WELLS FARGO & COMPANY quarterly report, Q2 FY2012

Wells Fargo & Company — Q2 2012 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2012. Comparisons below are to Q2 or first-half 2011 unless otherwise noted. Dollar amounts are in U.S. dollars.

Business context

Wells Fargo is a diversified financial services company with $1.3 trillion in assets. Its three reported segments are Community Banking, Wholesale Banking, and Wealth, Brokerage and Retirement. Results benefited from mortgage banking activity, fee income, loan and deposit growth, and improving credit quality.

Key financial metrics

Metric	Q2 2012	Comparable period
Total revenue	$21.3 billion	$20.4 billion, Q2 2011; up 4%
Wells Fargo net income	$4.62 billion	$3.95 billion, Q2 2011; up 17%
Net income applicable to common stock	$4.40 billion	$3.73 billion, Q2 2011
Diluted earnings per common share	$0.82	$0.70, Q2 2011
Net interest income	$11.04 billion GAAP; $11.21 billion taxable-equivalent	$10.68 billion GAAP; $10.85 billion taxable-equivalent, Q2 2011
Net interest margin	3.91%	4.01%, Q2 2011
Noninterest income / expense	$10.25 billion / $12.40 billion	$9.71 billion / $12.48 billion, Q2 2011
Efficiency ratio	58.2%	61.2%, Q2 2011
Provision for credit losses	$1.80 billion	$1.84 billion, Q2 2011

For the first half of 2012, revenue was $42.9 billion, net income $8.87 billion, diluted EPS $1.57, and noninterest expense $25.39 billion. Year over year, these were up 5%, 15%, 15%, and 1%, respectively.

Balance sheet and liquidity: At June 30, total assets were $1.336 trillion, loans $775.2 billion, deposits $928.9 billion, short-term borrowings $56.0 billion, and long-term debt $125.0 billion. Core deposits were $882.1 billion, or 114% of total loans. Cash and due from banks was $16.8 billion, with $74.6 billion in short-term investments. Total equity was $149.4 billion.

Capital: Basel I Tier 1 capital ratio was 11.69%, total capital ratio 14.85%, Tier 1 leverage ratio 9.25%, and Tier 1 common equity ratio 10.08%. Management estimated a 7.78% Tier 1 common equity ratio under the proposed Basel III rules; the estimate depends on proposals and assumptions that remained subject to change.

Cash flow: First-half operating cash flow was $35.4 billion, investing cash flow was negative $47.7 billion, and financing cash flow was positive $9.7 billion. Cash and due from banks declined $2.6 billion from year-end 2011 to $16.8 billion. Mortgage origination and sale activity contributed substantially to operating cash flows.

Material changes versus prior periods

• Q2 revenue growth was driven primarily by mortgage banking and modestly higher net interest income. Mortgage banking income rose 79% to $2.9 billion; mortgage originations were $131 billion, and the unclosed pipeline was $102 billion.
• Mortgage gains were materially reduced by a $669 million Q2 provision for mortgage repurchase losses, versus $242 million a year earlier. The repurchase liability increased to $1.76 billion from $1.44 billion at March 31 and $1.19 billion at June 30, 2011.
• Card fees fell 30% year over year in Q2 to $704 million, primarily reflecting lower debit interchange rates under rules effective in Q4 2011.
• The net interest margin was flat sequentially but down 10 basis points year over year, as higher-yielding assets ran off and the low-rate environment pressured returns.
• Average core deposits rose 9% year over year to $880.6 billion; deposit costs were 19 basis points, down 9 basis points year over year. Average loans rose 2% year over year to $768.2 billion.
• Credit indicators improved: Q2 net charge-offs were $2.2 billion, or 1.15% of average loans, versus 1.52% a year earlier. Nonperforming assets were $24.9 billion, down from $26.6 billion at March 31, 2012.
• Core loan balances grew, partly offset by runoff in non-strategic and liquidating portfolios. The company reported $6.9 billion of commercial loans acquired in Q2 through two business acquisitions.

Outlook, risks, contingencies and unusual items

• Management expected noninterest expense to decline from Q2 levels during the remainder of 2012 and targeted an efficiency ratio of 55%–59%. Given stronger revenue opportunities and reinvestment, it expected Q4 expense to exceed its previously announced $11.25 billion target.
• Management expected continued, but more modest, credit improvement and further allowance releases in 2012, absent significant economic deterioration. The $18.6 billion allowance for credit losses was management’s estimate and remained sensitive to economic conditions, housing prices, unemployment and borrower performance.
• Management expected continued net interest margin pressure as assets repriced in the low-rate environment. Interest-rate simulations estimated earnings at risk of less than 1% of the most likely plan over the next 12 months, subject to balance-sheet and rate assumptions.
• The mortgage repurchase liability involved significant estimation uncertainty. The filing reported up to $2.6 billion of reasonably possible losses in excess of the recorded liability. Increased GSE file requests and repurchase demands contributed to the Q2 provision; the company cited an improving appeals success rate as an offset.
• A federal-state mortgage servicing and foreclosure settlement included approximately $5.3 billion of program commitments: $3.4 billion consumer relief, $900 million refinancing, and $1 billion foreclosure assistance. The company expected to meet its commitments. The filing estimated that its refinancing program could reduce lifetime interest income by $1.4–$1.7 billion if the anticipated volume is completed.
• On July 12, 2012, the company agreed to a DOJ settlement, denied the allegations, and agreed to pay $125 million for borrower relief and $50 million for a community support program; related expenses were fully accrued by quarter-end. It also announced that it would stop funding mortgages originated, priced and sold through independent brokers in its wholesale division.
• On July 13, 2012, Wells Fargo and other defendants signed a memorandum of understanding for proposed interchange-litigation settlements totaling approximately $6.6 billion, subject to approval. Separately, the filing estimated reasonably possible litigation losses above accrued liabilities of up to $1.2 billion; the company said an unfavorable outcome could be material to a particular period.
• Basel III rules and other regulatory changes remained uncertain. The company was identified as a global systemically important bank, but its applicable capital surcharge had not been determined. It also expected swap-dealer registration to be required in late September or early October 2012.
• Q2 operating losses were $524 million, up from $428 million a year earlier, predominantly due to additional litigation accruals. Q2 included a $2.7 billion redemption of trust preferred securities; the company also repurchased shares and declared a $0.22 common dividend.

Important facts for investors to verify

• Whether mortgage repurchase demands, appeals outcomes and loss severity support the $1.76 billion recorded liability, given the disclosed possible additional losses.
• Whether mortgage originations and margins remain strong enough to offset repurchase provisions, servicing costs and potential MSR valuation changes.
• Whether net interest margin pressure, deposit pricing and asset repricing evolve as management expects.
• Whether credit improvement continues, and whether the allowance and anticipated releases remain appropriate if economic or housing conditions weaken.
• Execution and financial effects of mortgage settlement commitments, the proposed interchange settlements, and other litigation; and the final Basel III capital requirements and surcharge.