DBRS Comments on Wells Fargo & Company’s 3Q13 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 3Q13 results. The trend on all ratings is Stable.

Wells Fargo reported record earnings of $5.6 billion in the quarter, a 13.0% increase from 3Q12 and a 1.1% increase from 2Q13. DBRS sees the financial results as reflecting a mixed performance in a challenging slow-growth economy. Revenues contracted over the quarter and year as the anticipated slowdown in mortgage refinancing was only partially offset by asset growth. Positively, the improved credit performance stood out and the very modest loan loss provision enhanced earnings. Results also featured core loan growth, good deposit growth, reduced expenses, and a fortified balance sheet with growing equity and liquidity, yet an increase in long-term debt related to the increased liquidity. Evidencing franchise strength, the Company continued to record higher cross-sell metrics across its businesses.

As expected, given the abrupt rise in long-term interest rates, mortgage banking revenue declined by $1.2 billion to $1.6 billion and from 26% to 17% of noninterest income in 3Q13. While mortgage banking was the primary driver, lower trust and investment fees from slower activity and insurance fees due to seasonality also contributed to the 8% QoQ noninterest income decline. Equity, trading and other gains did partially offset some of the decline.

The mortgage banking business is transitioning to a higher interest rate environment and the Company has announced 5,300 FTE staff reductions in 3Q13 to appropriately scale operations. Highlighting the impact from the increase in interest rates, mortgage gain on sale dropped 36% to 1.42% in 3Q13 from 2.21% in 2Q13. Furthermore, first mortgage applications and originations fell 40% and 29% respectively, while the unclosed pipeline declined 44%. Refinances, especially sensitive to the rate increase, fell to 36% of applications from 54% in the prior quarter but even purchase applications declined 16% in the quarter. The Company expects lower originations in 4Q13 as refinances continue to decline and due to seasonality. Despite the headwinds, DBRS is mindful that Wells Fargo’s mortgage servicing portfolio will appreciate and grow in an interest-rising environment and expects that the mortgage business will remain a significant contributor to earnings.

With lower expenses only partially offsetting the decline in noninterest income and flat net interest income, Wells Fargo’s DBRS-calculated adjusted income before tax and provisions (IBPT) came in at $7.9 billion for the quarter, decreasing 11.8% from 3Q12 and 12.2% from 2Q13. Importantly to its rating level, asset quality levels further improved in 3Q13 and capitalization increased. Moreover, the Company continued to maintain a strong funding profile and improved its 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 $20.0 billion, down 5.9% from 2Q13 and 5.1% compared to 3Q12. End of period gross loans were up 1.3% over the quarter, while core loans grew $13.8 billion or 1.9% (excluding a $3.5 billion reduction in the liquidating portfolios). In the quarter, organic growth of $8.6 billion was led by $3.0 billion in C&I originations particularly from Capital Finance, Government, and Corporate banking with the consumer areas of non-conforming mortgage, auto, credit card, and private student lending all contributing. Loan growth was also augmented by the acquisition of $5.2 billion in CRE loans from Eurohypo ($4 bn UK) and ING ($1.2 bn U.S.).

Like most banks, the Company’s net interest margin (NIM) remained under pressure, and declined 8 bps to 3.38% sequentially. Specifically for 3Q13, deposit inflows and liquidity actions each accounted for 3 bps of the NIM decline, while variable income and balance sheet repricing, growth, and mix accounted for another basis point each. Wells Fargo expects net interest margin pressure to continue. Expenses declined $153 million or 1.3% in the quarter despite higher severance expense and the extra day in the quarter as lower commissions and incentive compensation, operating losses, FDIC expense, insurance and advertising costs were down in the quarter.

Due to the large drop in mortgage revenue and modest expense reduction, Wells Fargo failed to achieve positive operating leverage QoQ and YoY, as the 4.2% QoQ and 3.5% YoY reductions in revenue growth compared unfavorably to the 1.2% QoQ and 0.1% YoY declines in expense. The Company’s unadjusted efficiency ratio was 59.1%, up from 2Q13’s 57.3%. This metric is at the top of management’s 55% to 59% target range and would have been 60.6% 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 generating 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 $971 million to $15.6 billion; marking the fourteenth consecutive quarterly decline. The allowance represented 1.93% of loans and 93% of nonaccrual loans at quarter-end. Meanwhile, net charge-offs (NCOs) decreased $177 million in the quarter to $975 million, as continuing low commercial losses declined by double-digits as did consumer charge-offs. Wells Fargo’s reserves remain adequate in DBRS’s view barring a significant decline in national real estate values, an event which seems unlikely given empirical evidence of widespread appreciation at this point in the cycle.

On September 27th, the Company substantially resolved all repurchase liabilities related to loans sold to Freddie Mac prior to January 1, 2009. Adjusted for prior repurchases, Wells Fargo paid Freddie Mac $780 million for which it was already fully accrued. The mortgage repurchase liability therefore declined $801 million in the quarter to $1.4 billion, as additions slowed to just $28 million. DBRS notes that the total number of unresolved repurchase loan demands decreased 25% and original loan balance 27% in the quarter primarily due to the settlement.

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 1.6% from 2Q13 to $1,025.6 billion with average core deposits up $4.2 billion, or 2%, while average total deposit funding costs fell 2 bps to 12 bps. With regards to liquidity, the Company’s cash, Fed funds, and short-term investment position was substantial at over $201 billion at quarter-end, up 20.6% linked quarter while the AFS securities portfolio also increased by $10 billion (primarily agency MBS). At the same time, DBRS notes that Wells Fargo increased its long-term debt, $27.8 billion of which $22.4 billion (81%) was in liquidity-related issuances.

Wells Fargo maintains a comfortable capital cushion and ample loss absorption capacity. Indeed, the Company had a 3Q13 estimated Basel I Tier 1 Common ratio of 10.64%, down 7 bps driven by an increase in RWA from asset growth. The Company also reported an estimated Basel III Tier 1 Common ratio of 9.54%, strongly up 92 bps over the quarter primarily due to a 6.9% reduction in RWA adjustments and an earnings-based increase in equity. Demonstrating the earnings strength of the franchise, DBRS also notes that Wells Fargo generated organic capital growth in the quarter even with paying a dividend of $0.30 per share, repurchasing 50.9 million of common shares, and entering into a forward repurchase transaction for an estimated 9.8 million shares which is expected to settle in 4Q13.

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

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