Here’s Why Wells Fargo’s Growth Engine Sputtered in Q3

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For the United States banking sector, the third quarter earnings season comes amidst growing troubles: mortgage originations have slowed, still-uncertain legal costs, and the fact that the economy is still not strong enough to drive significant demand for new loans.

Even worse, the tactics that financial institutions used to bolster their balance sheets in previous quarters — like cost cutting and “releasing reserves” of cash that had been kept on hand to cover loan losses — are running out of steam. Last month, the investment firm Jefferies Group (NYSE:JEF) reported that profit for common shareholders in the fiscal their quarter had dropped 83 percent, causing analysts to worry its results were a precursor of what was to come.

“We’re fairly cautious heading into this earnings season,” Edward Jones Edward Jones Shannon Stemm, told MarketWatch, “more so than we’ve been in the past few quarters.”

For Wells Fargo (NYSE:WFC) and JPMorgan Chase (NYSE:JPM), the mortgage slowdown is of special concern. The mortgage refinancing surge drove strong results for many quarters for both banks, which are the country’s number one and number two largest mortgage lenders, respectively.

The problem is rising interest rates. The average rate for a 30-year fixed mortgage soared as high as 4.6 percent in the third quarter — a level that may not be very high historically, but is significantly higher than the 3.5 percent recorded a year ago. Wells Fargo has already alerted investors that its refinancing volume has declined, so what analysts will want the company to make clear during its earnings conference call is how the bank plans to compensate for that loss revenue. Since Wells Fargo originates about one-third of all United States mortgages, rising mortgage rates will take a high toll on the bank.

Yet, while the slowdown in the mortgage market did impede Wells Fargo’s growth to some degree, the bank reported that profit rose 13 percent in the third quarter. Improving the quality of its loans was one way in which the company was able to outmaneuver the declines in mortgage originations and a release of $900 million from the stockpile of cash it set aside during the crisis to offset bad loans contributed to the stronger results as well.

Net income rose to $5.6 billion, or 99 cents per share, up from the $4.9 billion, or 88 cents per share, Wells Fargo reported in the third quarter of 2012, making this quarter the fifteenth straight quarter of increasing profits. The results were also higher than the 97 cents per share in net income that analysts had forecast.

“Wells Fargo continued to demonstrate strong and consistent financial performance in the third quarter,” the company’s Chief Executive John Stumpf said in the earnings statement. It was also the tenth straight quarter that the bank reported record profit. But, comparatively, revenue fell from $21.4 billion in the year-ago quarter to $20.5 billion, a figure slightly below analysts estimates. The decrease in revenue revealed that below the strong profit number, the bank’s engine for growth — its mortgage business — has begun to sputter.

The rise in interest rates has discouraged borrowers from refinancing their mortgages. Only $87 billion worth of home loan applications were made in the third quarter of this year, down from $188 billion in the same quarter of last year, while its mortgage originations dropped from $139 billion to $80 billion in the same period. But, in particular, the decline in Wells Fargo’s mortgage banking revenue was the result of the drop in refinancing.

The fact that the Federal Reserve indicated earlier this year that would ease its stimulus program later this year as the economy continued to recover prompted the increase in rates. In response to the financial crisis and the economic recession, the central bank reduced interest rates to make borrowing cheaper, which sparked millions of borrowers to refinance home loans.

However, when the Fed began to indicate its strategy would shift, investors acted on that warning and drove up interest rates worldwide, making refinancing look less appealing. Rates did start to drop in the final days of the third quarter, after the Fed said in the middle of September that “it would be prudent to await further evidence of progress before” beginning to taper its stimulus program.

Follow Meghan on Twitter @MFoley_WSCS

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