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Summary

  • Wells Fargo failed to beat its sequential performance for the first time in five years.
  • Quantitative easing and poor performance of the mortgage segment are the biggest challenges for the bank.
  • Medium-long term prospects of the sector look good, as the quantitative easing program is decreased, which will increase the net interest margins of the banks.

Well Fargo (NYSE:WFC) has been one of the best performers in the banking sector since the crisis of 2008. The company has shown solid progress in earnings growth and the stock price movement has been extremely impressive. For the first time in the last five years, the company was not able to beat its sequential performance, as the growth in earnings for the most recent quarter fell short of the performance in the last quarter. However, year-over-year growth of about 4% still remains impressive. As a result, the stock has shown a downward trend after hitting its 52-week high of $53 per share. The chart below shows the five-year price performance of the stock.

In our previous articles, we have discussed the company's core strength, dividend potential and valuation in terms of its tangible book value - we have also compared its performance with some of its peers. In this article, we will look into the reasons which might have caused the company to break its 5-year profitability record.

Pinpointing the Challenges

The two major factors which have been slowing down the banking industry are falling net interest margins and the mortgage industry. The cause of the former is federal tapering, also called quantitative easing, through which the Federal Reserve has been strategically buying securities with long-term maturities in order to lower the long-term interest rates. While this challenge hits the banks at their core businesses, mortgage is another weak spot affecting Wells Fargo. Both these factors have caused the aforementioned quarterly decrease in profits. Let us now discuss how serious these challenges could prove to be in the coming quarters.

Net interest Margin

The tapering efforts of the Fed have been paying off, as economic activity has been increasing and the banks have been willing to lend more. However, as the long-term interest rates have been falling, the net interest margins for Wells Fargo have been falling since the second quarter of 2012. The image below shows the trend in net interest margins of the bank over the last three years.

Source: SEC Filings

However, despite this decrease, the bank has been able to keep its profitability growing steadily. Quantitative easing will continue to have some pressure on the margins in the short-term; however, as the Fed has been cutting back on quantitative easing, the medium-long term prospects of the sector look promising.

Mortgage Industry

After extremely increased activity in the mortgage industry in 2011-12, lenders saw a sharp decline due to the falling interest rates. Many homeowners went for refinancing their current mortgages. Mortgage origination volume stood at $139 billion in the third quarter of 2012, which came down to $36 billion in the previous quarter. This caused the mortgage revenue of the company to fall roughly 40% in the second quarter as compared to a year ago.

However, things might get better for Wells Fargo in the coming quarters. We have seen serious improvement in mortgage origination in the current quarter. As of the second-quarter results, mortgage origination increased from $36 billion to $47 billion representing a robust increase of 30%. This shows that fresh mortgage demand is increasing which will get better further, as lower interest rates offer an opportunity to homeowners. Wells Fargo is the largest mortgage lender and will be a major beneficiary of this improvement in the segment.

When will things get better?

A couple of months ago, Janet Yellen, chairman of the Federal Reserve, discussed plans regarding the conclusion of federal tapering. According to the discussion, the interest rates are expected to rise six months after the asset purchase program of the Federal Reserve. The Federal Reserve is slowly decreasing the amount of assets purchased, and as the tapering comes to an end, the interest rates will rise which will widen the interest margins (spread) of banks. Again, the medium-long term prospects of the sector look promising due to these developments.

Wells Fargo has significantly increased its deposits by $90 billion year-over-year. However, due to lesser returns on investments, the bank faced huge setbacks. To tackle this effect, it had to go sideways from its core banking profit generation to invest these deposits in securities which offered more return. Considering the overall banking situation, Wells Fargo is doing quite well under the current circumstances.

Conclusion

The stock price chart at the top of the page shows how good the stock has been doing - the performance of the stock price has been backed by solid growth in the fundamentals of the business. We believe the recent fall in the stock price and poor sequential performance will prove to be a minor bump in the road for the bank. We expect Wells Fargo to grow considerably in the medium-long term as the conditions in the sector turn favorable.

Additional Disclosure: This article is for educational purposes only and it should not be taken as an investment recommendation. Investing in stock markets involves a number of risks and readers/investors are encouraged to do their own due diligence and familiarize themselves with the risks involved.

Source: Is Wells Fargo A Solid Long-Term Bet?