Wells Fargo's Earnings Propelled by Lower Provisions for Credit Losses

The headline figure is impressive: On a year-over-year basis, Wells Fargo's (NYSE: WFC  ) net income increased by a 19%. However, a closer examination under the hood reveals a more nuanced picture.

The biggest question this quarter revolved around the impact of the recent surge in interest rates following comments by the Federal Reserve at the end of May. Since then, the rate on the 10-year Treasury shot up from below 2% to nearly 2.6% at the end of the second quarter. And mortgage rates skyrocketed; the 30-year fixed-rate mortgage went from below 3.5% to over 4.5% today. Just to be clear, these are massive moves, and particularly over such a short time period.

In terms of banks, and Wells Fargo in particular, the concern was twofold. First, that it would cause a large unrealized loss to the securities in its massive portfolio, as interest rates and the value of fixed-income securities move inversely. And second, that it would put a damper on Wells Fargo's bread and butter: its mortgage origination and servicing operations.

We now know that both of these concerns were well founded. For the three months ended June 30, Wells Fargo reported a net unrealized loss on its available-for-sale securities portfolio of $6.1 billion. The silver lining is that, thanks to the magnitude of the bank's net income, it didn't considerably decrease book value. For the quarter, Wells Fargo noted that its book value per share, which is the primary metric by which banks are valued, decreased sequentially by only $0.01, going from $28.27 in the first quarter to $28.26 last quarter.

And a similar trend can be seen in mortgage banking. On a year-over-year basis, noninterest income stemming from the origination and servicing of mortgages declined by 3%. Much of this was the result of the anticipated slowdown in mortgage demand, as Wells Fargo underwrote only $112 billion in mortgages last quarter compared to the $131 billion that it originated in the second quarter of 2012. Now, to be fair, this is still a staggeringly high number, accounting for more than a quarter of all mortgages originated nationwide -- click here to see a list of the nation's largest mortgage originators.

At this point, in turn, you may be wondering how Wells Fargo was able to grow its net income at all, much less by nearly 20%. To answer this question, we have to look at the top of the bank's income statement, where revenue from interest income is located.

While it's true, as the bank points out in its earnings release (link opens PDF), that net interest income increased in the quarter by 9%, all of the increase came from a drop in loan-loss provisions as opposed to an improved yield from its earning assets. And, in fact, its net interest margin, which is the difference between its yield on earning assets and its cost of funds, actually declined on a year-over-year basis, albeit by a relatively small margin (and not to get too deep into it here, it declined for a good reason: deposit growth).

So, what's the takeaway? Wells Fargo CEO John Stumpf began the earnings release by saying that "Wells Fargo achieved outstanding results for the second quarter." I would agree, with a caveat. There's simply no disputing the bank's success. It dominates the mortgage market. The quality of its assets continues to improve. And it's making more money than ever. But it's still mortal and subject to the same market forces as every other bank. We should see more of this in the upcoming quarters as the higher long-term interest rates settle in and take a firmer hold.

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