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Taper is out and the indices are on the rise. The S&P 500, Nasdaq 100 and DJIA all showed immediate increase. Although the market has perceived this positively this may spell the start of a decline for some.

Despite the positive market perception the impact on interest rates is quite adverse especially from a consumer's stand point. Fifteen-year and 30-year mortgage rates were up 0.08 percentage points and 0.05 percentage points, respectively. A similar trend was also seen with the treasury yields which have continued to rally since mid 2013. If these are signs of things to come, especially after the federal announcement, then the future prospects of the housing sector and specifically the mortgage industry might not be as bright.

With the perceived risk of lower demand for homes due to rising interest rates, which will make owning a property pricier, I have decided to look at the potential impact this might have on the largest company in the residential mortgage realm, Wells Fargo (NYSE:WFC). The company has the mean "Hold" recommendation and a consensus target price of $46.36. With the company currently trading at $0.97 below its target price the company does not seem to be providing much upside potential. Over the course of one year the company's earnings per share "TTM" has expanded by approximately 20 percent while its price has expanded by approximately 30 percent resulting in an approximate 9 percent increase in the price to earnings multiple.

At the close of the third quarter the company held total assets of $1,488 billion and net assets of $168.8 billion both reflecting a growth of 8.2 percent. The largest asset classes on the company's balance sheet were net loans and available for sale securities, a combined representation of 71 percent of the company's total assets. As of September 30, 2013 gross loans stood at $812.3 billion and available for sale securities were $259.4 billion up 4 percent and 13 percent from a year ago, respectively.

Break up of Earning Assets

During the first nine months of 2013 the company's average earning assets stood at $1,263.5 billion reflecting an increase of 9.4 percent over the last year. The weighted average yield on total earning assets fell by 49 bps to 3.79 percent during the first nine months of 2013 compared to 4.28 percent during the previous year. Cumulative exposure to mortgage lending and residential mortgage-backed securities stood at $440.9 billion or 34.9 percent of total earning assets. This reflects an increase of 4.4 percent compared to 2012. The weighted average yield realized on these assets was approximately 4.09 percent, 34 bps lower than the yield realized in 2012.

WFC's average exposure to residential mortgage-backed securities stood at approximately $116.6 billion reflecting an increase of 6.9 percent over the last year. The amount invested in mortgage-backed securities represented 9.2 percent of the company's average earning assets. The majority of the exposure in mortgage-backed securities was in the form of federal agency-backed securities which equaled $103.5 billion. The weighted average yield realized on these securities was approximately 3.65 percent which is 54 bps lower than last year.

The average exposure in residential lending stood at $324.3 billion over the first nine months of 2013 which was approximately 3.5 percent higher than last year. Total residential lending accounted for approximately 40 percent of the company's total loans and approximately 25.7 percent of the total earning assets. The weighted average yield realized on these loans was 4.25 percent which is 27 bps lower than 2012.

Although the company's average exposure to the residential mortgage sector fell to 34.9 percent throughout the first nine months of 2013 compared to 36.6 percent in 2012, it still represents a significant part of the company's total earning assets and correspondingly the company's earnings. Thus a poor outlook of this sector might adversely impact the company's financial results.

The Prospects of the Residential Mortgage Sector

Housing starts were up quite a lot in November compared to the previous month and November 2012. Housing starts increased 29.6 percent during November 2012 and increased 22.7 percent over the last month. The growth achieved in the month was one of the highest since the financial crisis. This rise in housing starts shows the amount of optimism within the homebuilders' community.

However, despite the rise in housing starts the demand from consumers has not been forthcoming. This is evident from the decline in the mortgage application rate since mid-2013. This decline in the mortgage application coincides with the rise in mortgage rates. Mortgage rates have been on the rise since May 2013 and this, coupled with rising home prices as measured by the S&P/Case-Shiller index, has made home ownership less affordable for the general public.

Now that the federal government has decided to taper with its QE3 program, it is expected that interest rates and specifically mortgage rates will rise further in 2013 making home ownership even more difficult. Now that the tapering is in place and the hike in fee charged of Fannie Mae and Freddie Mac it is safe to assume that mortgage rates will continue to rise in the future. As per one estimate it is expected that the 30-year mortgage rates will rise to 5 percent or even 5.5 percent. Although these rates will be lower than the 6 to 6.5 percent average rates in 2007 increasing the mortgage rate 5 to 5.5 percent can be difficult with higher unemployment and lower median income per capita. The unemployment rate is expected to remain around 6 and 6.5 percent over the short to medium term and this is 30 to 40 percent higher than the level prevalent in 2006-07. The median income per capita has fallen by more than 8 percent since 2007. Thus in my opinion the high level of optimism shown by home builders is not justified by the prevalent and expected market conditions.

Conclusion

Going forward I believe that the economy will experience a lower number of mortgage applications as rising home prices and interest rates will continue to make home ownership unaffordable for the general public. This means that in the short to medium term the mortgage industry will remain sluggish and with a high exposure of Wells Fargo in this industry I believe that it will become difficult for WFC to achieve high growth in earnings in the coming periods. The company might even see a little squeeze in earnings from its residential mortgage assets. Thus I expect Wells Fargo to underperform the financial sector as its higher exposure to residential mortgage industry will make it difficult for the company to expand net interest earnings.

Source: Will Wells Fargo Underperform The Financial Sector?