Wells Fargo ( WFC ) is a diversified financial services company headquartered in San Francisco. It is the fourth largest bank in the U.S. by assets and the second largest bank by market cap. It is also the second largest bank in deposits, home mortgage servicing, and debit cards in the United States. Wells Fargo's competitors include banks such as Bank of America ( BAC ), Goldman Sachs ( GS ), JPMorgan Chase ( JPM ), Citigroup ( C ) and UBS (UBS).
We estimate that the mortgage business is the largest contributor of value to Wells Fargo accounting for 28% of our $33.81 price estimate for the company's stock. This represents a slight premium of 5% to the market price. Below we show the main drivers of Wells Fargo's mortgage business and the factors that affect them.
Average outstanding balance on home mortgage loans will increase
Wells Fargo home mortgage portfolio includes family first mortgages and family junior lien mortgages. The graph above represents the average annual outstanding balance on Wells Fargo's home mortgage loan portfolio on which the firm earns interest income. The average outstanding balance on home mortgage loans has increased significantly from $122 billion in 2006 to $337 billion in 2010. The sharp increase in 2009 was due to acquisition of Wachovia's home mortgage portfolio.
We forecast a sharp increase in outstanding balance on home mortgage loans going forward driven by the following factors:
1. Wachovia acquisition provides new opportunities
With the acquisition of Wachovia, Wells Fargo will now have access to newer households. Since the cross-sell (number of banking products sold per customer) at Wachovia has been traditionally lower than that at Wells Fargo, this will provide additional opportunities for expansion. These factors will positively impact average outstanding balance on home mortgage loans in the future.
2. Loosening of lending standards will boost demand
Following the economic downturn in 2008-09, the average 30-year fixed-rate mortgage dropped to the lowest levels on record. As the economic conditions improve and assuming rates on mortgages remain low, in an effort to boost demand, home sales will increase back leading to new mortgage originations and higher average outstanding balance on home mortgage loans in the future.
Fewer writedowns in the future will increase profitability
Provisions for credit losses is a charge to income which represents an expense given the composition of a bank's credit portfolios, the probability of default, the economic environment and an allowance for credit losses already established. The chart above represents the provisions for credit losses on home mortgage loans as a percentage of average home mortgage loans outstanding.
Provisions as a percentage of mortgage loans outstanding increased sharply to 4.6% in 2008 primarily due to sub-prime mortgage mess in the U.S. which resulted in high default rates and hence increases in net charge offs on home mortgage loans. It declined back in 2009 to 3% despite an increase in net charge offs as the average home mortgage loans more than doubled due to Wachovia acquisition. In 2010, it declined further to 2.4% as there were fewer defaults on loans and thus fewer write downs with the improvement in the economic environment.
Going forward, we expect, the provisions for losses on home mortgage loans will decline even further dropping slowly back to historical levels of 0.2%-0.4%. Below are some of the factors that will lead to a decline in provision for credit losses on home mortgage loans outstanding:
1. Lower charge-offs as economy recovers
Charge-offs for home mortgage loans were 2.35% at the height of the economic recession in 2009 which were much higher than historical level of around 0.18%. Trefis forecasts charge-off rate will decline in the future as economic conditions in the U.S. improve.
2. Stricter regulations on banking industry
Due to the economic recession of 2008-2009, regulations on the banking industry have increased and lending requirements have become stricter. Also, banks have become more conservative in lending. These factors will lead to a decline in home loan defaults and thus provision for credit losses on home mortgage loans in the long run.
You can drag the trend lines above to see the impact of various home mortgage outstanding loan balance and credit losses scenarios on Wells Fargo's stock.