April 13, 2017 / 7:03 PM / 4 months ago

Fitch: Wells Fargo Reports Flat Earnings from Year Ago

(The following statement was released by the rating agency) CHICAGO, April 13 (Fitch) Wells Fargo & Company (WFC) reported $5.46 billion in net income for in 1Q17, resulting in a return on assets (ROA) of 1.15% and a return on equity (ROE) of 11.5%. Quarterly earnings improved 3.5% on a linked-quarter basis but were flat from a year ago. These earnings metrics remain somewhat modest on an absolute basis, in Fitch Ratings' opinion, and are on the low-end of internally targeted ranges. Last quarter, WFC reported approximately $600 million of net hedge ineffectiveness as compared to $193 million in losses this quarter. This hedge ineffectiveness arises from WFC's practice of routinely swapping its fixed rate long-term debt into floating rate and swapping its foreign currency-denominated debt into U.S. dollars. Excluding these items, pre-tax income was 4.4% lower on a linked-quarter basis. Adjusted pre-tax income declined on higher expenses, and a decline in spread income. This was partially offset by lower credit costs and an improvement in adjusted noninterest income, primarily from higher trading gains. WFC also reported a $197 million discrete tax benefit during the quarter. WFC reported a nearly 1% decline in spread income on a linked quarter basis, reflecting two fewer days during the quarter. This marks the first time in eight quarters that net interest income declined. Despite this, WFC noted that spread income could mid-single digit increase in full-year 2017 relative to 2016, even with no further increases in rates due to loan growth. The margin remained flat from last quarter at 2.87% during the quarter. Increasesin interest rates and other benefits were offset, in part, by lower income from trading assets and mortgages held for sale. Period-end loan balances declined 1% on a linked-quarter basis, primarily from lower consumer loan balances. WFC tightened underwriting standards in auto, which contributed to the 3% decline on a linked-quarter basis. The bank also reported continued reduction in energy loans, seasonally lower card balances, and a continued decline in junior lien mortgage loans. This was partially offset by higher CRE construction balances, growth in Wells Fargo Capital Finance, Asset Backed Finance, and commercial dealer services. Similar to quarters past, WFC continues to grow deposit balances, up 1% on a linked-quarter basis. WFC reported a 5bps uptick in deposit costs, primarily due to higher pricing on commercial deposits. The company's balance of short-term investments increased 16% on a linked-quarter basis reflecting growth in deposits and the linked-quarter decline in the loan portfolio. WFC also paused on securities purchases pending greater clarity on the interest rate outlook, particularly on the longer-end of the curve where it invests. Adjusting for the hedge ineffectiveness, noninterest income improved 1.3% on a linked-quarter basis, primarily from a significant increase in trading gains. This was offset by broad-based declines in other categories, including deposit service charges, trust and investment fees, card and other fees, lease income, and net gains on debt securities. WFC also reported a 13% decline in mortgage banking noninterest income due to lower mortgage origination revenue, more than offsetting improved servicing income from the rise in rates and slowing prepayment speeds. Quarterly noninterest expenses increased 4.4% primarily due to seasonally higher incentive compensation and employee benefits. Fitch expects WFC to report some volatility in operating losses during the year, as this line item includes litigation accruals. Further, marketing and outside professional services are likely to remain elevated as the company continues to focus on regulatory and compliance initiatives, including the sales practices issue. Sales-practices related spend was roughly $80 million in 1Q17 and is expected to be between $70 million and $80 million a quarter. WFC did not disclose the aggregated impact to earnings from sales-practices issues during the earnings call. The efficiency ratio deteriorated to 62.7% during the quarter, which is outside WFC's targeted range of 55% to 59%. The company is targeting $2 billion in expense reductions to be achieved by 2018, with the savings redeployed into the businesses, and as such, there will be no bottom line impact related to these ongoing initiatives. Management has indicated that it will discuss further anticipated expense reductions that will impact the bottom line at its investor day next month. Fitch revised WFC's Rating Outlook to Negative in early October, reflecting the potential damage to the firm's franchise and earnings profile following recent regulatory actions regarding unauthorized account openings. WFC recently disclosed the results of the review by the Board's independent directors into the company's retail banking sales practices. The report identified an incentive program, aggressive sales culture, unrealistic goals, and decentralized corporate and risk structure as contributing to the sales practices issues. During the quarter, WFC also announced an agreement in principle to settle a May 2015 class action lawsuit in the amount of $110 million, pending court approval. WFC expects this settlement to resolve claims in 11 other pending class actions that are related to unauthorized account openings. This amount was fully accrued for and, as such, did not impact quarterly results. It was also disclosed during the quarter that WFC's CRA rating was downgraded to "Needs to Improve" from "Outstanding." Given the consumer-related regulatory consent orders, this downgrade was expected by Fitch. The limitations imposed on the bank given the CRA rating should not materially impact WFC. Fitch views some weakening trends in retail banking activity as appearing to have stabilized. For example, WFC reported an increase in credit card applications, and consumer and small business deposits continue to grow. The company disclosed that checking account attrition levels are back to pre-settlement levels. WFC has reported modest growth in primary consumer checking customers over the past several months as well. Despite these developments, Fitch believes it is still too early to discern the ultimate impact from the firm's Sept. 8 settlement announcement related to the unauthorized account openings. Credit quality remained good, with lower loan losses, nonaccrual loans, and criticized balances. NCOs improved 3bps to 34bps of loans during the quarter, due to lower energy and residential mortgage charge-offs. Loan losses remain below the company's through-the-cycle loss estimate of 65bps and Fitch's expectations of normalized credit losses. NCOs exceeded provisions for a reserve release totaling $200 million during the quarter, up from $100 million last quarter. WFC also reported an improvement in nonperforming assets, down 6% on a linked-quarter basis. Capital remains sound, with the estimated Common Equity Tier 1 under Basel III Standardized Approach, fully phased-in, at 11.2% at quarter-end, up 40bps from the prior quarter, and above the company's internal target of 10%. Capital ratios were aided by retained earnings growth and lower risk-weighted assets. Capital ratios also benefited from some improvement in net unrealized losses on available-for-sale securities, down to $1.2 billion at quarter-end, as compared to $1.8 billion at Dec. 31, 2016. WFC also provided an estimate of its shortfall under the final TLAC rules. At March 31, 2017, the shortfall was approximately $1.4 billion. Fitch expects WFC will easily meet the shortfall. Related to its resolution plan outcome, WFC has elected to limit the company's nonbank and broker-dealer assets to levels in place as of Sept. 30, 2016, and expects to operate at this level for the foreseeable future. During the quarter, WFC reported approximately $100 million in lower trading related interest income, a potential proxy of the impact of this self-imposed restriction. While these restrictions are manageable to WFC given its predominantly U.S.-based traditional bank business model, Fitch would view a failure to adequately address the deficiencies in its March 31, 2017 filing negatively. 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