Wells Fargo 10-Q: Good News

Wells Fargo (WFC) filed its 10-Q and there were some very favorable items in it for shareholders.

Results:
We continued to profitably build our franchise in second quarter 2008, at a time when many in our industry have been primarily focused on fixing rather than growing their companies. Despite a $3.0 billion provision for loan losses in the quarter, including a $1.5 billion credit reserve build, we earned a $1.8 billion quarterly profit, generated return on equity of 14.6%, increased Tier 1 capital in the quarter by 32 basis points to 8.24%, and increased the combination of capital and loan loss allowance to 9.7% of average earning assets from 9.1% linked quarter.

Our continued profitable growth is reflected in the growth of our pre-tax pre-provision income, up $1.4 billion, or 34%, from a year ago, driven by a 20% increase in earning assets, a 16% increase in revenue, a 10% increase in noninterest income, record cross-sell of 5.64 products in our retail business and 6.3 products in our commercial business, a 3 basis point increase in the net interest margin to 4.92% (up 23 basis points linked quarter), and an increase in operating leverage, with expenses up only 2% versus 16% revenue growth.

In broad terms, the credit crisis itself has created incremental earnings opportunities for Wells Fargo, largely offsetting our incremental charge-offs from the crisis

Net Interest Income:
Net interest income is the interest earned on debt securities, loans (including yield-related loan fees) and other interest-earning assets minus the interest paid for deposits and long-term and short-term debt. The net interest margin is the average yield on earning assets minus the average interest rate paid for deposits and our other sources of funding. Net interest income and the net interest margin are presented on a taxable-equivalent basis to consistently reflect income from taxable and tax-exempt loans and securities based on a 35% federal statutory tax rate.

Net interest income on a taxable-equivalent basis increased 21% to $6.33 billion in second quarter 2008 from $5.23 billion in second quarter 2007. The increase was driven by 20% earning asset growth combined with an increase in the net interest margin to 4.92%, up 3 basis points from a year ago and up 23 basis points linked quarter. The improvement in the net interest margin reflects our focus on higher risk-adjusted yields on new loans and securities, a decline in funding costs, our disciplined deposit pricing, and the high percentage of checking and transaction accounts in our core deposit mix. For the first half of 2008, growth in net interest income has largely offset the impact of the credit crisis on charge-offs.

Credit Cards:
Card fees increased 14% to $588 million in second quarter 2008 from $517 million in second quarter 2007, due to continued growth in new accounts and higher credit and debit card transaction volume. Purchase volume on these cards was up 13% from a year ago and average card balances were up 30%.

Credit Losses:
The allowance for credit losses, which consists of the allowance for loan losses and the reserve for unfunded credit commitments, is management’s estimate of credit losses inherent in the loan portfolio at the balance sheet date. We assume that our allowance for credit losses as a percentage of charge-offs and nonaccrual loans will change at different points in time based on credit performance, loan mix and collateral values. The detail of the changes in the allowance for credit losses, including charge-offs and recoveries by loan category, is in Note 5 (Loans and Allowance for Credit Losses) to Financial Statements in this Report.

Net charge-offs for second quarter 2008 were $1.5 billion (1.55% of average total loans outstanding, annualized), compared with $1.5 billion (1.60%) for first quarter 2008 and $720 million (0.87%) for second quarter 2007. As previously announced, the Home Equity charge-off policy was changed in second quarter 2008 to provide more time to work with customers to solve their credit problems and keep them in their homes. The policy change had the effect of deferring an estimated $265 million of charge-offs from the second quarter, but did not reduce provision expense in second quarter 2008 since this loss content was included in the $1.5 billion credit reserve build. Total provision expense in second quarter 2008 was $3.0 billion, including a $1.5 billion credit reserve build, primarily for losses in the Home Equity, Wells Fargo Financial real estate, and unsecured consumer portfolios. The $792 million increase in net credit losses from a year ago included $243 million in the real estate 1-4 family junior lien category. Net credit losses in the commercial category (primarily Business Direct) increased $199 million from a year ago.

Because of our responsible lending and risk management practices, we have largely avoided many of the products others in the mortgage industry have offered. We have not offered certain mortgage products such as negative amortizing mortgages or option ARMs. We had minimal ARM reset risk across our owned loan portfolios at June 30, 2008. While our disciplined underwriting standards have resulted in first mortgage delinquencies below industry averages through June 30, 2008, we continually evaluate and modify our credit policies to address unacceptable levels of risk as they are identified. In the past year, for example, we have tightened underwriting standards as we believed appropriate. Home Mortgage closed its nonprime wholesale channel early in third quarter 2007, after closing its nonprime correspondent channel in second quarter 2007. In addition, rates were increased for non-conforming mortgage loans during third quarter 2007 reflecting the reduced liquidity in the capital markets. As a result of these underwriting and policy changes, as well as overall market changes, Home Mortgage has shifted its loan origination production mix to significantly more government and conforming loans than a year ago, when production included a higher level of non-conforming and nonprime loans.

Although credit quality in Wells Fargo Financial’s real estate-secured lending business has deteriorated, we have not experienced the level of credit degradation that many nonprime lenders have because of our disciplined underwriting practices. Wells Fargo Financial has continued its long-standing practice not to use brokers or correspondents in its U.S. debt consolidation business

We do not act as a sponsor for any SIVs. On the investment side of this business, we operate within disciplined credit standards and regularly monitor and manage our securities portfolios. We have not participated in the underwriting of any of the large leveraged buyouts that were “covenant lite,” and we have minimal direct exposure to hedge funds. Similarly, we have not made a market in subprime securities.

Long story short? Wells Fargo is in fantastic shape. Does that mean there will not be bumps in the road? Clearly if the economy continues to deteriorate, things will fall. When you look around the financial sector, I can’t find anyone making the kinds or statements (results based ones, not “anticipated results” promises) like Wells Fargo. Citi (C), Wachovia (WB), Washington Mutual (WM) are all repairing rather than growing. Even JP Morgan (JPM) and Bank of America (BAC) while not suffering can’t claim the same quality of assets as Wells.

Full 10-Q Filing:

Disclosure (“none” means no position):Long WFC, WB, C, None

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