Wells Fargo Golden Colorado 2013
The Wells Fargo bank branch is seen in Golden, Colorado October 11, 2013. Reuters

Wells Fargo & Co. (NYSE:WFC), a bellwether for the mortgage and housing sector, is expected to report a rise in profit in the first quarter of 2014, largely from strong expense control and less so from the release of reserves set aside for bad loans as higher rates have continued to eat into the bank's lucrative mortgage business.

“We anticipate there to be continued weakness in Wells Fargo’s mortgage banking results because refinancing activities are down and those were supporting a good percentage of the volume that they were running through that channel,” said Edward Jones financial services analyst Shannon Stemm.

“You will probably hear them [Wells Fargo management] talk more about the work to right-size that business and there have been headcount reductions trying to get the expense more in line with the new revenue level,” Stemm said.

Wells Fargo is slated to report its first quarter results on Friday before markets open. Analysts polled by Thomson Reuters are projecting a 5 percent increase to 96 cents a share in first-quarter earnings. Revenue is forecast to decline by 3 percent to $20.60 billion. In the same period a year earlier, EPS was 92 cents on $21.26 billion in revenue.

“This could be the first time in years in which the company [Wells Fargo] does not post a sequential-quarter increase in EPS,” KBW’s Christopher Mutascio said. Wells Fargo reported EPS of $1.00 a share in the fourth quarter of 2013, which marked the 16th consecutive quarter of profit growth.

Weakness in trading results should impact Wells Fargo much less than some of its big-bank peers, given that Wells Fargo doesn’t do nearly as much business on the investment banking and trading side.

But when it comes to the more traditional banking side, Stemm said she wouldn’t be surprised if there is additional pressure on net interest margin -- the spread banks earn from borrowing and lending -- given the fact that interest rates are still sitting at a very low level.

Mortgage Slump

The mortgage-refinancing boom that helped Wells Fargo and others drum up business for years began to fizzle last summer. Interest rates started moving higher in May 2013, when the Federal Reserve first suggested it could gradually start to reduce its support for the U.S. economy.

The San Francisco-based lender, which originated nearly one in three U.S. mortgages in 2012, saw its home-lending originations drop to $50 billion in the last three months of 2013, compared with the $125 billion a year earlier and $80 billion in the third quarter of 2013.

Wells Fargo chief financial officer Timothy Sloan said at an investor conference in early February that he expected originations to continue to decline in the first quarter of 2014. “But we expect the rate of decline to slow from the levels that we saw in the third and fourth quarters of last year,” he added.

“Given the unusually low interest rate environment we’ve been in and thus really low mortgage rates, there was a lot of refinancing activity as consumers took advantage of the lower rates,” Stemm said. “There was a quarter or two when three-fourth of Wells Fargo’s mortgage volume, if not more, was driven by refinancing versus new home purchases.”

What Wells Fargo is faced with is a sharp slowdown in refinancing activities, but not enough new purchase activities to offset the slowdown. “While the housing market is certainly healthier today, the activity is not enough to offset how much the volume Wells Fargo was doing on the refinancing side,” Stemm added.

Recent data from Inside Mortgage Finance, a trade publication, indicates that the home loan market has experienced its worst quarter in nearly a decade and a half.

In the first three months of the year, mortgage origination amounted to $192 billion -- 26 percent lower sequentially than the fourth quarter of 2013, and 60 percent lower than the first quarter of 2013. The origination numbers were the weakest seen in the first three months of the year since 2000, when total home loan volume for the quarter was $122 billion. That figure topped $600 billion in 2003.

Amid the search for opportunities to stem its revenue decline as overall mortgage lending volume plunges, Wells Fargo has decided to tiptoe back into subprime home loans -- the very business that brought the banking system to the brink of collapse in the financial crisis.

Wells Fargo announced in February that the firm would begin originating purchase loans backed by the Federal Housing Administration with credit scores as low as 600. Previously, the minimum was 640, which is often seen as the cutoff point between prime and subprime borrowers. U.S. credit scores range from 300 to 850.

To avoid being associated with the word “subprime,” lenders are calling their loans “another chance mortgages” or “alternative mortgage programs” intended to boost housing demand from borrowers who have been forced to sit out the recovery of home prices in the past couple of years.

Expense Control

To shore up profit as mortgage revenue has fallen, Wells Fargo has moved to cut costs, in part through laying off employees who process mortgages.

The bank announced plans to eliminate 700 more jobs from its mortgage business in February. The reductions are on top of 250 cuts made in January and more are possible in the coming months.

Just last year alone, Wells Fargo cut about 6,000 jobs in its mortgage business. Total employment at year-end was 264,900, according to the bank’s earnings statement.

Across the bank, quarterly expenses were 58.5 percent of total revenue in the fourth quarter of 2013, a slight drop from 58.8 percent in the year-ago period.

“While we will have seasonally higher personnel costs in the first quarter, we expect to have lower project spending and lower mortgage expenses reflecting a full quarter run rate from the reduced staffing that we announced in the third and the fourth quarters,” Sloan said in February. He expects Wells Fargo’s efficiency ratio to remain within the firm’s target range of 55 percent to 59 percent in the first quarter.

Reserve Release

Wells Fargo’s earnings have benefited as its bad loan expenses have dropped sharply. The amount the bank set aside in 2013 for loan loss reserves was $2.3 billion, well below the $7.2 billion in 2012.

Reserve releases, an accounting maneuver that enables banks to add any money set aside (for bad loans when credit quality improves) to profits, come at a time when banks are being slammed by revenue slowdowns.

However, banks can only rely so long on reserve releases to pad their bottom lines.

“We saw for a long time that reserve releases were helping to grow earnings despite the weakness in the revenue line,” Stemm said. “But at this point, Wells Fargo is much more dependent on expense control to deliver that kind of consistent earnings generation given reserve releases are becoming smaller in magnitude.”

“We anticipate that there will probably be minimal reserve releases in the first quarter,” Stemm added.

Stock Performance

Wells Fargo has increased dividends aggressively since 2010, with the figure jumping from just over $1 billion in 2010 to almost $6 billion in 2013. The bank also sped up its share repurchases over the period.

But the decision announced earlier this month to buy back as many as 350 million shares -- about 6.6 percent of its outstanding shares -- still came as a pleasant surprise to investors due to the sheer magnitude of the repurchase plan.

“We like the company’s emphasis on returning capital to shareholders,” said Morningstar's Jim Sinegal. Wells Fargo plans to eventually return 50 percent and 65 percent of its earnings in the form of dividends and repurchases.

Investors are keen on Wells Fargo’s stocks, up more than 8 percent since the beginning of the year.