Wells Opts to Keep More Mortgages on Books

Wells Fargo (WFC) rode the mortgage refinancing wave to record earnings in the third quarter, but investors seem more concerned with what will drive profits when the good times end.

Though Wells beat consensus earnings-per-share estimates, the nearly 3% drop in its share price Friday reflected broader investor unease about shrinking net interest margins and what will replace mortgage lending when interest rates eventually rise. Refinances, which are being driven by record-low interest rates, currently account for 75% of Wells Fargo's mortgage business.

"I think in general investors are concerned about two things about banks," said Moshe Orenbuch, an analyst with Credit Suisse. "Wells sits at the nexus of both of those."

On a conference call with analysts, Wells Chief Executive Officer John Stumpf and Chief Financial Officer Tim Sloan cautioned against reading too much into volatile quarterly interest margins.

And though the pair acknowledged that the mortgage boom can't last forever, they don't see it ending soon, either.

"We expect to have a pretty strong mortgage quarter in the fourth quarter," Sloan said. "How long that will last, we don't know for sure. But it feels like it's going to last at least a few quarters, and obviously we hope it does."

In the meantime, Wells faces a different question — how to prop up margins when overall loan demand remains sluggish.

In the third quarter, Wells Fargo decided to retain on its balance sheet $9.8 billion in mortgage loans, rather than securitizing them and then purchasing mortgage-backed securities backed by Fannie Mae and Freddie Mac. And it announced its intention to retain more mortgages in the fourth quarter.

"While retaining these mortgage loans on our balance sheet reduced mortgage revenue this quarter, we expect to generate spread income in future quarters from mortgage loans with higher yields than mortgage backed securities we could have purchased in the market," Sloan said. "We are in a unique position to have a large enough mortgage business and strong capital to be able to make these choices that should benefit long-term results."

He acknowledged that the strategy carries certain risks, including the chance that borrowers will default, and the risk that interest rates will rise, but said the company is comfortable with those exposures.

Orenbuch agreed that the risks of the strategy are manageable, given Wells' $1.3 trillion in assets.

"You're talking about $10 billion out of a trillion, right?" he said. "So if it got to $100 billion out of a trillion, we'd start thinking about it differently."

For the quarter, Wells' reported earnings of $4.9 billion, up 22% from the same period last year. Revenue climbed 8% year over year, due almost exclusively to refinancing volume, to $21.2 billion, but were down slightly from the prior two quarters.

Of greater concern to analysts was the 25-bais point drop in in its net interest margin from the prior quarter, to 3.66%, due largely to a $375 million dip in net interest income. "This was worse than management had suggested just a month or so ago (which in and of itself had been disappointing to investors)," Sandler O'Neill Research wrote Friday in a note to investors.

In an interview with American Banker, Sloan noted that the metric can fluctuate from quarter to quarter, and he pointed out that it is down only 0.18% from the same time last year.

"I don't think that that's necessarily alarming given the decline in rates," Sloan said.

Instead, he placed greater emphasis on earnings per share, which at 88 cents per share were up 22% from a year ago. That beat a consensus estimate of 87 cents per share, according to a Bloomberg survey of 33 analysts.

In its earnings announcement Wells also stated that it was using reserves to increase its net loan charge-offs by $567 million — in order to comply with guidance from the Office of the Comptroller of the Currency involving the classification of loans to borrowers who have filed for bankruptcy.

Sloan said in the interview that Wells expects some of those loans to be repaid, which should allow the bank to recover some of the $567 million.

Like many banks, Wells is also looking to get a better handle on expenses. Its efficiency ratio for the quarter was 57%, in line with its target ratio of between 55% and 59%.

"We still think expenses are too high. But we've also said we're not going to be slavish to a number and turn away revenue," Stumpf said on the call.

Wells' shares closed at $34.27 Friday.