Wells Fargo Is Doing Worse than It Seems

Reggie Middleton on Wells Fargo's 3Q09 Reported Performance

Results Review - 3Q09

Wells Fargo & Co. (WFC) reported higher-than-expected earnings for 3Q-09, beating consensus estimates for the second time in a row, primarily on back of increased revenues from mortgage banking. Although WFC's reported EPS at $0.56 was up 14.0% y-o-y, it declined 2.0% q-o-q in 3Q09. A y-o-y growth in earnings reflected strong growth in non-interest income (up 169.8% y-o-y) and net interest income (up 83.1% y-o-y) led by higher customer base and increase in product offerings to its existing customers, partially offset by increased provisions for credit losses (up 144.9% y-o-y and 20.2% q-o-q) during the same period. Excluding the impact of gains from mortgage servicing rights (MSR) and hedging gains (included in mortgage revenues and overall constituting a part of non-interest income), the Company's earnings declined in 3Q2009 on q-o-q basis. The contracting base of interest earning assets (q-on-q) along with higher loan losses provides a significant headwind to the company's valuation in the near-term.

In 3Q-09 WFCs' net charge-offs increased to $5.1 billion, or 2.5% of average loans (up 156.2% y-o-y and 16.5% q-o-q) primarily due to higher charge-offs from Wachovia's loan portfolio which contributed 33.8% to total net charge-offs. Wachovia's net charge-off rate deteriorated sharply to reach 1.66% in 3Q09 from 0.92% in 2Q09 while WFC's legacy loan portfolio charge-off rate rose 2 basis points to 3.37% in 3Q09 from 3.35% in 2Q09. Further, non-performing assets also rose 27.9% q-o-q to $23.5 billion as of September 30, 2009, or 2.9% of total loans, reflecting deterioration in the Company's consumer loans and Wachovia's commercial and commercial real estate nonaccrual loans.

Click to expand

The major support for WFC came from mortgage banking revenues which increased to $3.1 billion (up 243.8% y-o-y), representing 13.7% of the total consolidated revenues in 3Q09 compared with 8.6% in 3Q08. Out of total mortgage banking revenues reported in 3Q09, $1.5 billion were related to "non-recurring" mortgage servicing rights (MSRs) and hedging gains. Excluding the impact of these items, the Bank's non-interest income contracted 4.7% q-o-q to $9.3 billion in 3Q09 as compared to $9.7 billion in 2Q09. In 3Q09, non-interest revenues (including MSR and hedging gains) accounted for 48.0% of the total net revenues against 47.7% in 2Q09 and 38.5% in 3Q08.

More importantly, net interest income declined 0.7% q-o-q to $11.7 billion in 3Q09 from $11.8 billion in 2Q09 despite 0.06% increase in net interest margin off lower average earning assets in 3Q09. Net interest margin, however, declined significantly on y-on-y basis - to 4.36% in 3Q09 from 4.79% in 3Q08 - as decline in yield on interest earning assets exceeded the decline in yield on interest bearing liabilities. The tough credit environment and decline in loan demands contracted the total interest earning assets in 3Q09. WFCs' total loan portfolio contracted 2.6% q-o-q to $800.0 billion in 3Q09.

Net income to common shareholders reached $2.6 billion (increasing 2.4% q-o-q in 3Q-09) primarily off higher mortgage banking revenues (which included $1.5 billion gains from MSRs and hedging gains in 3Q09 versus $1.0 billion in 2Q09), lower non-interest expenses over 2Q09 off FDIC charge of around $565 million in 2Q09 and decline in tax rate of 2.0%. Excluding the impact of gains from mortgage services rights and hedging gains (recorded in 3Q09 and 2Q09), and FDIC charge off recorded in 2Q09, net income in 3Q09 declined 47.7% to $1.1 billion from $2.2 billion in 2Q09.

Click to expand

In 3Q09, provision for loans losses increased significantly to $6.1 billion or (3.06% of total loans), up 20.2% q-o-q, while net charge-offs rose to $5.1 billion (2.48% of total loans) with an increase of 16.5% q-o-q. Total non-performing assets (NPAs) also increased to $23.5 billion (2.93% of total loans) from $18.3 billion (2.23% of total loans) at the end of 2Q09 and $6.3 billion (1.53% of total loans) at the end of 3Q08. The growth in NPAs was driven by deteriorating Wachovia's loan portfolio.

Here I introduce you to another "I told'ja so" starting as far back as September of 2007:

• Will the commercial real estate market fall? Of course it will.
• Do you remember when I said Commercial Real Estate was sure to fall?
• The Commercial Real Estate Crash Cometh, and I know who is leading the way!

The allowance for credit losses totalled $24.5 billion or (3.1% of total loans) in 3Q09 as compared to $23.5 billion or (2.9% of total loans) in 2Q09. An increase in $1.0 billion credit reserve was estimated by the management as inherent losses on its portfolio as of 3Q09, particularly from commercial loan portfolio. Further, loans 90 days or more past due and still accruing increased to $18.9 billion, or 2.4% of total loans, in 3Q09 as compared to $16.7 billion, 2.0% of total loans, in 2Q09. The banks' Texas ratio also worsened to 32.5% in 3Q09 compared with 29.9% in 2Q09 and 20.7% in 3Q08.

In closing, and in short on WFC, I told you so. Many times, and these days, most of the time, the economic truth is not reflected share prices, CNBC nor accounting numbers. You can be sure to get the unbiased record from your buddy Reggie, though. So as to not simply pick on Wells, JP Morgan (JPM), this country's most respected bank, is really in the same position save a trading arm that had artificially high margins that are already on the decline (I will post an article on FICC risks and revenues next). See "Reggie Middleton on JP Morgan's Q309 results" and "If a Bubble Bubble Bursts Off Balance Sheet, Will Anyone Be There to Hear It?: Pt 2 - JP Morgan, then download:

Comments

[J Stew:]

So you think Warren buffett is dead-wrong on WFC, and that he's "dumb-money" by keeping his $8+ Billion stake in Wells Fargo? You're focusing too much on the short-term losses WFC faces, and not enough on the short-term deposit base that WFC gained in the Wachovia deal, which equates to large Net Interest Margins for the bank in the medium an dlonger-term. Best of luck to you on this one - hopefully you don't get squeezed too much ...

Oct 23 10:12 AM

[Dr. Roberts:]

Follow Reggie and die a pauper. What has Reggie told us? Has Reggie told us that WFC would shake off the attack by the Bears and climb from 8 and change to over 30 since March? Has Reggie informed us that WFC will soon get the Government out of its boxer shorts and pay back all 25 billion dollars of TARP money that Dick Kovacevich never wanted in the first place? Has Reggie clued in his "audience" that WFC has not converted Treasury held preferred stock to equity and along with a public stock offering has grown itself into meeting the requirements of Tiny Tim's "asinine" stress test? Has Reggie mentioned that the synergies of Legacy Wells Fargo and Legacy Wachovia have already begun making hefty contributions to the bottom line? Nope, Ol' Reg has been mum! WFC will hit 60 in less than two years. At 30 bucks buy all you can. Let's make a Paypal bet Reggie. You willing to put your own dough where your mouth is?

Oct 23 10:21 AM

[spanish moss:]

Something worth mentioning about WFC is its long history, a very long history, of swings in the valuation of servicing rights, this goes way back beyond the acquisition of WB. Those swings have historically been based on impariments or (and what - repairments?) taken as the valuation of the servicing book rises and falls. Very sharp, very experienced minds work on the hedge that is utilized to balance market impacts on the servicing valuation. In fact, about 2 years ago, the positon of president of Wells Fargo Home Mortgage was split into two co-presidencies to have one strong leader over operations/production and another over servicing which includes collections, sub servicing (also corporate trust services, I think) and THE HEDGE of the servicing valuation and unsold pipeline. In regard to servicing valuations, when rates rise, valuation falls because servicing revenue falls as loans refinance with other lenders, when rates fall, servicing valuations rise because homeowners are less apt to refinance and that creates less threat of loans running off and diminishing the servicing revenue stream. So, when Middleton (or Richard Bove) try to paint the swing from mortgage hedging as something the company uses to meet its numbers, the record shows it has been doing that, and doing it successfully, for a long time. In order to make the case it is a bad thing, one has to balance the rise and fall of servicing valuation (impairment/ re-pairment) over the long haul with the gain/loss on the hedge. It is well executed, and more often than not is a gain due to astute exectution and an unparrelled knowledge of the mortgage business. Remember, WFC is the only institution that has a long term strategy of using mortgages to build customer relationships. It is the largest and best rated servicer in the world... ergo, while the points about servincing might hold water in a general sense to other institutions, to apply that fear to WFC ignores its exceptional track record and its strategic use of mortgages as a builder of the customer base over a very long period of time.

Oct 23 01:05 PM

[buoy:]

If anything happens...the gov't will be there for them.

Oct 24 08:17 AM

[ebworthen:]

I think the bigger banks are in more trouble than they admit because individuals have taken their money out.

I know I did.

If FDIC backs all the banks I may as well deal with my local credit union. I certainly don't want the bailout boys to have any more of my money to play with.

I believe in the past year there has been a silent run on the bailout banks. Combine that with loan losses and you begin to see the reason the FED has backstopped them and given them trillions at 0% and pumped up the markets. The big banks are still insolvent, and they need more taxpayer and investor money to leverage.

Oct 24 11:21 AM

[najdorf:]

ebworthen: Your claim is the kind of idea for which really good data exist - don't use anecdotes. Most large banks are growing their deposit bases through acquisitions and many consumers preferring banks who can offer more services, more locations, clearer government backstop, etc. Read the SEC filings on WFC, BAC, JPM, etc. and you'll see that it's true.

The lesson of the crisis w/r/t deposit banking is that if you rate chase at small banks who have to pay high rates to attract funding, you face a significant risk of either rate cuts when they stabilize or having to deal with the vagaries of the FDIC takeover process. The FDIC or the banks they re-sell to can cut rates and terms, make you do a lot of extra paperwork and mailing, etc. People who want clarity and simplicity are often banking with the TBTF banks.

Oct 24 11:46 AM

[ebworthen:]

Right.

I'm happy to do a little work to not support the tyranny of the banking oligarchs.

;-)


On Oct 24 11:46 AM najdorf wrote:

> ebworthen: Your claim is the kind of idea for which really good data
> exist - don't use anecdotes. Most large banks are growing their deposit
> bases through acquisitions and many consumers preferring banks who
> can offer more services, more locations, clearer government backstop,
> etc. Read the SEC filings on WFC, BAC, JPM, etc. and you'll see that
> it's true.
>
> The lesson of the crisis w/r/t deposit banking is that if you rate
> chase at small banks who have to pay high rates to attract funding,
> you face a significant risk of either rate cuts when they stabilize
> or having to deal with the vagaries of the FDIC takeover process.
> The FDIC or the banks they re-sell to can cut rates and terms, make
> you do a lot of extra paperwork and mailing, etc. People who want
> clarity and simplicity are often banking with the TBTF banks.

Oct 24 01:22 PM

[Plan B Econ...:]

This paper rally is really starting to look 'toppy'. Markets can't rally on 'good' news...but one analyst downgrade tanks the market.

Fundamentals may be catching up with the market - so the market may stay flat as they catch up. On the other hand, the market is hypersensitive to disappointments. Doesn't sound like the risk-reward I want to take.

www.planbeconomics.com.../

Oct 24 03:45 PM

[Plan B Econ...:]

...for those wondering...the downgrade I speak of was Wells Fargo.


On Oct 24 03:45 PM Plan B Economics wrote:

> This paper rally is really starting to look 'toppy'. Markets can't
> rally on 'good' news...but one analyst downgrade tanks the market.
>
>
> Fundamentals may be catching up with the market - so the market may
> stay flat as they catch up. On the other hand, the market is hypersensitive
> to disappointments. Doesn't sound like the risk-reward I want to
> take.
>
> www.planbeconomics.com.../

Oct 24 03:46 PM

[Urbane Gori...:]

Yep.. My little credit unions have been bought out twice now. First by Wells Fargo and next by Chase. My Credit Card Company was bought out by Bank of America. In each instance, I got screwed. I will once again move my business to a smaller bank. The large banks are no longer worth supporting. Even with the bailouts, they expend their energies in trying to weasel another buck out of their customer base. You cannot buy a little bank and step on the same customers that bailed them out. To Hell with the big banks.

@Urbane_Gorilla


On Oct 24 11:46 AM najdorf wrote:

> ebworthen: Your claim is the kind of idea for which really good data
> exist - don't use anecdotes. Most large banks are growing their
> deposit bases through acquisitions and many consumers preferring
> banks who can offer more services, more locations, clearer government
> backstop, etc. Read the SEC filings on WFC, BAC, JPM, etc. and you'll
> see that it's true.
>
> The lesson of the crisis w/r/t deposit banking is that if you rate
> chase at small banks who have to pay high rates to attract funding,
> you face a significant risk of either rate cuts when they stabilize
> or having to deal with the vagaries of the FDIC takeover process.
> The FDIC or the banks they re-sell to can cut rates and terms, make
> you do a lot of extra paperwork and mailing, etc. People who want
> clarity and simplicity are often banking with the TBTF banks.

Oct 24 05:26 PM

[forge98:]

$60 a share that quickly? That would put they're P/E at like 55 to 60. This is not BIDU, GOOG, etc. These large banks are going up because they are fleecing us. First TARP money for trading and CYA, and also lending at 0. What is your credit card interest rate? How about getting a loan? These large banks aren't loaning to small business. I hope it goes to $15 where it should be.

Oct 24 06:11 PM

[countrybanker:]

WFC will hit 60 in less than two years. At 30 bucks buy all you can. Let's make a Paypal bet Reggie. You willing to put your own dough where your mouth is?


Hey Doc, I'll take that bet. Lets get together. How much?

Oct 24 08:44 PM

[E Nuff Sed:]

I think both of you are right. I too think WFC is a $60 stock - but in five years. I think it may hit $15 in 2 years because of all the option ARM re-sets which will start hitting the Wachovia/GW mortgage portfolio. They have to get through that. There will be another big buying opportunity.

On Oct 24 08:44 PM countrybanker wrote:

> WFC will hit 60 in less than two years. At 30 bucks buy all you can.
> Let's make a Paypal bet Reggie. You willing to put your own dough
> where your mouth is?
>
>
> Hey Doc, I'll take that bet. Lets get together. How much?

Oct 24 10:53 PM