Wells Fargo & Co's (WFC.N) loan book is performing better than many of its peers and better than even the bank expected in the middle of the last year, thanks to factors including higher house prices and tougher loan standards.
In the third quarter, Wells posted its lowest quarterly loan loss rate in at least nine years. The lower losses allowed the bank to dip into funds it set aside to cover bad loans, boosting profits by about $600 million after taxes.
Part of the improvement stems from a 2009 move to tighten underwriting standards for consumer loans, like more stringent requirements for verifying prospective homeowners' income.
Residential real estate loans made since then "have virtually no losses," Chief Financial Officer Tim Sloan said at an investor conference in September.
Another factor helping loan performance: post-crisis loans make up a larger share of Wells Fargo's portfolio overall now, driving quality higher. Nearly half the commercial loans and around 45 percent of consumer loans on the books at the end of the third quarter were made after the financial crisis.
Meanwhile, home prices increased 12.4 percent nationwide in August from a year earlier, according to CoreLogic. That had a big impact on the quality of Wells Fargo's home equity loans, where losses, also called charge-offs, fell by nearly 3/4 since the third quarter of 2012.
Many of these loans are hovering just below or just above the value of the home, so as home prices go up, the losses on the loans can change dramatically, a spokeswoman said. Over half of the decline in loan losses between the third quarters of 2013 and 2012 came out of Wells Fargo's home equity portfolio.
"When you put all that together," Sloan told Reuters in a recent interview, "it makes for a rapid improvement in credit quality."
To be sure, Wells Fargo is not the only U.S. bank to benefit from more of its customers paying their bills. Bank of America's total loss rate declined to 0.73 percent in the third quarter, a level not seen at the bank since 2005, Chief Executive Brian Moynihan told analysts. Bank of America reduced its allowance for bad loans by $1.4 billion in the third quarter.
"I don't think anybody expected charge-offs a few years ago to be as low as they are now," investor Warren Buffett said in a October 16 CNBC interview, in which he highlighted the low loss rates at both Wells Fargo and Bank of America. Buffett is a major shareholder in both banks.
"HUGE NUMBER" OF RESERVES
Wells' overall loss rates were even better than Bank of America's at just 0.48 percent of the loan book, a steep drop from a year earlier. The numbers may be better because of its mix of business - commercial loans often perform better than credit card loans, for example.
But credit performance has outperformed even the bank's expectations. Wells Fargo chief risk officer Mike Loughlin said in May 2012 he expected loss rates to be about 1.00 percent through the credit cycle.
These improvements in overall credit have allowed the bank to set aside less money to cover future losses. It stashed away just $75 million to cover bad loans in the third quarter, down 95 percent from the $1.6 billion set aside a year earlier.
As losses continue to decline, Wells Fargo can also dip into funds set aside previously to cover bad loans, known as "releasing reserves." The bank released $900 million of loss reserves in Q3, before taxes, or about $600 million after taxes.
But the extent to which some banks are leaning on reserve releases to boost profits has caught regulators' attention. In September, Comptroller of the Currency Thomas Curry said some banks had become hooked on re-purposing reserves in the form of earnings.
Citing some signs of rising credit risk across the banking system, Curry said it seemed like a "singularly bad time for banks to be scrimping on their allowances against their loan losses."
Analysts said the current rate of Wells Fargo's reserve releases might not be sustainable. Jennifer Thompson, research director at Portales Partners, said the money that Wells Fargo set aside for future losses every quarter was coming down faster than its current losses, a process that would bottom out eventually and require the bank to build reserves back up.
Sloan said the bank was mindful of regulators' views, but at the same time was bound by accounting principles that dictate reserve releases. "When your loan portfolio improves as much as ours did, it's appropriate to release reserves," he said.
Even with the release, the money the bank has set aside over time covers four times the losses the bank could expect to have in a year at current rates, up from 3.6 times in the second quarter.
"That's a huge number," Chief Executive John Stumpf told Reuters in a recent interview.
(Reporting by Peter Rudegeair in New York, Editing by Dan Wilchins and Krista Hughes)