WELLS FARGO & COMPANY quarterly report, Q3 FY2019

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Wells Fargo & Company — Q3 2019 Form 10-Q

Reporting period: Quarter and nine months ended September 30, 2019. Wells Fargo is a diversified U.S. financial services company with $1.94 trillion in period-end assets. The company’s three reportable segments are Community Banking, Wholesale Banking, and Wealth and Investment Management. Charles W. Scharf became CEO and President on October 21, 2019.

Financial performance and condition

  • Q3 earnings: Net income was $4.61 billion, down 23% from $6.01 billion a year earlier. Diluted EPS was $0.92 versus $1.13. Results included a $1.6 billion litigation accrual related to previously disclosed retail sales practices matters and a $1.1 billion pretax gain on the sale of the Institutional Retirement and Trust (IRT) business.
  • Revenue and margins: Revenue was $22.01 billion, approximately flat year over year. Net interest income was $11.63 billion, down $947 million; noninterest income was $10.39 billion, up $1.02 billion. Net interest margin fell to 2.66% from 2.94%, reflecting repricing and balance-sheet mix.
  • Costs and profitability: Noninterest expense rose 10% to $15.20 billion, mainly due to higher operating losses and litigation accruals. The efficiency ratio worsened to 69.1% from 62.7%; pre-tax pre-provision profit was $6.81 billion versus $8.18 billion. Annualized ROA was 0.95% and ROE 9.00%, down from 1.27% and 12.04%.
  • Credit: Provision for credit losses was $695 million, up from $580 million. Net charge-offs were $645 million, or 0.27% of average loans, compared with $680 million, or 0.29%. Nonaccrual loans were $5.5 billion, down 17% year over year. The allowance for credit losses was $10.6 billion, or 1.11% of loans.
  • Balance sheet and funding: Period-end assets were $1.944 trillion; loans $954.9 billion; deposits $1.308 trillion; and total equity $194.4 billion. Long-term debt was $230.7 billion and short-term borrowings $123.9 billion. Average deposits increased 2% year over year, while the average deposit cost rose 24 basis points to 0.71%.
  • Liquidity and capital: The quarterly average liquidity coverage ratio was 119%, above the 100% minimum. Unencumbered primary liquidity sources totaled $415.0 billion. Fully phased-in CET1 was 11.61%, above the company’s 10.00% internal target; supplementary leverage ratio was 7.36%. Eligible external TLAC was 23.29% of risk-weighted assets versus a 22.00% minimum.
  • Shareholder returns: The company returned $9.0 billion through dividends and net share repurchases in Q3, including repurchase of 159.1 million shares for $7.4 billion. The quarterly common dividend was $0.51 per share.
  • Nine-month results and cash flows: Net income was $16.68 billion versus $16.33 billion; revenue was $65.20 billion versus $65.43 billion. Operating cash flow was negative $5.69 billion, compared with positive $21.04 billion in 2018; investing cash flow was negative $27.11 billion and financing cash flow positive $8.24 billion. Cash, cash equivalents, and restricted cash declined $24.56 billion during the nine months.

Material changes versus comparable periods

  • Q3 net income and diluted EPS declined substantially, largely reflecting the discrete litigation accrual, higher operating costs, lower net interest income, and higher credit provision; the IRT sale gain partly offset these pressures.
  • Lower rates and balance-sheet mix reduced Q3 net interest margin by 28 basis points year over year. Higher funding costs also contributed: average deposit cost rose to 0.71%.
  • Noninterest income increased, including gains from the IRT sale and equity securities, while mortgage servicing income weakened. Q3 mortgage servicing income was a $142 million loss, including a $284 million net MSR valuation loss.
  • Credit indicators were generally favorable year over year: net charge-off rate declined and nonaccrual loans fell. The allowance coverage ratio also declined from 1.16% to 1.11%.
  • Period-end assets increased $48.1 billion from year-end 2018, while total equity declined $2.7 billion, mainly reflecting share repurchases, partly offset by retained earnings and higher accumulated other comprehensive income.

Outlook, risks, contingencies, and unusual items

  • Regulatory asset cap: A 2018 Federal Reserve consent order caps consolidated assets at the December 31, 2017 level until required governance and risk-management plans are accepted, implemented, and reviewed to the FRB’s satisfaction. The company reported that assets calculated under the order remained below the cap at Q3 end.
  • Legal and customer remediation: The company continues reviews and remediation involving retail sales practices and other customer matters, including auto lending and insurance products, account freezing and closures, fiduciary fees, foreign exchange pricing, mortgage modifications, and deposit-account fees. The company recorded a $1.6 billion Q3 litigation accrual. The high end of reasonably possible losses above accrued probable losses was approximately $3.6 billion; outcomes remain uncertain.
  • Other regulatory exposure: CFPB and OCC consent orders require an aggregate $1 billion in civil penalties and customer remediation relating to compliance-risk management, auto collateral protection insurance, and mortgage rate-lock extensions. The company remains subject to regulatory reviews and litigation, including retail sales practices matters.
  • Forward-looking items: Management gave no specific earnings or revenue guidance in the supplied filing text. It expected to continue share repurchases through the remainder of 2019, subject to regulatory, legal, capital, and market factors. The sale of Eastdil Secured closed October 1, 2019; an approximately $360 million pretax gain was expected in Q4.
  • CECL: Adoption was planned for Q1 2020. Based on portfolio composition and the then-current economic environment, management estimated an approximately $1.4 billion decrease in the allowance for credit losses, which it expected to increase retained earnings and regulatory capital at adoption. The ultimate effect could change with portfolio composition, credit quality, economic conditions, and model refinements.
  • Principal risks: The asset cap and consent orders, further litigation or remediation costs, interest-rate and deposit-pricing pressure, mortgage servicing rights valuation and prepayment sensitivity, credit deterioration, LIBOR transition, cyber and operational risks, and economic or market volatility. Management noted that lower rates could reduce net interest income; its modeled second-year sensitivity to a 100-basis-point rate decline was a $3.5–$4.0 billion decrease versus base expectations.

Investor facts to verify

  • Whether the $1.6 billion litigation accrual and the estimated $3.6 billion upper range of additional reasonably possible legal losses adequately capture potential outcomes.
  • Progress toward satisfying the FRB consent order, completing required third-party reviews, and ultimately removing the asset cap.
  • Whether underlying earnings can recover from margin compression and elevated expense levels after adjusting for the IRT gain and litigation accrual.
  • CECL’s final adoption impact versus the estimated $1.4 billion allowance decrease, including resulting capital effects.
  • Credit trends by portfolio, particularly credit cards, commercial and industrial lending, and mortgage loans, and whether allowance coverage remains appropriate.
  • Execution and economics of the IRT transition-services arrangement and the Eastdil sale gain, including the effect of client-asset transitions on future fees and costs.