QE3 Downgrades Wells Fargo

NEW YORK ( TheStreet) -- After Wells Fargo ( WFC) predicted a significant net interest margin decline for the third quarter, and the Federal Reserve made its QE3 announcement, Stifel Nicolaus analyst Christopher Mutascio on Monday downgraded Wells Fargo to a "Hold" rating.

Speaking at the Barclays Capital Global Financial Services Conference last Tuesday, Wells Fargo CFO Tim Sloan said that although the company achieved a "stable" net interest margin during the second quarter, in part because of "a 7 basis point linked quarter benefit from higher variable items," the margin for the third quarter "could be similar to what we experienced in the third quarter of last year when our net interest margin was down 17 basis points."

A bank's net interest margin is the annualized spread between its average yield on loans and investments and its average cost for deposits and borrowings.

During the second quarter, Wells Fargo's net interest margin was 3.91%, unchanged from the first quarter, but declining from 4.01% in the second quarter of 2011, in line with most of the industry, which continues to face margin pressure as short-term rates remain near zero, and long-term rates also remain at historically low levels.

Wells Fargo had a good second quarter, with strong mortgage loan demand feeding net income applicable to common stock of $4.4 billion, or 82 cents a share, increasing from $4.0 billion, or 75 cents a share, the previous quarter, and $3.7 billion, or 70 cents a share, a year earlier. The strong mortgage loan volume for the industry follows President Obama's expansion in January of the Home Affordable Refinance Program, or HARP, under which qualified borrowers with loans held by Fannie Mae ( FNMA) or Freddie Mac ( FMCC), can refinance their entire loan balances at today's low rates, no matter how much the value of the collateral property has declined.

The Federal Reserve Open Market Committee on Thursday announced that the central bank would purchase "additional agency mortgage-backed securities at a pace of $40 billion per month," bringing its total mortgage-backed securities purchases to a pace of roughly $85 billion per month. The Fed also said that "exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015." The target federal funds rate is currently at a range 0 to 0.25%.

Mutascio on Monday said that a 17-point third-quarter drop in Wells Fargo's net interest margin "would be nearly double the 9 basis points of margin compression we were anticipating this quarter." This will be partially offset by "stronger than originally anticipated mortgage banking income will partially offset the negative impact of the substantial margin compression," according to the analyst, but "as the refinance boom wanes, we believe the margin compression will have a greater impact on EPS - especially if the Fed stays true to its pledge of near 0% short-term interest rates for the next three years."

Mutascio lowered his 2012 earnings estimate for Wells Fargo by only three cents, to $3.30 a share, but lowered his 2013 EPS estimate by 13 cents to $3.52, and lowered his price target for the shares by two dollars, to $38.00.

Wells Fargo's shares closed at $36.13 Friday, returning 34% year-to-date, following a 10% decline during 2011. The shares trade for 2.1 times tangible book value, according to Thomson Reuters Bank Insight, and for 10 times the consensus 2013 EPS estimate of $3.66, among analysts polled by Thomson Reuters.

The shares trade at a much higher price-to-book ratio than the other three members of the "big four" U.S. banking club, however, Wells Fargo's steady and solid earnings support the higher valuation. The company's operating returns on average assets (ROA) have ranged between 1.26% and 1.40% over the past five quarters, according to Thomson Reuters Bank Insight, while its operating returns on equity (ROE) have ranged between 11.51% and 12.37%.
  • Shares of JPMorgan Chase (JPM) closed at $41.57 Friday, returning 28% year-to-date, following a 20% decline last year. The shares trade for 1.3 times tangible book value, and for eight times the consensus 2013 EPS estimate of $5.20. Over the past five quarters, the company's ROA has ranged from 0.68% to 0.99%, while its ROE has ranged from 8.25% to 11.94%.
  • Shares of Bank of America (BAC) closed at $9.55 Friday, returning 72% year-to-date, following a 58% decline during 2011. The shares trade for 0.8 times tangible book, and for 1.5 times the consensus 2013 EPS estimate of 91 cents. Over the past five quarters, Bank of America's ROA has ranged from a negative 1.51% - during the second quarter of 2011, when the company lost $8.8 billion, or 90 cents a share, mainly from a mortgage putback settlement with private investors -- to 1.08%. BAC's ROE has ranged from a negative 15.02% to 11.21%, over the same period.
  • Shares of Citigroup (C) closed at $34.79 Friday, returning 32% year-to-date, following a 44% decline during 2011. The shares trade for 0.7 times tangible book value, and for eight times the consensus 2013 EPS estimate of $4.53. Citigroup's ROA has ranged from 0.20% to 0.77% over the past five quarters, while the company's ROE has ranged from 2.18% to 8.41%.

Despite the downgrade, Mutascio said that "for those investors trying to hedge themselves against the never-ending "risk-on"/"risk-off" rotation trades," we would still view WFC (as well as US Bancorp - USB - Hold) as the high quality names within a bar-bell investing approach (holding some high quality banks along with some banks with more risk), given their above-peer profitability and strong management teams."

A different view on mortgage volume.

FBR analyst Paul Miller on Monday reiterated his "Outperform" rating on Wells Fargo, with a price target of $39, saying after meeting with the company's mortgage banking management that "we continue to favor WFC due to its significant exposure to the mortgage market, which should provide a meaningful tailwind to earnings for the foreseeable future."

Miller estimates that Wells Fargo will earn $3.35 a share for 2012, followed by EPS of $3.65 in 2013.

The analyst said that "WFC has a strong HARP pipeline. Almost 50% of the loans in its servicing portfolio are eligible for refinancing and management commented that, even without solicitation, product is practically walking through the door."

Miller added that "in this uncertain environment, investors will be looking to get into quality names at opportunistic prices," and that "WFC, in particular, will benefit from this flight to quality and that current levels represent an attractive buying opportunity." He also sees Wells Fargo as "an attractive defensive holding in a volatile market," in light of its "largely domestic footprint.

Interested in more on Wells Fargo? See TheStreet Ratings' report card for this stock.

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-- Written by Philip van Doorn in Jupiter, Fla.

>Contact by Email.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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