Fitch: Wells Fargo 2Q'16 Earnings Demonstrate Resiliency

Wells Fargo & Company (WFC) reported $5.6 billion in net income, higher on linked-quarter basis, resulting in a return on assets (ROA) of 1.20%, and a return on equity (ROE) of 11.7%. Earnings reflected continued growth in spread income, stable credit costs, and lower noninterest expenses, according to Fitch Ratings. The quarter also included a $290 million gain on the sale of the health benefit services business, as part of the company's strategy to reduce non-core businesses, simplify the organization, and improve the risk profile. This follows last quarter's gain of $381 million on the sale of the crop insurance business.

The current quarter's performance was within the company's targeted ranges for ROA of between 1.10% and 1.40% and ROE of between 11% and 14%, albeit on the lower end of these ranges.

Similar to quarters past, WFC added duration during the quarter reflecting its view that rates will remain lower for longer. The company also converted floating rate loans to fixed rate through interest rate swaps. WFC grew the securities portfolio with $38 billion of gross purchases, most of which was completed before the large decline in long-term rates following the Brexit vote. Even with the securities purchases, WFC remained asset sensitive at quarter-end.

The quarter reflected $31 billion in acquired GE Capital loans, acquired on March 1, which WFC anticipates will contribute approximately $300 million in quarterly net interest income, and be accretive to net income for the year. Spread income improved on loan growth, aided by the GE transaction, partially offset by accelerated prepayments on MBS and higher long-term debt expenses. WFC still expects to grow net interest income during the year, even with the current rate environment.

WFC reported incremental margin compression, primarily driven by long-term debt, deposits, and reduced yield on securities portfolio. Deposit costs increased by 1 basis point (bp), driven by higher funding costs on certain wholesale deposits, to a still very low 11bps during the quarter.

Noninterest income declined 1% during the quarter. Stripping out the gains on the sale of the non-core business previously mentioned; core noninterest income was flat with higher trust and investment fees, market-sensitive revenues, and lease income, offset by lower mortgage revenues and insurance income, reflecting the sale of the crop insurance business

Mortgage production increased during the quarter reflecting a sizeable jump in origination volumes. This was more than offset by lower servicing income as a result of negative MSR valuation adjustments.

Noninterest expenses were lower during the quarter, as personnel expenses declined from a seasonally higher first quarter. This reflected lower operating losses and litigation expenses, offset by an increase in outside professional services. Effective July 1, WFC will also face an increase of $100 million in FDIC assessments.

Credit quality remained generally benign with 39bps of loan losses during the quarter, with higher energy-related net charge-offs (NCOs) offset by improved residential losses. NCOs remain below the company's through the cycle loss estimate of 65bps, and Fitch's expectations of normalized credit losses. Credit losses excluding oil & gas losses were 28bps during the quarter, the same as a year ago.

Nonperforming assets (NPAs) declined on a linked-quarter basis as a decline in residential and CRE nonaccruals was partially offset by $651 million higher oil and gas nonaccruals. WFC once again built loan loss reserves by $150 million with provisions exceeding NCOs primarily driven by growth in the commercial, auto and credit card portfolios, following a $200 million reserve build last quarter.

At June 30, 2016, WFC's direct exposure to energy lending is modest at less than 2% of total loans outstanding. O&G exposure declined to $39.1 billion during the quarter due to borrowing base reductions. WFC disclosed there were no defensive draws during the quarter.

Fitch notes that WFC's portfolio includes a larger percentage of sub-investment grade borrowers than its peers. Both NCOs and NPAs levels deteriorated during the quarter given expected deterioration in borrower financial performance, the run-off of borrower hedges, and less sponsor support. Despite this, WFC did not build energy-related reserves reflecting the increase in energy prices, slowed pace of deterioration, and improved criticized asset levels during the quarter. Fitch notes that WFC's oil and gas reserves of 9.2% are on the higher end of peers reporting to date.

In terms of WFC's compliance with pending total loss absorbing capital (TLAC), WFC issued approximately $11 billion in parent debt during the quarter. The company still anticipates around $50 billion in issuance needed to comply with the requirements, inclusive of a 100bps buffer. We expect WFC to comply with this rule, particularly in light of a five year phase-in period.

The estimated Common Equity Tier 1 under Basel III Standardized Approach, fully phased-in, was 10.6% at quarter-end, flat from the prior quarter. WFC received no objection to its capital under CCAR. WFC did not disclose its request for dividend request nor share repurchases, but did recently increase the common dividend to $0.38 per share, up from $0.375, as part of last year's CCAR capital plan.

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