Improving Credit Conditions Help Wells Fargo Post Strong Q2 Results

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Wells Fargo (NYSE:WFC) kicked off the earnings season among banks by reporting its performance figures for the second quarter of the year on Friday, July 11. ((Wells Fargo reports $5.7 billion in net income, Wells Fargo Press Releases, Jul 11 2014)) Shrinking net interest margins and weak demand for mortgages finally caught up with the bank, as this was the first time Wells Fargo reported a quarter-on-quarter reduction in its net income over the last four years – something we anticipated in our recent article Wells Fargo’s Fee Revenues Unlikely To Make Up For Shrinking Interest Margins In Q2. But that should hardly be a reason to dismiss another strong performance by the bank, which relies heavily on the traditional loans-and-deposits model to make money. After all, an important factor behind Wells Fargo’s record earnings figure in Q1 2014 was a tax-related gain. The fact that the bank’s Q2 pre-tax profit of $8.66 billion was the highest in its history should go a long way in explaining how well it fared this quarter.

Wells Fargo churned out record trust and investment fees of $3.6 billion for Q2 2014 compared to $3.4 billion in Q1 2014 and $3.5 billion in Q2 2013. Improving credit conditions also helped the bank’s results, as provisions fell to $217 million for the quarter from $652 million a year ago (a 67% improvement) and $325 million in Q1 2014 (a 33% improvement). The bank also made some progress on its plan to return $17 billion to shareholders through stock repurchases by buying back more than 39.4 million of its shares in Q2.

We maintain a $54 price estimate for Wells Fargo’s stock, which is slightly ahead of its current market price.

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See our complete analysis of Wells Fargo here

Net Interest Margins Will Take Some More Time To Catch Up With The Fed’s Tapering Plan

Wells Fargo’s biggest concern over the last couple of years has been its rapidly shrinking net interest margin (NIM) figure. While the current prolonged low-interest rate environment has impacted interest incomes for the banking industry as a whole, the impact is move evident in Wells Fargo’s results as net interest revenues are responsible for more than half of its total revenues.

The table below summarizes Wells Fargo’s reported net NIM figures for each of the last fourteen quarters:

Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014
4.05% 4.01% 3.84% 3.89% 3.91% 3.91% 3.66% 3.56% 3.48% 3.46% 3.38% 3.26% 3.20% 3.15%

As can be seen here, Wells Fargo’s NIM figure has fallen by nearly one percentage point over this period. Thanks to a steady increase in interest-earnings assets, the bank has been able to maintain its net interest revenues of between $10.5 billion and $11 billion throughout this period despite increasing pressure on the NIM figure from the Federal Reserve’s decision to hold benchmark rates at record-low levels and the rapid growth in the bank’s deposit base. However, the Fed’s tapering plan is expected to benefit interest margins over subsequent quarters, as the reduction in overall liquidity should ease interest rates.

You can better understand the partial impact of changing net interest margins on the bank’s total value by making changes to the chart below, which represents Wells Fargo’s NIM on interest-earning assets (excluding loans).

The Declining Trend In Mortgage Originations Finally Reverses

The slowdown in the country’s mortgage industry since late 2012 has resulted in lenders seeing a sharp decline in the demand for home loans after a period of extremely elevated activity in 2011-2012. The record-low interest rates and government-led initiatives were responsible for the frantic activity then, as homeowners stood to gain by refinancing their existing mortgages. The slump is demonstrated by the fact that the total volume of mortgage originations by Wells Fargo fell from a record high of $139 billion in Q3 2012 to $36 billion in Q2 2014 – the lowest since the bank’s acquisition of Wachovia.

But things changed for the better in Q2 2014 as Wells Fargo’s mortgage origination volume climber to $47 billion. Also, the number of mortgage applications increased for the first time since late 2012, indicating that the demand for fresh mortgages is on the rise. Thanks to this, Wells Fargo’s origination-related fees increased 20% from $572 million in Q1 2014 to $688 million in Q2 2014. The figure is significantly below the Q2 2013 figure of $2.4 billion, though, but this is a good sign for the country’s largest mortgage lender.

Moreover, the bank’s mortgage servicing unit continues to report strong growth in revenues, with servicing revenues increasing to $1.04 billion in Q2 – the highest since Q2 2010.

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