DBRS Comments on Wells Fargo & Company Q1 2009 Earnings - Senior at AA

DBRS has today commented on the Q1 2009 operating performance, earnings of Wells Fargo & Company (Wells Fargo or the Company) and subsequent events. Q1 2009 marks the first quarter that Wachovia Corporation’s results were included in the Company’s consolidated income statement although Wachovia’s results were included in the Q4 2008 balance sheet.

With strong earnings generation from legacy Wells Fargo, the addition of Wachovia’s revenue and very strong mortgage fees, the Company reported record net income of $3.0 billion, revenues of $21.0 billion and income before provisions and taxes (IBPT) of $9.2 billion (including $206 million in merger expenses and $516 million in OTTI security impairment). 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. Indeed, the Company’s $4.6 billion provision in the quarter included a $1.3 billion credit reserve build signaling its expectation of further deterioration. 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 remaining sound and credit fundamentals within expectation, DBRS sees Wells Fargo’s ratings as unaffected by Q1 2009 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 Corporation.

The Company’s additional capital buffer against adverse scenarios was estimated by the Treasury’s Supervisory Capital Assessment Program (SCAP) to be $13.7 billion. On May 8th, Wells Fargo elected to issue common shares from which it will receive $8.6 billion in gross proceeds while the Company plans to generate the balance of the $5.3 billion in SCAP buffer from earnings and internally generated sources. The Company’s strong financial profile was validated by its demonstrated ability to efficiently access capital markets in addition to its internal capital generation ability. DBRS therefore believes that Wells Fargo will readily be able to meet its SCAP Buffer requirement by the November 9, 2009 deadline.

The profound impact of purchase accounting on Wachovia’s asset quality metrics (that were essentially reset at closing) have made quarter over quarter comparisons of the combined Company less meaningful, however we will still attempt to present the factual data as is. Net loan charge-offs increased $454 million from the prior quarter to $3.3 billion from $2.8 billion (82% from Wachovia) but the 1.54% (annualized) rate to average loans fell from 2.69% in Q4 2008. Non-performing loan (NPLs) grew $3.7 billion in the quarter to $10.5 billion and rose sharply to 1.25% of total loans from 0.79% in the prior quarter; 57% of the increase was from consumer loans and 43% from commercial while Wachovia’s loans accounted for 40% ($1.5 billion) of the increase. While the pace of consumer NPAs growth was expected, the rise in commercial non-performers was on the high side of DBRS’s expectations albeit coming from a low base level. With continued valuation declines in real estate markets and rising unemployment, DBRS expects nonperforming assets to continue to grow for the remainder of 2009 and into 2010.

With a loan loss provision of $4.6 billion for Q1 2009, Wells Fargo bolstered loan loss reserves by another $1.3 billion above charge-offs. At March 31, the combined allowance for credit losses was $22.8 billion ($22.3 loan loss reserve alone) or 2.71% of gross loans and leases, a 115 basis points (bps) increase from a year ago, and a 20 bps increase from the prior quarter. The loan loss reserve now covers 212% of non-performing loans (NPLs) and 122% of NPLs including 90 day past due loans. While credit costs are likely to remain elevated due to weakness in consumer credit for the balance of 2009 into 2010 and commercial loans are expected to further deteriorate, 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 of 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 continuing difficult operating environment, the Company has continued to report solid operating revenues, strong core deposit and loan growth, and positive operating leverage (compared to the prior quarter), which differentiates Wells Fargo from many of its bank peers. Benefiting from a marked flight-to-quality, deeper market penetration and higher mortgage escrows, the Company’s total core deposits grew $10.8 billion (6% on a linked-quarter annualized basis) to $756 billion despite the maturity of $34 billion in higher yielding Wachovia CDs. Net new consumer checking and savings accounts were up a robust 31% (annualized) in the quarter. Also encouraging was the fact that Wachovia’s deposits and checking accounts that had been running off since earlier in 2008 have been growing since December. DBRS views the potential benefits of successful integration of the Wachovia franchise to be significant. This includes both potential revenue growth from the previously constrained Wachovia and $5 billion in expense savings that will begin to be realized in Q2 2009 (but will be offset by somewhat less than $7.9 billion in merger costs).

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 for the legacy Wells Fargo increased at a slower 1.5% from the prior quarter but a robust 18% compared to a year ago reflecting net interest margin contraction and slower asset growth. Non-interest income at legacy Wells Fargo increased $2.7 billion (99%) from the prior quarter to $5.4 billion as mortgage banking fees soared and were $2.5 billion compared in Q1 2009 to $631 million the prior year and a $195 million loss in the prior quarter. Nearly all fee lines at legacy Wells Fargo including service charges on deposits, trust, and card fees were down for the second consecutive quarter, a trend that DBRS will watch closely.

The 139 bps linked-quarter decline in loan yield from the combination with Wachovia and declining interest rates combined with a more modest 58 bps decline in interest bearing deposit yield from Wachovia’s higher cost deposits and contributed to the NIM drop in the quarter. The Q1 2009 NIM was 4.16%, down 74 bps from 4.90% the prior quarter. On a same quarter year-over-year basis, NIM fell 53 bps to 4.16%, yet remains one of the highest among its peers.

The Company’s capital ratios improved materially in the first quarter even before the recent $8.6 billion in common equity issuance gross proceeds mentioned above. The Q1 2009 Tier 1 and Total Capital Ratios rose 44 bps each to 8.28% and 12.27% respectively. Similarly, tangible common equity (TCE) to tangible assets increased 42 bps to 3.28% from the prior quarter. The improvement came from two accounting changes: 1) Early adoption of FAS 157-4’s $4.4 billion reduction on the unrealized securities loss recorded in other comprehensive income; 2) FAS 160’s (noncontrolling interests) accounting equity impact on the Prudential Joint Venture and others combined with the $3.0 billion in quarterly net income. DBRS estimates that the common equity offering will raise the TCE ratio by approximately 65 bps. Wells Fargo capital metrics are expected to continue to grow from strong earnings generation, the reduced dividend payout and earning asset declines in the near term.

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

The applicable methodologies are Rating Banks and Bank Holding Companies Operating in the United States and Enhanced Methodology for Bank Ratings – Intrinsic and Support Assessments, which can be found on our website under Methodologies.

This is a Corporate (Financial Institutions) rating.