DBRS Comments on Wells Fargo & Company’s 1Q13 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 1Q13 results. The trend on all ratings is Stable.

Wells Fargo reported record earnings of $5.2 billion in the quarter, a 21.7% increase from 1Q12 and a 1.6% increase from 4Q12. DBRS sees the financial results as reflecting a competent performance in a slow-growth economy. Modest declines in adjusted revenues for the quarter highlighted growth challenges. Nonetheless, results also featured modest core loan growth, good deposit growth despite a decline in non-interest bearing balances, continued improving credit quality, and a fortified balance sheet from equity growth and declining long-term debt. Evidencing franchise strength, the Company continued to record higher cross-sell metrics across its businesses.

Reflecting the flexibility in its business model and the ability to leverage its mortgage business, Wells Fargo elected to retain $3.4 billion of its conforming first-mortgage production (vs. 3Q12’s $9.8 billion and 4Q12’s $9.7 billion) on balance sheet and also opportunistically purchased $17.8 billion in agency MBS in the quarter. Noteworthy was an expectedly weaker, yet still strong mortgage banking quarter at $2.8 billion in revenue. Although originations and pipeline declined during the quarter, they remained historically strong at $109 billion and $74 billion, respectively, as significant refinancing volumes were complimented by increased purchase activity. DBRS also notes that gain on sale margins continue to track at high levels. While DBRS expects mortgage banking revenue and margins to decline in 2013, the mortgage business should remain a significant contributor to earnings.

Reflecting a struggling economy, Wells Fargo’s core net revenue fluctuated, as its DBRS-calculated adjusted income before tax and provisions (IBPT) of $8.7 billion increased 5.0% from 1Q12’s $8.3 billion, but declined 6.4% from 4Q12. DBRS notes that the 4Q12 adjusted IBPT calculation excluded $715 million in equity investment gains, the $644 million in foreclosure settlement costs, and the $250 million Wells Fargo Foundation contribution. Importantly to its rating level, capital and asset quality levels improved in 1Q13. Moreover, 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 $21.1 billion, down 0.9% from 4Q12 and 0.8% from 1Q12. The linked quarter revenue decrease reflected lower net interest income primarily from the two fewer days in the quarter, comparatively weaker mortgage banking income and margin pressure. End of period gross loans were basically flat over the quarter, while core loans grew $4.1 billion (excluding a $3.7 billion reduction in the liquidating portfolios). Loan growth for the quarter included the addition of the aforementioned $3.4 billion in retained residential mortgage loans accounting for 84% of the core loan growth, while commercial loans increased $516 million with Asian trade finance loans making a strong contribution. Like most banks, the Company’s net interest margin (NIM) remained pressured, declining 8 basis points (bps) to 3.48% over the quarter and 43 bps over the year. Specifically for 1Q13, deposit inflows accounted for 3 bps of the NIM decline, variable income another 3 bps, while balance sheet repricing, growth and mix precipitated the remaining 2 bps of the decline.

Wells Fargo achieved positive operating leverage compared to the year-ago quarter as the DBRS-adjusted revenue decrease of 0.8% was exceeded by expense decreases of 4.6% YoY. However, the linked quarter adjusted numbers were unfavorable with adjusted expense growth of 3.3% far exceeding the 0.9% decline in revenue. Adjusted for the aforementioned 4Q12 foreclosure settlement and the Foundation contribution, expenses increased $398 million over the quarter, but decreased $593 million over the year. The linked-quarter increase was due to seasonal increases in employee benefits and incentive compensation, while the YoY decrease primarily came from lower operating losses, foreclosed asset expense, contract services, deposit assessments, and professional services. The Company’s unadjusted efficiency ratio was 58.3%, a modest improvement from 4Q12’s 58.8%. This was toward the upper range of management’s 55% to 59% target and would have been 58.8% on a DBRS-adjusted basis. Management has clearly signaled that the Company remains focused on cost saves and generating positive operating leverage, but will not trade revenue growth for expense savings. Positively, consultant and internal expenses associated with the regulatory consent order are no longer expected to reoccur. Wells Fargo also announced a new branch format in Washington, D.C. that at 1,000 square feet is one-third to one-quarter the size of a traditional branch. If successful and rolled out on a significant scale, this new model could deliver material costs savings over time. DBRS sees the Company’s expense initiatives 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 indicated significant improvement including nonaccrual loans and 30 to 89 days past due, while PCI loans continued to perform better than expected with the improved housing market and outlook. Accruing 90+-days past due loans were flat in the quarter.

As a result of improving credit quality, the allowance for credit losses declined $284 million to $17.2 billion, marking the twelfth consecutive quarterly decline. The allowance represented 2.15% of loans and 88% of nonaccrual loans at quarter-end. Meanwhile, net charge-offs (NCOs) decreased $662 million in the quarter highlighted by especially low commercial losses. Wells Fargo’s reserves remain adequate in DBRS’s view barring a significant decline in national real estate values.

Mortgage repurchase reserves rose 5.0%, or $111 million, in the quarter to $2.3 billion, as $309 million in additions were only partially offset by the $198 million in losses that fell 3.9% from $206 million in 4Q12. DBRS notes that both the number of unresolved repurchase loan demands (number of loans down 9.7% and original balance down 7.7%) decreased in the quarter primarily due to decreases in GSE claims.

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 1.0% from 4Q12 to $986.2 billion with average core deposits down $3.0 billion, or 0.3%, while average total deposit funding cost fell 1 bp to 15 bps. With regards to liquidity, the Company’s cash, Fed funds, and short-term investment position totaled a substantial $160 billion at quarter-end, up 0.6% linked quarter while at the same time Wells Fargo decreased long-term debt by $1.2 billion.

Wells Fargo maintains a comfortable capital cushion and ample loss absorption capacity. Indeed, the Company had a 1Q13 estimated Tier 1 Common ratio of 10.38%, up 26 bps driven by retained earnings. The Company also reported an estimated Basel III Tier 1 Common ratio of 8.39%, up 21 bps over the quarter, which is virtually already in compliance with current guidelines, but could be subject to further regulatory change. DBRS notes that organic capital growth took place in the quarter when it paid dividends of $0.25 per share, repurchased 16.6 million of common shares, and redeemed $2.8 billion in trust preferred securities. Wells also issued $625 million of perpetual preferred shares in the quarter.

In March, the Federal Reserve announced its results for the Comprehensive Capital Analysis and Review (CCAR). Under the severely adverse scenario, Wells Fargo & Company’s Tier 1 common and leverage ratios were 5.94% and 6.18% respectively at their minimums and the Fed did not object to its planned capital actions. The Company subsequently announced an increase of its common dividend to $0.30 per share starting in 2Q13 subject to board approval and an increase in share repurchases

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

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