Wells Fargo’s Q1 Results Low Oil Prices, Weak Mortgage Activity
Wells Fargo (NYSE:WFC) managed to surpass investor expectations with its first quarter results late last week, but it was not all good news for the banking giant as losses from its loan portfolio to oil and gas companies continue to swell even as its cornerstone mortgage banking business remains under pressure. ((Wells Fargo Q1 2016 Results, Wells Fargo Investor Relations, Apr 14 2016)) Wells Fargo’s results for the quarter received a boost from the integration of $30.8 billion in loans and leases from GE, and also from a $381 million gain from the sale of its crop insurance business. But these gains did not reflect in the bottom line due to seasonally high operating expenses coupled with higher lease-related expenses from the GE acquisition.
While Wells Fargo’s credit exposure to energy companies presents a sizable downside to its overall value, we maintain our $60 price estimate for Wells Fargo’s stock, which is around 25% higher than the current market price.
See our complete analysis of Wells Fargo here
No Respite For Wells Fargo Yet, As Net Interest Margin Shrinks
Among the largest U.S. banks, Wells Fargo’s results are the most sensitive to changes in interest rates as the bank relies primarily on the traditional loans-and-deposits model to drive revenues. With the Fed holding benchmark interest rates at record low since the economic downturn of 2008, the bank saw its net interest margin (NIM) figure shrink sharply from 4.05% in Q1 2011 to 2.92% in Q4 2015. Although the Fed finally hiked the rate by 25 basis points (0.25%) in December 2015, Wells Fargo’s business has yet to realize the benefit of this, as the NIM figure fell to a new all-time low of 2.9%.
However, things are likely to change over coming quarters, as subsequent rate hikes help life the NIM figure. You can see the impact of an increase in yield from investment securities on Wells Fargo’s total value by making changes to the chart below.
Mortgage Originations Fall Sharply, Servicing Fees Makes Up Shortfall
Wells Fargo’s business model focuses considerably on the mortgage industry, with the bank making significant gains in market share over 2010-2012 even as key competitors like Citigroup and Bank of America slashed their mortgage operations. While the industry suffered from extremely poor demand over 2014, things improved over the first half of 2015 before sliding again for three consecutive quarters. Wells Fargo originated mortgages worth just $44 billion in Q1 2016 – faring worse on just occasion in the last ten years (Q1 2014, when it originated $36 billion in mortgages). This led to net gains on mortgage origination activity falling to $748 million this quarter – the lowest since Q2 2014.
While new mortgage applications improved from $64 billion in Q4 2015 to $77 billion in Q1 2016, this is still well below the $93 billion figure for the year-ago period and points to depressed origination activity levels for the next couple of quarters at least. Fortunately, mortgage servicing income increased to $850 million from $523 million a year ago and $730 million in the previous quarter – mitigating the impact of low origination volumes on the top line to a good extent.
How Much Could Wells Fargo Potentially Lose If Oil Remains Cheap?
Wells Fargo’s commercial lending business has grown rapidly over recent years to grow from under $200 billion in early 2011 to well over $300 billion now. And over this period, it has been a major driver of profits because of the low charge-off rates associated with these loans. Things, however, became noticeably worse in Q4 2015 as the bank reported an increase in charge-offs for commercial and industrial loans from an average quarterly figure of around $150 million over Q1 2014 – Q3 2015 to $275 million in Q4 2015. The situation deteriorated further in Q1 2016, as the charge-off figure swelled to $349 million. The increase over the last two quarters has been almost completely due to the impact of low oil prices on the loans Wells Fargo handed out to clients in the oil & gas industry.
According to the bank’s earnings supplement for the quarter, it has $17.8 billion in loans to companies in the oil & gas industry – representing just under 2% of its total loan portfolio. [1] What makes things worse is that the banks has roughly $23 billion more in unfunded commitments to oil and gas companies – taking the bank’s total exposure to the oil and gas sector to $40.7 billion. Nearly 80% of this exposure is to companies that have a credit rating below investment grade. Also, 45% of the exposure is in the exploration and production (E&P) sector – the one hit hardest by sliding oil prices.
Assuming that 20% of the unfunded commitments are called into loans in the near future, the total loan portfolio of oil and gas loans can be estimated to be around $22.5 billion. So loans to E&P companies would be around $10 billion. Considering a worst-case scenario where 80% of the loans to E&P companies default, this represents total charge-offs of roughly $8 billion for Wells Fargo. As the bank has already set aside $1.7 billion in provisions for oil and gas loans, the net loss under this scenario is $6.3 billion – or a little more than 2% of Wells Fargo’s total market value.
You can make changes to the chart below to understand how an increase in commercial loan provisions impacts Wells Fargo’s total value.
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