DBRS Comments on Wells Fargo & Company Q4 2008 Earnings - Senior at AA

DBRS has today commented on the Q4 2008 operating performance and earnings of Wells Fargo & Company (Wells Fargo or the Company). Wells Fargo’s balance sheet included the acquisition of Wachovia Corporation (Wachovia; acquired on December 31, 2008), but Wachovia’s results were not reflected (except for conforming allowances) in the Company’s consolidated income statement.

Despite strong loan, deposit and mortgage application growth, Wells Fargo produced a $2.5 billion loss in the quarter, its first since Q2 2001, while Wachovia produced an outsized $11.1 billion loss, its fourth consecutive quarterly loss. Wells Fargo’s loss, however, was driven by $5.6 billion in pre-tax provisions that improve its future loss-absorption ability, while Wachovia’s losses were not indicative of its future financial performance. As anticipated, Wells Fargo’s credit costs rose in the quarter as the continuing decline in housing prices and rising unemployment further pressured both consumers and businesses. At the same time, the Company is de-risking Wachovia’s balance sheet as fast as it can while simultaneously moving Wachovia to its business model. While DBRS believes that asset quality issues will continue to constrain earnings for the Company, strong operating performance and top-line revenue growth continue to position Wells Fargo relatively well to successfully manage its way through the current credit turmoil and difficult operating environment. With the Company’s franchise strengths and credit fundamentals remaining sound, DBRS sees Wells Fargo’s ratings as unaffected by Q4 2008 results. The Company’s AA Issuer & Senior Debt rating remains on Negative trend, where it was placed on January 1, 2009, following the completed acquisition of Wachovia.

The quarterly loss at Wells Fargo was primarily driven by a $5.6 billion credit reserve build (including $3.9 billion for conforming loan allowance), $473 million in securities write-downs and $413 million in mortgage warehouse write-downs and repurchase reserve build. Net loan charge-offs increased in the quarter to $2.8 billion or 2.69% (annualized) of average loans from $2.0 billion or 1.96% in Q3 2008. The increase was dominated by a $504 million or 149% increase in commercial and commercial real estate charge-offs that included $294 million in loans to customers who could not repay due to their losses on Madoff investments. Consumer charge-offs also increased by $301 million or almost 19% during the quarter, as real estate prices continued to deteriorate. Unemployment and depressed used auto prices also contributed to the increase.

Non-performing assets (NPAs) grew $2.7 billion in the quarter to $9.0 billion but dropped to 1.04% of total loans from 1.53% in the prior quarter, due to the addition of Wachovia’s loans whose stressed and written-down loans (per SOP 03-3) were not recorded as NPAs. While consumer NPAs continued to grow rapidly (27.7% over the quarter), it was the growth in commercial non-accruals –that was even steeper at approximately 50% in the quarter – that exceeded DBRS expectations.

With a loan loss provision of $8.4 billion, Wells Fargo bolstered loan loss reserves by another $5.6 billion (of which $3.9 billion was for the conforming loan allowance), bringing the year-over-year reserve build to $8.1 billion (or $5.6 billion without the conforming loan allowance). At December 31, the combined allowance for credit losses was $21.7 billion, or 2.69% of gross loans and leases, a 141 basis point (bp) increase from a year ago, and a 73 bps increase from the prior quarter. While credit costs are likely to remain elevated due to weakness in consumer credit for the balance of 2009 and the likelihood of further commercial loan deterioration, DBRS perceives that the Company has taken a number of steps to reduce its embedded risks, including building a strong reserve base and taking asset write-downs and impairments associated with purchase accounting (for Wachovia) to address a large portion those costs. On the other hand, if the combined credit costs continue to escalate beyond DBRS’s expectations, negative rating actions could result, as suggested by the Negative trend placed on Wells Fargo’s ratings on January 1, 2009.

Despite the difficult operating environment, the Company has continued to report solid operating revenues, strong core deposit and loan growth, and positive operating leverage, which differentiates Wells Fargo from many of its bank peers. Benefiting from a marked flight-to-quality, the Company’s average core deposits grew $30.1 billion (up 10% on a linked-quarter annualized basis) to $345 billion on average for the quarter, ending at $745 billion for Q4 2008 (including Wachovia) and $24.9 billion or 31% from Q3 2008 (Wells Fargo alone). Net new consumer checking accounts in the quarter were up a robust 6.2% from Q4 2007. Also encouraging was the fact that Wachovia’s deposits and checking accounts, which had been running off since earlier in 2008, began to grow in December.

The Company’s revenue growth has been broad based, driven by a peer-leading net interest margin (NIM) and strength in spread income. Net interest income increased 5.4% from the prior quarter, due to strong asset growth and NIM expansion. Non-interest income declined $898 million from the prior quarter, due to net investment losses of $473 million and $413 million in mortgage warehouse write-downs and an increase in repurchase reserves. The decrease in mortgage value, including mortgage servicing rights, was more than offset by debt security hedging gains. Nearly all fee lines, including service charges on deposits, trust, and card fees, were down in the quarter, a trend that DBRS will watch closely.

As for Wells Fargo operating segments, Community Banking suffered a 34% drop in income before tax and provisions (IBPT), to $2.5 billion from $3.8 billion, due to lower mortgage income, security losses and merger expenses. Fourth-quarter results in Wholesale Banking were strong, with robust loan and deposit growth and good expense control boosting IBPT 109% to $813 million. Wells Fargo Financial’s results, however, were slightly down from Q3 2008 due to weakness in fee income. In the meanwhile, all segments continue to be pressured by materially elevated credit costs. That said, the Company has gone to great lengths to take the most conservative stance in its conforming allowance.

The strong underlying operating performance generated by the Company was masked by elevated credit costs, purchase accounting adjustments and various one-time charges. Average loans grew 10% annualized in the quarter and 11% over the prior year, led by a strong commercial lending performance, while average consumer loans were up 3% in the quarter as well. The Company continues to benefit in the current dislocated credit environment by having the ability to generate loans at attractive spreads. Average core deposits grew 31% annualized over the quarter and 10.0% over the prior year, driven by the noted flight-to-quality rather than by increased rates on the Company’s part. The 30 bps linked-quarter decline in the cost of interest-bearing core deposits contributed to NIM improvement in the quarter. The Q4 2008 NIM was 4.90%, up 11 bps from the prior quarter, primarily due to falling interest rates and the 2.7% linked-quarter growth in average earning assets. On a year-over-year basis, NIM expanded 28 bps to 4.90, one of the highest in the industry.

DBRS continues to view the elevated provisioning as manageable for Wells Fargo, which is well positioned to ride out the challenging economic environment. Excluding the one-time charges, Wells Fargo’s IBPT fell 9% from $5.8 billion in Q3 2008 to $5.3 billion in Q4 2008; however, it rose 23% from $4.3 billion in Q4 2007. Moreover, growth in net interest income continues to absorb the growth in net loan charge-offs. Underpinning the Company’s rating is its strong, broadly diversified franchise; its predictable, recurring earnings; consistent management and business strategy; adequate capital levels and ample liquidity.

After receiving $25 billion via the TARP Capital Purchase Program, the Company’s Tier 1 capital ratio actually dropped to 7.9% from 8.6% in the prior quarter. This can be attributed to the impact of de-risking the Wachovia balance sheet for the credit impairment of loans and the write-down of negative cumulative other comprehensive income, which reduced Tier 1 by approximately 230 basis points in the quarter. Similarly, DBRS’s calculation of tangible common equity-to-tangible assets decreased 189 basis points to 3.50% from the prior quarter from the combination with Wachovia and the addition of preferred shares, while common equity-to-total assets dropped 233 basis points to 5.21%. For this reason, DBRS notes that the Company will need to focus on rebuilding its capital levels in the near to medium term.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The applicable methodology is Rating Banks and Bank Holding Companies Operating in the United States, which can be found on our website under Methodologies.

This is a Corporate (Financial Institutions) rating.