DBRS Comments on Wells Fargo & Company Q2 2009 Earnings - Senior at AA; Trend Remains Negative

DBRS has today commented on the Q2 2009 operating performance and earnings of Wells Fargo & Company (Wells Fargo or the Company). With strong earnings generation from legacy Wells Fargo, the addition of Wachovia’s revenue (39% contribution to consolidated revenue) and very strong mortgage fees, credit card revenue, and brokerage fees, the Company reported record net income of $3.17 billion, revenues of $22.5 billion and income before provisions and taxes (IBPT) of $9.8 billion in the second quarter of 2009. As expected, Wells Fargo’s credit costs rose in the quarter as the weakening economy and rising unemployment further pressured both consumers and businesses. The Company’s $5.1 billion provision in the quarter, $528 million above Q1 2009, included a $700 million 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, although capital levels that are already understated due to purchase accounting may be further pressured by the likely consolidation of off-balance sheet vehicles. With the Company’s franchise strengths remaining sound and credit fundamentals within expectation, DBRS sees Wells Fargo’s ratings as unaffected by Q2 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.

Credit losses continued to mount in the second quarter given the weak economy, declining real estate values and higher unemployment in the quarter. Q2 2009 NCOs were $4.4 billion or 2.11% of average loans, compared with $3.3 billion or 1.54% (annualized) in Q1 2009. Legacy Wells Fargo NCOs were $3.4 billion compared with $2.9 billion (+17%) in Q1 2009 and Wachovia NCOs were $984 million compared with $371 million (+165%) in Q1 2009. The Wachovia portfolio losses are starting from a much lower level due to the SOP 03-3 purchase accounting marks taken at closing. In the quarter, the rate of loss acceleration in commercial loans far exceeded that of consumer credit. Total nonperforming assets (NPAs) increased rapidly (45%) in the quarter to $18.3 billion (2.23% of total loans) at June 30, 2009 from $12.6 billion (1.50% of total loans) at March 31, 2009. The increase in NPAs was attributable to several factors including inflows from Wachovia’s non-impaired loan portfolio (60% of the inflows), asset pricing impacting the ability to liquidate assets, an increase in loan modifications that continue to remain in NPAs (until the customer demonstrates performance), and deterioration in commercial real estate and certain other portfolios. 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 $5.1 billion in Q2 2009 (up 12% over Q1 2009), Wells Fargo bolstered its loan loss reserves by an additional $700 million above charge-offs of $4.4 billion. The allowance for credit losses, including the reserve for unfunded commitments, totaled $23.5 billion (2.86% of total loans) at June 30, 2009 compared with $22.8 billion (2.71% of total loans) at March 31, 2009. The loan loss reserve now covers 149% of nonperforming loans and 128% of non-performing assets both decreasing over the quarter from 217% and 181% respectively. 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 believes 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. In addition, the Company has exited several higher risk, non-strategic businesses and is liquidating these portfolios such as Pick-a-Pay, legacy Wells Fargo indirect auto, and the broker originated home equity portfolios. On the other hand, if the combined credit costs increase beyond DBRS’s expectations and exceed IBPT, and/or capital levels materially decline, negative rating actions could result as suggested by the Negative trend placed on Wells Fargo’s ratings on January 1, 2009.

Net interest income was $11.8 billion, up 4% from $11.4 billion that was earned in Q1 2009. The net interest margin widened 14 basis points from the first quarter reflecting the benefit of continued growth in core customer deposits (average consumer checking and savings deposits increased 5% on a linked quarter basis). Non-interest income of $10.7 billion grew 11% from $9.6 billion in Q1 2009 and included record mortgage banking income of $3 billion (including $1.0 billion from MSR hedging gains), trust and investment fees of $2.4 billion, and card and other fees of $1.9 billion as many fees businesses experienced strong revenue growth. Noninterest expense was $12.7 billion compared with $11.8 billion in Q1 2009. The increase largely stemmed from the FDIC special assessment of $565 million and higher variable compensation in mortgage, brokerage, and investment banking. Noninterest expense also included $244 million of merger-related costs. Including the FDIC special assessment charge and merger costs, the efficiency ratio was 56.4%, flat compared to the first quarter. The Wachovia integration is proceeding on schedule and is on track to realize annual run-rate savings of $5 billion upon full integration.

Wells Fargo continued to build its capital in Q2 2009. Tier 1 capital and DBRS-calculated tangible common equity to tangible assets ratios both increased to 9.8% and 4.41% respectively at June 30, 2009 from 8.3% and 3.23% respectively at March 31, 2009. DBRS views the Company’s capital levels (which include $25 billion in TARP preferred shares) as weaker than peers but recognizes that they are somewhat understated due to the SOP 03-3 write-downs taken on the Wachovia loan portfolio. On the other hand, they do not yet take into account the negative impact of off-balance sheet vehicle consolidation that is likely to occur per accounting guidelines on or before January 1, 2010. At March 31, 2009, Wells Fargo had $266 billion in unconsolidated variable interest entities (VIEs) and $1.6 trillion in qualifying special purpose entities. The potential capital impact of the consolidation of some or all of these entities is unknown at this time but is likely to materially pressure the Company’s capital levels which may have negative rating implications.

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. At June 30, 2009, the Company had exceeded this requirement by $500 million through an $8.6 billion equity raise, and internally generated capital including $2.4 billion of IBPT in excess of the Federal Reserve’s estimate, $2.7 billion realization of deferred tax assets, and $500 million of other internally generated sources of capital including core deposit intangible amortization. With the SCAP requirement met, Wells Fargo expects to generate additional capital cushion internally in the third quarter.

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.