Question-and-Answer Session
Jason Goldberg
Actually, before we take questions from the audience, we’ll go to our automated response questions. If we could put those up, please.
First, for those in the audience, if you currently don’t own shares of Wells Fargo [unintelligible], which of the following would be most influential in changing your mind: 1) more attractive valuation, 2) greater clarity in terms of how it hopes to offset the decline in mortgage volume, 3) a stronger loan growth environment, 4) increased capital return, and 5) greater clarity around outstanding legal [unintelligible] issues? I’ll give you 10 seconds to respond.
Let’s see, 30% would choose 1, the valuation, and then mortgage and loan growth, kind of all three pretty much tied around that. I know valuation you can’t fully control, Tim, but in terms of how you think about the mortgage environment, I know you kind of touched on it, but I guess talking about a pretty strong [unintelligible] in originations in the third quarter, lower gain on sale margins, how quickly could you actually get out the cost base? And how much further, given the origination outlook, would you expect headcount to decline?
Tim Sloan
Well, as you know, we’ve been in this business for over 30 years, and we’ve seen cycles in terms of the growth of the business and the decline of the business. In fact, the 14-quarter period that we showed on the chart, you saw pretty significant volatility in almost half of those quarters.
Generally, our experience has been that it takes anywhere from one to two quarters to get the costs out of the business relative to the size of the originations. So the reductions that we’ve announced so far this quarter, and that we’ve made, will come out of the expense base on a run rate basis in the fourth quarter. Now, as I mentioned, the commission expense is reduced almost immediately.
So it will take one to two quarters to adjust to this type of environment. Again, it’s something that we’ve seen in the past. I think the important thing is that if we’re not a monoline mortgage business, even though we’re the largest mortgage originator in the country, we have a lot of other levers that we continue to pull and push, some within the mortgage business. As I mentioned, we’re hopeful to see some increase in our servicing income in the quarter.
In addition, as I mentioned, credit continues to improve pretty significantly. And then, as you saw in the second quarter, some really nice increases in terms of our other businesses from a fee standpoint, that I mentioned. So the expenses will come out over the next couple of quarters, and again, we’re hopeful to be able to grow earnings over that same period.
Jason Goldberg
Before we go to the next question, just this issue. We had the exact same question last year, and for those that don’t remember, in terms of more exact valuation, we had 30% this year. Last year was similar, around 27%. In terms of handling the decline in mortgage originations, that was 44% of the people. That was the number one reason last year. So the number’s actually declined to 30%, and the accelerate of loan growth was 19% of people said that last year. Now it’s 29%, and the latter two remain at 6%.
If we go to the next ARS question, which of the following, in your view, poses the greatest threat to the future share price appreciation: 1) mortgage, 2) loan growth, 3) uncertainty around legal environment, 4) lower than peer asset sensitivity, and 5) end of its record EPS growth streak?
And the answer is, 44% the one about the soft loan growth environment. I guess Tim, you talked about some acquisitions to kind of help supplement the challenges there. What are you looking for in terms of, say, more robust pickup in loan growth and in terms of what you think are the bigger constraints holding that back?
Tim Sloan
I think the biggest constraint in terms of loan growth is just underlying economic growth. The economy’s growing at plus or minus about a 2% rate. We’ve been able to grow loans even ex-acquisitions over the last year at about twice that. If you look at our core loan growth in the second quarter, year over year we were up about $ 40 billion. So we haven’t seen any major changes in underlying demand for loans in the third quarter relative to the second quarter. It continues to be slow but steady.
And so our expectation, because we’ve been in this environment for a while, is that our core loan growth should be at a multiple of underlying economic growth. We’ll continue to see some decline in our liquidating portfolio, though the level of that decline from an absolute dollar standpoint has continued to decline as that portfolio is lower, and then we’ll see opportunities from time to time which we’re pleased to be able to take advantage of in terms of making acquisitions.
So when you put it all together, we feel like we can continue to grow loans over time, and we’ve been able to demonstrate that over the last few years.
Jason Goldberg
Thanks. And then the last ARS question, which type of acquisition would you like to see Wells Fargo undertake: 1) continued asset purchases of U.S. nonbanks, like Tim talked about, 2) credit card, 3) refrain from acquisitions, 4) auto, 5) insurance, 6) international, 7) investment banking?
And the answer is, number one, U.S. assets. And number two was refrain. And then let’s see, number three would have been credit card. You were active in asset purchases, then kind of slowed down, and it appears to have maybe picked up again in the current quarter. Maybe talk about how much more you see coming from that as European banks continue to deleverage.
Tim Sloan
We saw a significant opportunity in 2011 in terms of buying the domestic assets from some of the European banks, particularly the Irish banks, in the summer of 2011. And then we made some additional acquisitions through the early part of ’12. But the liquidity facilities that the European banking authorities put in place really reduced the flow of opportunities that we’ve been seeing since those facilities were put in place.
And so I wouldn’t say that just because we announced two acquisitions this quarter that it’s meant that there’s a big pickup in acquisition activity. I think it just tends to be pretty slow and steady right now. I wish it were greater, because we’d love to be able to grow the loan base with good quality acquisitions, and we’re going to do as many as we can, and we’ve been very pleased to be as successful as we have been over the last couple of years, and hopefully that will continue, but the level of activity has been pretty stable over the last year or so.
Jason Goldberg
And with credit cards toward the top of the list, I know that’s a business you’ve talked about kind of expanding on, and more deeply penetrating the retail banking customers. Just maybe talk about your appetite to acquire more scale in that business.
Tim Sloan
Well, we don’t think we need to make any acquisitions in the credit card business to be able to successfully grow the business. Our primary focus in that business over the last few years has been to increase our penetration rates with our existing customer base. And you’ve seen that our folks in the retail bank on Carrie Tolstedt’s team have done a great job in terms of increasing penetration so that we ended the second quarter with about a 35% penetration rate.
In addition to that, we’re very pleased with being able to announce the partnership with American Express. And the goal there is to just expand the card offerings that we have to new and future customers, as well as in terms of improving our rewards program. That doesn’t mean that we don’t want to continue to have a good relationship with Visa. We have a great relationship with Visa. We just want to have more offerings from our customer base.
So with all that, we’ve got a lot of opportunity to be able to grow the credit card business. That said, if the right acquisition comes along, like it’s done in our commercial real estate business, or like it did in our asset-based business, or like it did in our energy business last year, we’d be happy to take a look at it. But we don’t feel that we need to make an acquisition to be able to grow that business.
And you saw that in our results, because our fee income in card was up on a double digit basis year over year, and our oustandings were up about the same. So it’s been good.
Unidentified Audience Member
A number of your peers have been significant sellers of mortgage servicing rights. I was just wondering what Wells’ plan is in that regard.
Tim Sloan
I think the primary driver for many of the mortgage servicing rights sales in the industry over the last few years have been for capital reasons. And we don’t really have a lot of pressure on our capital. As I mentioned, our tier one common equity at the end of the second quarter was 8.62%. So it’s well above the minimum requirement, and already into the buffer that we want to operate within.
Having said that, we’ve seen a real shift in the demand for mortgage servicing rights, because an industry has been created that wants to buy mortgage servicing rights. And so the market’s much more attractive from our perspective. So I think it’s likely that over the next few quarters that we’ll want to test that market.
This is different than selling our reverse mortgage servicing portion of that business, or selling some of the [IOs] and the like. So we don’t want to test that market. I wouldn’t read anything more into that, that it would make sense for us to go ahead and test the market, so that if we ever get into a period where we have to sell, we’ve already gone through the process. I think that’s just good from a risk management standpoint.
So again, look for us to potentially do something in the next couple of quarters. It won’t be significant. It will primarily be focused, if we go ahead and execute on mortgage only customers who we don’t have any confusion from a relationship standpoint.
Unidentified Audience Member
I think you mentioned you were hoping to grow earnings over the next couple of quarters as you work these mortgage costs out. Is that sequential or year over year, first of all? And then second, could you talk to us about the drivers behind that? You mentioned several of them, I think, in the presentation, with servicing and credit, etc.
Tim Sloan
Well, I’m hopeful that we can grow on a year over year and sequential basis. We can’t promise you that’s going to happen. But I think the good news is that, again, notwithstanding the decline in mortgage origination revenue, which I talked about, I think it’s important, if you look at those 14 quarters, you could overlay the two slides together and you could see in six of those 14 quarters where we’ve experienced earnings growth, we’ve had a decline in mortgage origination revenue.
We think that over time we can continue to increase servicing income, just in the mortgage business. We are looking to take costs out of the mortgage business as we’ve talked about. But again, that’s just the mortgage business.
As I mentioned, credit continues to be a very strong tailwind for the company. You saw that in our decline in our loan loss rates from 72 to 58 basis points. I’m hopeful that they will continue to come down over the next few quarters. We talked about the fact that we think our reserve release is going to be greater in the third quarter than what we experienced in the second quarter.
And then to me, if that wasn’t enough, the other exciting thing is that we’ve got 89 other businesses across the company that hopefully will continue to grow. I don’t know exactly which one is going to grow the most or least, but the factors that drove the year over year growth that we saw in the second quarter in many of our businesses haven’t stopped. They’ve continued to provide a tailwind for the business. So we think we can grow our other businesses too.
Unidentified Audience Member
Will Wells have to issue incremental debt to comply with orderly liquidation authority rules?
Tim Sloan
I don’t know the answer to that, because I don’t know what the rules are going to look like. Clearly there’s been a lot of discussion about what an orderly liquidation authority might look like, and whether or not there would be an incremental long term debt requirement.
If you look back seven, eight months, there were discussions that the total levels of capital plus debt would have to be between 25% and 30%. That was kind of the high end of the range. I think that’s probably unlikely. I can’t promise you for sure, but I think that’s unlikely. I think the regulators have been very responsive to a lot of discussion that the industry and in particular we’ve had with them.
And we’re hopeful that whatever final rules occur, and whenever they occur, that they’re risk-based, so it’s not a one size fits all kind of structure, and they’re also reflective of the losses that the industry actually experienced in the last downturn.
Because if you look at the averages, the industry in total experienced some pretty significant losses, but when you factor out a couple, two, three, four different firms, that losses for diversified financial institutions, particularly banks like ours, were much less than even the capital levels that we have today, let alone capital plus long term debt.
So long answer to your question. I don’t know for sure. It’s something that we’ve been spending a lot of time on, but it’s not something that we’re overly concerned about right now.
Unidentified Audience Member
Looking at the falloff in mortgage originations that you’re expecting, looking in the details, how much of that might be some renewed deterioration in the housing market?
Tim Sloan
I don’t think we’ve seen any sort of deterioration in the housing market. That said, I don’t think it’s logical to assume that, even with the improvement in the housing market, that it’s logical that we’re going to have double digit improvements in housing prices for the rest of our lives, right? At some point, they’re going to start to slow down. Year over year, I think the last numbers showed about a 12% increase in housing values.
Again, I don’t know if that’s sustainable, but we do believe that housing price appreciation at some leverage is sustainable, and we don’t believe that the recent increases in mortgage rate are going to, in any way, shape, or form snuff out the housing recovery that we’ve had. Because when you look at any sort of statistics, and certainly the demographics in terms of household creation, as well as household affordability, they’re still very attractive, and should drive a continued recovery in the housing business.
Unidentified Audience Member
We’re in the beginning or the middle of a debate in Washington on Fannie and Freddie and how those two organizations will be structured, and what their role will be in the mortgage market. Do you have any opinion on that? And assuming they are sort of wound down, will that be positive for Wells Fargo, or negative?
Tim Sloan
First, we think it’s good that we’re going to have a conversation about what should happen with Fannie and Freddie. It’s too bad it’s taken this long, but now we’re having a conversation, which is good. It’s a conversation that we’re very involved in, because as the largest mortgage originator, we’d obviously have a little bit of an opinion in terms of what mortgage finance might look like.
We do think that it makes sense to have some sort of a government program. It doesn’t necessarily have to look like Fannie and Freddie today. It could be smaller, and it could but much more focused on an FHA-type program, VA-type programs.
But one of the missing links today in terms of this whole discussion is that we don’t have a robust private mortgage securitization, we don’t have that kind of activity, and that’s because we haven’t fully finalized the QM, and we haven’t finalized the QRM rules.
Once that occurs, than that’s going to provide a base for private mortgage securitization. That’s fine from our perspective. We operate in that environment. That will be okay. But we can’t really do that in volume until we see the final rules. The final rules are now out for comment, at various levels in both of the rules.
The fact of the matter is, given the size of the mortgage market in the U.S., it’s likely that when the dust settles, we’ll have some sort of government programs, that we hope are done on an a make-sense basis. We’ll have a private mortgage securitization business, and then we’ll have on balance sheet activity.
And when that occurs, we don’t know. We’ve been able to operate very profitably in the mortgage business in any of the environments. But we’re going to be involved in the discussion, and we’re going to have an opinion about it.
Unidentified Audience Member
Just in terms of resi mortgage lending standards, you mentioned QM and QRM as being a big factor. Are there other factors that are keeping lending standards so tight right now? And what’s your outlook for that?
Tim Sloan
Yeah, I think it’s fair for folks to say that lending standards seem tight, because we went through a period, say since 2000 to 2007, where lending standards just got out of control. And that’s the most recent comparative timeframe that we have to compare today to. I think if you look at the lending standards today, they’re much more comparable to what we saw 10 years ago, 15 years ago, and 20 years ago. And these are the standards that we’re going to live with. QM is going to be a big driver for that.
There certainly will be some non-conforming lending that occurs. It’s going to need to occur at companies other than Wells Fargo. We’re not going to do a lot of nonconforming lending, with the exception of the jumbo mortgages that we provide that we put on balance sheet. So I don’t really anticipate the standards changing a whole lot, given that QM is going to be the new standard for the industry.
Jason Goldberg
With that, please join me in thanking Tim for his time.