Wells Fargo & Co (WFC) Earnings Preview: Q3 Profit Up On Reserve Release, Cost Cutting; Mortgage Business Slows

Wells Fargo & Co. (NYSE: WFC), a bellwether for the mortgage and housing sectors, is seeing signs of slowing in its home loan machine as a recent uptick in interest rates discouraged borrowers from refinancing their mortgages. However, the bank is still expected to post higher third-quarter profit driven mostly by further cost cuts and greater reserve releases.

Wells Fargo, which reports earnings on Friday before markets open, is likely to book its 14^th straight quarter of earnings-per-share growth. Analysts polled by Thomson Reuters are projecting a 10 percent increase to 97 cents a share in third-quarter earnings. Revenue is forecast to be little changed at $21.0 billion. In the same period a year earlier, EPS was 88 cents on $21.2 billion in revenue.

Mortgage Slide

A refinancing boom that boosted profit at Wells Fargo earlier this year has fizzled. As mortgage revenue declines, Wells Fargo is looking to trim expenses in the unit.

The biggest U.S. mortgage lender announced in September that it will cut 1,800 jobs in its home loan business. The reductions are in addition to the 3,000 employees who had already been laid off in the third quarter.

The San Francisco-based company, which originated nearly one in three U.S. mortgages in 2012, saw its market share drop to 23 percent in the second quarter, according to industry publication Inside Mortgage Finance.

Chief Financial Officer Tim Sloan told investors at a conference on Sept. 9 that he expects “mortgage revenue to decline in the third quarter with declines in mortgages and originations.”

Sloan expects Wells Fargo to make $80 billion in home loans in the third quarter, nearly 30 percent below its second-quarter figure. Gain-on-sale margins, what the bank makes when it sells home loans into the secondary market, would fall 32 percent.

The forecasts reflect clients pulling back amid speculation the Federal Reserve would scale back its $85 billion-a-month in purchases of Treasury bonds and mortgage-backed securities.

Until now, banks have benefited from government policies intended to stimulate the economy in the wake of the financial crisis. Low interest rates have spurred millions of borrowers to refinance their home loans to take advantage of the lower costs.

The shift started to show in Well Fargo’s second-quarter results. The lender received $146 billion worth of quarterly home loan applications, down from $208 billion in the year-ago period. Its mortgage originations totaled $112 billion, down from $131 billion.

Yields started to climb following Fed Chairman Ben Bernanke’s speech on May 22, where he said the central bank could take a step down in the pace of purchases in the “next few meetings.”

The average rate on 30-year fixed-rate mortgages jumped to a high of 4.8 percent in September before slipping back to 4.49 percent last week. That is still more than a percentage point higher than the near-record low of 3.35 percent recorded in early May.

“The spike in mortgage rates this spring led to a sharp drop in refinancing activity,” Capital Economics’ Paul Diggle wrote in a note to clients. “The index of refinancing applications reverted back to early 2011 levels.”

Reserve Release

As a key source of income growth for Wells Fargo slows down, the bank may dip into the money it had previously set aside in tougher times to cover bad loans -- known as “releasing reserves.” The move will give the firm a direct boost to its bottom line.

After releasing $500 million of reserves in the second quarter, a $300 million increase over the first quarter reserve release level, Wells Fargo guided to a further increase in reserve release in the third quarter but did not provide a specific number.

Continued credit improvement -- as more borrowers pay their loans on time -- allows the lender to keep less money on hand to cover loan losses. Citi's Keith Horowitz looks for a reserve release of about $600 million in the third quarter.

Six percent of Wells Fargo's second-quarter profit came from reserve releases. However, reserve releases are not quality earnings and can offset lower revenue growth only for so long before the bank has to find ways to make up the difference.

WFC's allowance for loan losses is down 36 percent from its early 2010 peak, to $16.14 billion at June 30, equal to about 90 percent of nonperforming loans.

“Ramping up reserve releases this many years after the financial crisis doesn’t seem to be a sustainable way to grow EPS if interest rates remain low and the economy sluggish,” Chris Mutascio, an analyst at Keefe, Bruyette & Woods, said in a note to clients.

Seperately, Wells Fargo announced on Sept. 30 that it will pay Freddie Mac $869 million to repurchase loans it sold to the mortgage firm that didn't conform to its guidelines. The bank said the cost of its agreement is covered by existing reserves, so the impact to third-quarter earnings will be negligible.

Stock Performance

Bank stocks are up 25 percent year-to-date. “Unfortunately, it seems to us that the fate of the bank stocks (in terms of positive catalysts) is now tied directly to the macro-economic environment,” said Keefe Bruyette & Woods analyst Christopher Mutascio.

“A breakout of the gross domestic product malaise could allow for further multiple expansion and outperformance. Conversely, it is hard for us to envision further outperformance at these levels if economic growth remains sluggish -- leading to tepid revenue growth and EPS growth that is driven more by non-cash loan loss reserve releases than it is by pre-tax pre-provision income growth,” Mutascio said.

JPMorgan Chase & Co. (NYSE: JPM), the biggest U.S. bank by assets, and Wells Fargo will kick off bank earnings Oct. 11. Bank of America Corp (NYSE: BAC), Citigroup Inc (NYSE: C), Morgan Stanley (NYSE: MS) and Goldman Sachs Group Inc (NYSE: GS) release results the following week.

Shares of Wells Fargo closed up 0.30 percent, to $40.36 a share in Wednesday's session. So far this year, the stock has gained 18.1 percent.