (recurring) coming from employee benefits. Efficiency (unadjusted) at 58.8% was higher than 3Q12’s 57.1%, but was within management’s 55% to 59% target and would have been 56.4% on a DBRS-adjusted basis. With the independent foreclosure review settlement completed, approximately $125 million in run rate consultant and internal expenses associated with the regulatory consent order are no longer expected to be incurred. Management has made clear that more cost saves are likely. Nonetheless, the Company will not trade revenue for expense and will remain focused on generating positive operating leverage. DBRS sees the expense initiative as important for continuing to generate positive operating leverage in the currently difficult operating environment. However, DBRS recognizes and understands that the Company’s focus on revenue generation is one of the keys to its success.

Asset quality metrics generally indicated improvement including nonaccrual loans (including $394 million of NPLs from new guidance), accruing 90+ days past due and 30 to 89 days past due while PCI loans continued to perform better than expected with the improved housing market and outlook.
As a result of improving credit quality, the allowance for credit losses declined $326 million to $17.5 billion, marking the eleventh consecutive quarterly decline. The allowance represented 2.19% of loans and 85% of nonaccrual loans at quarter-end. Meanwhile, net charge-offs (NCOs) decreased $277 million in the quarter. The NCOs included $321 million from the addition of performing consumer loans restructured in bankruptcy due to the implementation of new OCC guidance (i.e. NCOs were flat at $1.8 billion over the quarter adjusted for the guidance). Since the Company had already fully reserved for the loans to bankrupt consumers prior to the guidance, DBRS sees the change as essentially accelerating already anticipated losses. Wells Fargo’s reserves remain adequate in DBRS’s view barring a significant decline in national real estate values.

Mortgage repurchase reserves rose 8.5%, or $173 million, in the quarter to $2.2 billion, as $379 million in additions were only partially offset by the $206 million in losses that rose 7% from $193 million in 3Q12. DBRS notes that the number of unresolved repurchase loan demands (number of loans and original balance) decreased in the quarter as decreases in private label and mortgage insurance recissions more than offset modest GSE increases.

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 3.1% from 3Q12 to $976.1 billion with average core deposits up $33.5 billion, or 3.7%, while average total deposit funding cost fell two bps to 16 bps. With regards to liquidity, the Company’s cash, Fed funds, and short-term investment position totaled a substantial $159 billion at quarter-end, up 36% linked quarter primarily reflecting the deposit inflows. At the same time, Wells Fargo decreased long-term debt by $3.4 billion.

Wells Fargo maintains a comfortable capital cushion and ample loss absorption capacity. Indeed, the Company had a 4Q12 estimated Tier 1 Common ratio of 10.12%, up 20 bps driven by retained earnings. The Company also reported an estimated Basel III Tier 1 Common ratio of 8.18%, up 16 bps over the quarter, which is virtually already in compliance with current guidelines. DBRS notes that organic capital growth took place in the quarter when it paid $0.22 per share in dividends, repurchased of 42.1 million common shares and entered a forward repurchase transaction of another estimated 5.9 million shares. Management indicated that it asked for additional capital distributions relative to 2012 in its 2013 capital plan submission to regulators.

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

[Amended on May the 23rd, 2014 to remove unnecessary disclosures.]