Shrinking Interest Margins Weigh On Wells Fargo's Q3 Results

At first glance, Wells Fargo's ( WFC ) performance figures for the third quarter of the year show nothing out of the ordinary. The banking giant reported revenue as well as earnings per share ( EPS ) numbers which were in line with what investors expected for a rather uneventful quarter. As there were no one-time revenues or charges recorded over the period, one would assume that the results accurately demonstrate the earning capacity of Wells Fargo's risk-averse business model. However, given that the bank's shares fell nearly 3% over trading on Tuesday, October 14 after the results were announced, investors clearly saw something they did not like.

The primary culprit is the bank's shrinking net interest margin. The increasing pressure on banks' interest margins from the prolonged low interest rate environment is hardly a secret, with every U.S. bank reporting a steady decline in this metric since early 2011. While interest margins are expected to shrink further over coming quarters until the Federal Reserve raises benchmark rates, what stood out in Wells Fargo's Q3 results was the magnitude of the fall this time around. The 9 basis point reduction over the quarter was largely unexpected. So even though the bank churned out record deposit service fees and brokerage fees in Q3, and also saw a notable improvement in mortgage origination revenues for the period, concerns about the interest margin took priority in investors' mind.

We maintain a $54 price estimate for Wells Fargo's stock , which is about 10% ahead of its current market price.

See our complete analysis of Wells Fargo here

Net Interest Margins Continue To Fall

Wells Fargo's biggest concern over the last couple of years has been its rapidly shrinking net interest margin ( NIM ) figure. While the current prolonged low-interest rate environment has impacted interest incomes for the banking industry as a whole, the impact is particularly evident in Wells Fargo's results as net interest revenues are responsible for more than half of its total revenues.

The table below summarizes Wells Fargo's reported NIM figures for each of the last fifteen quarters:

Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q3 2014
4.05% 4.01% 3.84% 3.89% 3.91% 3.91% 3.66% 3.56% 3.48% 3.46% 3.38% 3.26% 3.20% 3.15% 3.06%

As can be seen here, Wells Fargo's NIM figure has fallen by almost one percentage point over this period. Notably, the 9 basis point fall in Q3 2014 was much worse than the five basis point drop the bank reported in the previous quarter. Thanks to a steady increase in interest-earning assets, the bank has been able to maintain its net interest revenues of between $10.5 billion and $11 billion throughout this period despite increasing pressure on its NIM figure due to low interest rates and rapid growth in the bank's deposit base. However, interest margins have not improved much despite the Fed's tapering plan, and only an increase in benchmark rates will help improve this figure.

You can better understand the partial impact of changing net interest margins on the bank's total value by making changes to the chart below, which represents Wells Fargo's NIM on interest-earning assets (excluding loans).

The Bank Did Leverage Other Avenues To Maintain Profitability

Over the last few quarters, Wells Fargo has been able to report strong performance figures despite a slowdown in the mortgage industry primarily due to two reasons: the bank's ability to refocus on other sources of revenue, and its cost-cutting measures. In the last two years, the bank has grown its asset management and investment banking fees quite notably, and has also stepped up its equity investments. The bank saw service charges on deposit accounts cross $1.3 billion for the first time in Q3, even as trust and investment fees reached a record $3.6 billion.

The bank's fortunes in the mortgage industry have also improved, as origination volumes increased meaningfully for the first time since late 2012. The bank fared slightly better in Q3 2014, originating $48 billion in mortgages for the quarter. This helped origination-related fees jump almost 40% from $688 million in Q2 2014 to $954 million in Q3 2014.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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