DBRS Comments on Wells Fargo & Company Q3 2009 Earnings - Senior at AA; Trend Remains Negative

DBRS has today commented on the Q3 2009 operating performance and earnings of Wells Fargo & Company (Wells Fargo or the Company). The Company reported record net income of $3.24 billion, revenues of $22.5 billion and income before provisions and taxes (IBPT) of $10.8 billion in the third quarter of 2009. Robust earnings generation from the combined Wells Fargo and Wachovia franchises included a net interest margin of 4.36%, strong mortgage banking income, card fees, and trust and investment fees. As expected, Wells Fargo’s credit costs rose in the quarter as the weakening economy and rising unemployment further pressured both consumers and businesses, but at a slower pace than in the prior quarter. The Company’s $6.1 billion provision in the quarter, $1,025 million above Q2 2009, included a $1 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 with robust revenues and good expense control continue to position Wells Fargo 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 Q3 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 grow in the third quarter given the weak economy, declining real estate values and higher unemployment in the quarter but appeared to slow from the second quarter pace. Q3 2009 net charge-offs (NCOs) were $5.1 billion or 2.50% of average loans, compared with $4.4 billion or 2.11% (annualized) in Q2 2009. Legacy Wells Fargo NCOs at 3.37% of average loans in the quarter stabilized at $3.39 billion compared with $3.40 billion (-0.5%) in Q2 2009, while Wachovia NCOs were $1,726 million compared with $984 million (+75%) in Q2 2009. The Wachovia portfolio losses started from scratch January 1, 2009 due to the SOP 03-3 purchase accounting marks taken at closing. In the quarter, legacy Wells Fargo consumer credit losses were flat while commercial losses declined 3.9%. At the same time, Wachovia losses in commercial loans accelerated faster than consumer losses but both were primarily driven by the aforementioned lag in the non-impaired portfolios.

Total nonperforming assets (NPAs) increased $5.1 billion (28%) in the quarter to $23.5 billion (2.93% of total loans) at September 30, 2009 from $18.3 billion (2.23% of total loans) at June 30, 2009 but at a slower rate than the prior quarter. The sizable increase in NPAs was widespread but the rate of Wachovia’s inflows was far above those of legacy Wells Fargo. The overall increase was attributable to several factors including purchase accounting influenced inflows from Wachovia’s non-impaired loan portfolio, 5 commercial relationships that accounted for $800 million of the increase and the inclusion of $1.8 billion in consumer restructured loans that remain in NPAs until the customer demonstrates 6 consecutive months of performance. 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 well into 2010. One other indicator of potential stabilization is that the $6.0 billion in 90 day or more past due loans (excluding insured or guaranteed) were flat from the second quarter.

With a loan loss provision of $6.1 billion in Q3 2009 (up 20% over Q2 2009), Wells Fargo bolstered its loan loss reserves by an additional $1.0 billion ($900 million for commercial credits) above charge-offs of $5.1 billion. The allowance for credit losses, including the reserve for unfunded commitments, totaled $24.5 billion (3.07% of total loans) at September 30, 2009 compared with $23.5 billion (2.86% of total loans) at June 30, 2009. The loan loss reserve now covers 118% of non-accrual loans and 105% of nonperforming assets both decreasing over the quarter from 149% and 128% respectively. While credit costs are likely to remain elevated due to weakness in credit, 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, Wells Fargo Financial 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, or indicators of significant merger problems arise, negative rating actions could result as suggested by the Negative trend placed on Wells Fargo’s ratings on January 1, 2009. DBRS notes that the third quarter $4.7 billion buffer between provisions and IBPT provides considerable downside credit protection for the Company.

Net interest income was $11.7 billion, down 0.7% from $11.8 billion that was earned in Q2 2009 although average earning assets declined 2.1%. The net interest margin widened 6 bps to a superior 4.36% from the second quarter reflecting the benefit of the sale of $23 billion of the lowest-yielding MBS in the portfolio and the maturing of $38 billion in higher-yielding Wavhovia CD’s that more than offset the 2.9% decline in average loans over the quarter from weak demand and liquidating assets. While average total deposits declined 0.8% over the quarter (due to the runoff of Wachovia CD’s mentioned above), average checking and savings deposits increased 11% (annualized) and account growth remained strong. Non-interest income of $10.8 billion was flat compared to the prior quarter and included record mortgage banking income of $3.1 billion (including $3.6 billion from MSR hedging gains that more than offset the $2.1 billion decrease in the MSR fair value), trust and investment fees of $2.5 billion, and card and other fees of $1.9 billion as many fees businesses performed well. Non-interest expense was $11.7 billion compared with $12.7 billion in Q2 2009. The decrease largely stemmed from the absence of the Q2 2009 FDIC special assessment of $565 million along with merger and other expense savings. The efficiency ratio for the third quarter improved to 52.0% from 56.4% in the second quarter even including $200 million in merger-related costs. Wells Fargo also updated its merger integration cost estimate to be $5.5 billion or $2.4 billion below the original $7.9 billion estimate. This is in addition to the $5 billion in annual costs saves of which one-third have already been realized in the current run rate.

Wells Fargo continued to build its capital in Q3 2009. Tier 1 capital (including $25 billion in TARP preferred shares), Tier 1 common equity and DBRS-calculated tangible common equity to tangible assets ratios increased to 10.6%, 5.2% and 5.32% respectively at September 30, 2009 from 9.8%, 4.5% and 4.41% respectively at June 30, 2009. DBRS views the Company’s capital levels as moving upward to peer levels but recognizes that they are understated due to the SOP 03-3 write-downs taken on the Wachovia loan portfolio. The Company’s internal capital generation ability and excellent capital market access produced $20 billion in capital over the past 6 months. They do not yet take into account the negative impact of off-balance sheet vehicle consolidation that is scheduled to occur per accounting guidelines on or before January 1, 2010, however, that impact is now likely to be less significant and may decrease even further. Currently, Wells Fargo is estimating that an additional $55 billion in incremental GAAP assets or $28 billion in incremental risk-weighted assets will be added to its balance sheet.

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.