DBRS Comments on Wells Fargo & Company’s 2Q13 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 2Q13 results. The trend on all ratings is Stable.

Wells Fargo reported record earnings of $5.5 billion in the quarter, a 19.4% increase from 2Q12 and a 6.7% increase from 1Q13. DBRS sees the financial results as reflecting a good performance in a slow-growth economy. Revenue grew modestly for the quarter highlighting growth challenges, but improved credit performance stood out and enhanced earnings. Results also featured modest core loan growth, good deposit growth, and a fortified balance sheet from growing equity and declining long-term debt. Indeed, it appears that the Company is one of the few large banks already exceeding the newly proposed supplementary leverage ratio. Evidencing franchise strength, the Company continued to record higher cross-sell metrics across its businesses.

Noteworthy, given the rise in long-term interest rates, was a stronger than expected mortgage banking quarter at $2.8 billion in non-interest revenue, which was roughly flat over the quarter and down 3.1% YoY. First mortgage applications and originations rose 4.3% and 2.8% respectively, but the unclosed pipeline declined almost 15% and refinances fell to 54% of applications from 65% in the prior quarter. DBRS also notes that the gain on sale margin declined 35 basis points (bps) to a still healthy 2.21%. If interest rates continue to rise, DBRS would expect mortgage banking revenue and margins to decline in 2H13, yet the mortgage business should remain a significant contributor to earnings.

With stronger net interest income and lower expenses, Wells Fargo’s DBRS-calculated adjusted income before tax and provisions (IBPT) increased 1.3% to $9.0 billion from 2Q12 and 3.1% from 1Q13. Importantly to its rating level, capital and asset quality levels improved in 2Q13. 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 strong earnings, consistent management and business strategy, good credit quality, strong capital levels, and ample liquidity.

Company-wide DBRS-adjusted net revenues were $21.2 billion, up 0.6% from both 1Q13 and 2Q12. End of period gross loans were basically flat over the quarter, while core loans grew $5.2 billion (excluding a $3.2 billion reduction in the liquidating portfolios). In the quarter, growth was driven by commercial loans along with auto, foreign, credit card and non-conforming first mortgages. Like most banks, the Company’s net interest margin (NIM) remained under pressure, but declined only 2 bps to 3.46% sequentially. Over the past year, the decline is more pronounced at 45 bps. Specifically for 2Q13, deposit inflows accounted for 6 bps of NIM decline partially offset by a 2 bps increase from variable income and another 2 bps from balance sheet repricing, growth and mix. Wells Fargo expects net interest margin pressure to continue.

Despite the challenging environment for growth, Wells Fargo achieved positive operating leverage QoQ and YoY, as the 0.6% modest revenue growth for both periods compared favorably to the 1.2% quarterly decline in expense and flat level YoY. The linked-quarter decrease reflected lower employee benefit costs, which are seasonally elevated in Q1. The Company’s unadjusted efficiency ratio was 57.3%, a substantial improvement from 1Q13’s 58.3%. This metric is moving toward the middle range of management’s 55% to 59% target and would have been 57.7% 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. DBRS sees the Company’s expense initiatives as important for continuing to generate positive operating leverage in the currently difficult operating environment. However, DBRS also 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, accruing 90+ day past due loans and 30 to 89 day loans past due, while PCI loans continued to perform better than expected with widespread improvements in both home appreciation and outlook.

As a result of improving credit quality, the allowance for credit losses declined by $575 million to $16.6 billion, marking the thirteenth consecutive quarterly decline. The allowance represented 2.07% of loans and 93% of nonaccrual loans at quarter-end. Meanwhile, net charge-offs (NCOs) decreased $267 million in the quarter, as continuing low commercial losses were accompanied by a double-digit decline in consumer charge-offs. Wells Fargo’s reserves remain adequate in DBRS’s view barring a significant decline in national real estate values, which seems unlikely at this point given the empirical evidence of widespread appreciation.

The mortgage repurchase liability declined 4.1%, or $95 million, in the quarter to $2.2 billion, as $65 million in additions were more than offset by the $160 million in losses, a decline of 19% from $198 million in 1Q13. DBRS notes that both the number of unresolved repurchase loan demands (number of loans up 3.1% and original balance up 0.2%) increased in the quarter primarily due to increases 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 2.4% from 1Q13 to $1,009.8 billion with average core deposits up $10.2 billion, or 1.1%, while average total deposit funding costs fell 1 bp to 14 bps. With regards to liquidity, the Company’s cash, Fed funds, and short-term investment position was substantial at over $166 billion at quarter-end, up 4.1% linked quarter. At the same time, DBRS notes that Wells Fargo decreased it’s long-term debt by $2.8 billion.

Wells Fargo maintains a comfortable capital cushion and ample loss absorption capacity. Indeed, the Company had a 2Q13 estimated Tier 1 Common ratio of 10.73%, up 34 bps driven by an improvement in retained earnings. The Company also reported an estimated Basel III Tier 1 Common ratio of 8.54%, up 15 bps over the quarter. The capital ratio increase is especially noteworthy in a quarter where the sudden long-term interest rate rise contributed to a $3.3 billion OCI reduction. Demonstrating the earnings strength of the franchise, DBRS also notes that Wells Fargo generated organic capital growth in the quarter even with paying dividends of $0.30 per share, repurchasing 26.7 million of common shares, and entering into a forward repurchase transaction for an estimated 13 million shares that is expected to settle in 3Q13.

On July 9th, U.S. regulatory agencies proposed a rule requiring a supplementary leverage ratio of 5% for the largest bank holding companies and 6% for their banking subsidiaries to be considered “well capitalized” phasing in to be fully effective on January 1, 2018. Based on an initial review, the Company believes its leverage capital ratios would already exceed the well-capitalized requirements at both the bank and the holding company.

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

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