WELLS FARGO & COMPANY quarterly report, Q3 FY2020

Wells Fargo & Company — Q3 2020 Form 10-Q

Reporting period: Quarter and nine months ended September 30, 2020. Comparisons below are primarily with the corresponding 2019 periods; balance-sheet comparisons are with December 31, 2019.

Business context

Wells Fargo is a diversified U.S. financial services company with $1.92 trillion in assets. Results reflect the economic effects of COVID-19, a low interest-rate environment, elevated credit-loss reserves, customer support measures, ongoing remediation and regulatory requirements. The Federal Reserve’s consent-order asset cap remained in effect, subject to exclusions for qualifying PPP and Main Street Lending Program exposures.

Financial performance and condition

Metric	Q3 2020	Q3 2019	Nine months 2020	Nine months 2019
Total revenue	$18.9 billion	$22.0 billion	$54.4 billion	$65.2 billion
Net interest income	$9.4 billion	$11.6 billion	$30.6 billion	$36.0 billion
Provision for credit losses	$769 million	$695 million	$14.3 billion	$2.0 billion
Noninterest expense	$15.2 billion	$15.2 billion	$42.8 billion	$42.6 billion
Net income	$2.0 billion	$4.6 billion	$309 million	$16.7 billion
Diluted EPS	$0.42	$0.92	($0.23)	$3.43

Third-quarter net income applicable to common stock was $1.7 billion. Nine-month results included a $3.1 billion income tax benefit, but common shareholders recorded a $932 million loss after preferred dividends and other items.
Net interest margin was 2.13% in Q3, down from 2.66% a year earlier. Management attributed the decline chiefly to lower rates, higher mortgage-backed securities premium amortization and changes in asset and funding mix.
The efficiency ratio was 80.7% versus 69.1% a year earlier. Pre-tax, pre-provision profit was $3.6 billion, down 47% year over year.
Q3 revenue fell 14% year over year, primarily on lower net interest income and lower noninterest income. Higher mortgage banking revenue partly offset the decline. Nine-month revenue fell 17%.
Q3 noninterest expense included $961 million of customer remediation accruals and $718 million of restructuring charges, predominantly severance. Expense also reflected COVID-related occupancy costs. The prior-year quarter included a $1.6 billion discrete retail-sales-practices litigation accrual, which makes the year-over-year expense comparison less straightforward.
At September 30, assets were $1.922 trillion, loans $920.1 billion, deposits $1.383 trillion and total equity $182.0 billion. Loans declined 4% and deposits rose 6% from year-end 2019. Average deposits rose 8% year over year in Q3, while average loans declined 2%.
Cash, cash equivalents and restricted cash were $246.8 billion at quarter-end, up $105.5 billion from year-end 2019. For the first nine months, operating cash flow was $24.8 billion, investing cash flow was $102.0 billion and financing cash flow was negative $21.3 billion.
Long-term debt was $215.7 billion and short-term borrowings were $55.2 billion at September 30. The filing reports long-term debt down $12.5 billion from year-end.

Credit quality, capital and liquidity

The allowance for credit losses on loans, including unfunded commitments, was $20.5 billion, or 2.22% of loans, versus $10.5 billion, or 1.09%, at year-end 2019. The nine-month loan provision was $14.1 billion. Management said the reserve reflected COVID-related economic forecasts and significant qualitative uncertainty; its scenario weighting was 80% base case and 20% downside.
Nonperforming assets were $8.2 billion, up 45% from year-end, and 0.89% of loans. Nonaccrual loans were $8.0 billion. Q3 net charge-offs were $683 million, or 0.29% annualized; commercial charge-offs increased year over year while consumer charge-offs declined.
COVID-related payment deferrals and other accommodations may delay recognition of delinquencies and losses. At September 30, $42.6 billion of consumer loans and $3.7 billion of commercial loans remained in deferral programs. The filing reported that 92%–96% of consumer loans exiting deferral in several major categories were current, depending on category.
Common Equity Tier 1 was 11.38%, above the stated 9% regulatory minimum and 10% internal target. The liquidity coverage ratio was 134%, above the 100% minimum; eligible external TLAC was 25.76% of risk-weighted assets versus a 22% minimum. The Company’s supplementary leverage ratio was 7.75%.
Primary liquidity sources totaled $536.1 billion, including $494.2 billion unencumbered; available borrowing capacity at Federal Home Loan Banks and the Federal Reserve Discount Window was approximately $262.7 billion.

Material changes and notable items

Compared with Q3 2019, net income declined 56%, revenue declined 14% and diluted EPS fell from $0.92 to $0.42. The nine-month net income decline was driven especially by the $12.3 billion increase in provision for credit losses.
Wells Fargo adopted CECL on January 1, 2020. Adoption reduced the loan allowance by about $1.3 billion before the subsequent COVID-related reserve build; the filing cautions that credit-quality disclosures are not fully comparable with prior periods.
Mortgage banking benefited from higher originations and margins: Q3 mortgage banking income was $1.6 billion versus $466 million. At the same time, residential mortgage servicing rights fell to $6.4 billion from $11.5 billion at year-end, mainly due to valuation changes and realization of expected cash flows.
In Q3, the Company declared a $0.10 common dividend per share versus $0.51 a year earlier. Federal Reserve restrictions generally barred capital distributions through Q4 2020, subject to limited exceptions. Common share repurchases were restricted; Q3 repurchases were limited to employee-plan and deferred-compensation-related activity.
Standard & Poor’s lowered the Company’s long-term rating to BBB+ from A- in July and revised the outlook to stable; Moody’s affirmed ratings in September but changed its outlook to negative. The filing reports $1.6 billion of additional collateral potentially required on certain derivatives if ratings fell below investment grade.

Outlook, risks and contingencies

The filing provides no specific earnings, revenue or credit-loss guidance. Management emphasized uncertainty over the duration and severity of the pandemic and its effects on customers, credit losses, revenues and operations.
The Federal Reserve asset cap remains a constraint on balance-sheet growth until required plans and third-party reviews satisfy the regulator. PPP and Main Street program exposures receive specified exclusions; related fees and economic benefits must be transferred as required by the amended order.
Management is pursuing expense-reduction and organizational-efficiency initiatives, including potential headcount, vendor and location reductions. Further restructuring actions may occur.
Legal and regulatory matters remain significant. The filing reports approximately $2.4 billion as the high end of reasonably possible potential legal losses in excess of accruals at September 30, 2020. Actual outcomes could exceed reserves; the ultimate effect of retail sales-practices matters cannot be determined.
Key risks include COVID-19-related credit deterioration and operational disruption, regulatory and remediation costs, the asset cap, low rates, mortgage servicing and repurchase exposures, market volatility, and the LIBOR transition. Management’s ACL sensitivity analysis indicated a hypothetical $2.3 billion increase under a separate, equally weighted base/downside scenario analysis; this is not management’s estimate of expected losses.
The Company said it planned to update operating-segment disclosures in Q4 2020 following its organizational restructuring. It also announced an exit from private student lending, with new applications accepted through January 28, 2021, for the 2020–2021 academic year.

Most important facts for investors to verify

Whether the asset cap, consent-order remediation plans and required third-party reviews change the Company’s ability to grow assets or earnings.
Whether the $20.5 billion loan-credit allowance proves adequate as deferrals expire and economic conditions develop, particularly in commercial real estate, oil and gas, and other criticized sectors.
How much of the $961 million Q3 remediation accrual and the approximately $2.4 billion excess reasonably possible legal-loss range becomes additional expense or cash outflow.
Whether lower rates and reduced net interest margin continue to pressure earnings, and whether mortgage banking gains offset that pressure sustainably.
How capital distribution restrictions, the reduced common dividend, rating outlooks and potential derivative collateral requirements affect capital returns and funding costs.