3 Troubling Trends at Wells Fargo

Source: The Motley Fool

If you weren't careful, you'd be excused for concluding that Wells Fargo (NYSE: WFC  ) had yet another fantastic performance in the third quarter -- that, at least, was my initial impression. It generated record earnings over the three-month time period and achieved its 15th consecutive quarter of earnings-per-share growth. Not too shabby.

Yet, as I discussed on Tuesday, there was a lot more to these figures than first met the eye. Namely, Wells Fargo's revenue plummeted in the third quarter while its expenses stayed flat. Needless to say, this isn't an effective formula for sustained earnings growth.

With this in mind, I've dug further into Wells Fargo's earnings materials to identify the three most troubling trends afflicting the California-based bank.

1. Net interest margin is falling
Wells Fargo's net interest margin has been a hot topic of conversation over the last three years. Since the middle of 2010, it's fallen from 4.4% all the way down to 3.38% in the most recent quarter.

The bank's response is that it's not focused on the net interest margin, but rather on its net interest income. "You've heard me say many times that our focus is not on our net interest margin," its chief financial officer, Timothy Sloan, said at a recent industry conference, "but on growing our net interest income over time."

There's something to be said for this for sure, given that what ultimately matters is how much money a bank makes, which is represented by net interest income, and not some non-GAAP financial measure favored by analysts.

But there's a limit to how much this holds up. And I believe that Wells Fargo's third-quarter results are testing that limit.

While the bank did in fact grow its net interest income on a year-over-year basis, more than all of the growth came from reduced interest expense. I say "more than all," because its interest income actually fell by $149 million compared to the same period last year. As a result, the $235 million reduction in interest expense translated into an increase in net interest income of only $86 million.

2. Provisions are accounting for the lion's share of growth
There's an argument to be made that growth is good, regardless of where it comes from. At the same time, not all growth is equally sustainable. And the latter is where Wells Fargo is beginning to run into problems.

As I intimated at the outset, Wells Fargo has a lot to be proud of. Its bottom line has expanded for 15 consecutive quarters, the 10 most recent of which were all record quarters in terms of profitability.

However, the source of the growth over the last two quarters -- the most recent one in particular -- has stemmed from a reduction in loan-loss provisions as opposed to either revenue expansion or expense reduction.

In the three months ended September 30, Wells Fargo set aside only $75 million. By comparison, in the same period last year, its loan-loss provisions amounted to $1.6 billion.

The point being, there isn't much more that this can give. In the future, the bank will have to look elsewhere for bottom-line growth.

3. Mortgage volumes are plummeting
Wells Fargo likes to emphasize the fact that it has a well-diversified operation. Its CEO, for instance, likes to make an analogy about its operations to a coach being pulled by "85 to 90 horses."

Be that as it may, however, there's no getting around the fact that Wells Fargo is the nation's largest mortgage originator and that it looks to the activity for a significant share of income.

You can see this in the bank's third-quarter results, and particularly its noninterest income. The latter figure, which accounts for roughly half of Wells Fargo's revenue, fell by 7.8% on a year-over-year basis. And the entire drop was attributable to a decline in mortgage-banking income. Without that, noninterest income would have increased by roughly 5%.

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  • Report this Comment On October 17, 2013, at 7:29 PM, rd80 wrote:

    1. Net interest margin is falling, but, as noted, net interest income was up. The driving factor for lower margins was and increase in deposits - and that's a good thing.

    2. Yes, reserve releases can't go on forever, but during the conference call, WFC management said we should expect reserve releases to continue for awhile.

    3. The decrease in mortgage business is a concern. However, for the 3rd quarter, Wells saw all of the decrease in activity but almost none of the cost savings from reduced head count - that'll start to show up this quarter.

    Good article. I think there's a good chance the string of record earnings will be broken, but no intentions of selling any of my shares and would be glad to see a dip to add some more.

  • Report this Comment On October 24, 2013, at 6:07 PM, dmawhinney wrote:

    There's nothing wrong with a decrease in net interest margin. It tends to move with the steepening or flattening of the yield curve. The business side of the bank must do its best to increase interest income. It's up to the funding side of the bank to determine its cost of capital.

    No bank should ever chase after higher yielding (read higher risk) business just to satisfy some Wall Street writer who wants to focus on interest margins. That will lead to higher provisions for loan loss eventually.

    So you say the net interest margin is down--no big deal. You say provisions for loan losses are down--great news. We're getting back to normal. Mortgage volumes are plummeting--probably the reason for the other two observations.

    All three reasons to be a buyer of Wells Fargo

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