Improving Mortgage Industry Conditions Should Help Wells Fargo’s Q2 Results

Wells Fargo (NYSE:WFC) kicks off the earnings season for U.S. banks along with JPMorgan (NYSE:JPM) on Tuesday, July 14, and the banking giant’s results for Q2 2015 will provide some valuable insight into the key trends that affected commercial banks over the period. While the banking sector has had trouble maintaining profits over the last few years due to shrinking net interest margins and declining mortgage origination figures, this issue should have been mitigated to an extent this quarter due to an improvement in mortgage banking activity.

Wells Fargo has focused its efforts over recent years on growing its fee-based revenue streams, and the combined effect of higher fees from asset management, investment banking as well as mortgage banking operations should help the bank report strong improvements to its performance in Q2 2014 as well as Q1 2015. Year-on-year improvements in income for the bank will be driven by higher revenues, while the income figure will be sequentially higher due to elevated operating expenses in the first quarter of a year.

We maintain a $58 price estimate for Wells Fargo’s stock, which is slightly ahead of its current market price.

See our complete analysis of Wells Fargo here

Wells Fargo To Contend With Shrinking Net Interest Margins Again

Wells Fargo’s single biggest source of concern over recent years has been its rapidly shrinking net interest margin (NIM) figure. While the current prolonged low-interest rate environment has hurt interest incomes for the banking industry as a whole, the impact on Wells Fargo is aggravated due to its reliance on the traditional loans-and-deposits banking model.

The chart below summarizes Wells Fargo’s reported net NIM figures for each quarter since early 2005.

The steady decline in Wells Fargo’s NIM figures over the last decade stands out clearly from the chart above. It should be noted that the sharp reduction in the figure in Q1 2009 was due to Wells Fargo’s acquisition of Wachovia. Taking this into account, the reduction since early 2012 stands out. The NIM figure has fallen almost 100 basis points (1 percentage point) over this period. Thankfully, the impact of this decline on the top line has been cushioned by the steady increase in interest-earning assets – allowing Wells Fargo to report quarterly net interest incomes of around $11 billion throughout this period.

With the Federal Reserve likely to hike benchmark rates only in October, interest margins are unlikely to improve this year. You can gauge 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 outstanding mortgages.

But Things Are Looking Upbeat On The Mortgage Front

Wells Fargo is the undisputed leader in the country’s mortgage industry with a share of nearly one-third of the market. The importance of the business to the bank’s overall value is evident from the chart below, which shows that mortgage banking contributes to more than 20% of its total share value.

But the mortgage industry has been in a state of flux recently. Mortgage origination volumes were at record levels in 2012 due to a large number of home owners opting to refinance their existing mortgages, as they sought to benefit from record low mortgage rates and also from government-led initiatives. But this mortgage refinancing wave began dying down in Q4 2012, and has been reduced to a trickle now. The chart below shows Wells Fargo’s total mortgage origination volume (fresh as well as refinanced mortgages) for each quarter since early 2005.

As can be seen from the chart above, mortgage origination volumes for Wells Fargo tanked from a peak of $139 billion in Q2 2012 to a ten-year low of $36 billion in Q1 2014. While there has been a slight improvement over the Q2 2014-Q1 2015 period, average origination volumes remained at an underwhelming $47 billion. Thankfully, the unclosed mortgage pipeline jumped to $44 billion last quarter from around $25 billion over Q3-Q4 2014. This should have helped Wells Fargo originate between $55-$60 billion in mortgage loans in Q2 2015 – translating into notable gains in mortgage origination fees for the period compared to Q1 2015.

You can see how changes in origination fees affect the bank’s share value by making changes to the chart below.

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