UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549
FORM 10-Q
ü QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended June 30, 2004
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934
Commission file number 001-2979
WELLS FARGO & COMPANY(Exact name of registrant as specified in its charter)
420 Montgomery Street, San Francisco, California 94104(Address of principal executive offices) (Zip Code)
Registrant’s telephone number, including area code: 1-800-292-9932
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.
Yes ü No
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
FORM 10-QCROSS-REFERENCE INDEX
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PART I — FINANCIAL INFORMATION
FINANCIAL REVIEW
SUMMARY FINANCIAL DATA
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This Report on Form 10-Q for the quarter ended June 30, 2004, including the Financial Review and the Financial Statements and related Notes, has forward-looking statements, which include forecasts of our financial results and condition, expectations for our operations and business, and our assumptions for those forecasts and expectations. Do not rely unduly on forward-looking statements. Actual results might differ significantly from our forecasts and expectations. Please refer to “Factors that May Affect Future Results” for a discussion of some factors that may cause results to differ.
OVERVIEW
Wells Fargo & Company is a $420 billion diversified financial services company providing banking, insurance, investments, mortgage banking and consumer finance through banking stores, the internet and other distribution channels to consumers, businesses and institutions in all 50 states of the U.S. and in other countries. We ranked fourth in assets and in market value of our common stock among U.S. bank holding companies at June 30, 2004. When we refer to “the Company”, “we”, “our” and “us” in this report, we mean Wells Fargo & Company and Subsidiaries (consolidated). When we refer to the Parent, we mean Wells Fargo & Company.
In second quarter 2004, we achieved diluted earnings per share of $1.00, up 11% from a year ago, with net income of $1.71 billion, up 12% from a year ago. We have historically had one of the highest earning asset yields and one of the lowest average funding costs among large U.S. banks. Taking advantage of market opportunities available during the second quarter, we took a number of actions to increase the yield on our earning assets and to reduce the cost of our long-term funding. We repurchased $2.2 billion of long-term debt with a weighted-average coupon of 6.20%, for a cost of $2.4 billion. This buyback increased second quarter noninterest expenses and reduced pre-tax earnings by $176 million or $.06 per share after-tax. In addition, we recorded losses of $222 million, or $.08 per share after-tax, connected with the sale of $14 billion of securities and adjustable rate mortgages (ARMs) with yields below 4% and replaced most of those assets with newer securities yielding close to 6% and with newly originated higher yielding ARMs. Taken together, these balance sheet repositioning actions reduced after-tax earnings by $.14 per share. To the extent markets remain as volatile as they were in the second quarter, we may take advantage of additional opportunities to further improve asset yields or reduce long-term funding costs in future quarters.
Our corporate vision is to satisfy all the financial needs of our customers, help them succeed financially, be recognized as the premier financial services company in our markets and be one of America’s great companies. Our primary strategy to achieve this vision is to increase the number of products we provide to our customers and to focus on providing each customer with all of the financial products that fulfill their needs. Our cross-sell strategy and diversified business model facilitates growth in strong and weak economic cycles, as we can grow by expanding the number of products our current customers have with us. We estimate that our average banking household now has 4.4 products with us, which we believe is among the highest, if not the highest, in our industry. Our goal is eight products per customer, which is currently half of our estimate of potential demand. Our core products grew this quarter compared with a year ago, with average loans up 30% and average core deposits up 9%. Loan growth during the quarter included commercial lending activity such as small business, middle market, commercial real estate, leasing, trade finance, and asset-based lending, and included the first meaningful increase in middle-market loans in nine quarters.
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We believe it is important to maintain a well-controlled environment as we continue to grow our businesses. We manage our credit risk by maintaining prudent credit policies and continuously examining our credit process. In second quarter 2004, nonperforming loans and net charge-offs as a percentage of loans outstanding declined from the prior year. Asset quality improved in second quarter 2004 compared with a year ago, with net charge-offs down 6% and nonperforming assets (including nonaccrual loans and foreclosed assets) down 8%. Loan losses declined to $390 million despite the continued growth in our loan portfolio. We manage the interest rate and market risks inherent in our asset and liability balances within prudent ranges, while ensuring adequate liquidity and funding. Wells Fargo Bank, N.A. is the only bank in the U.S. to be “Aaa” rated by Moody’s Investors Service, their highest rating. Our stockholder value has increased over time due to customer satisfaction, strong financial results and the prudent way we attempt to manage our business risks.
Our financial results included the following:
Net income for second quarter 2004 was $1.71 billion, up 12%, compared with $1.53 billion for second quarter 2003. Diluted earnings per common share for second quarter 2004 were $1.00, up 11%, compared with $.90 for second quarter 2003. Return on average assets (ROA) increased to 1.68% and return on average common equity (ROE) was 19.57% compared with 19.62% a year ago.
Net income for the first six months of 2004 was $3.48 billion, or $2.03 per share, compared with $3.02 billion, or $1.78 per share, for the first half of 2003. ROA was 1.76% in the first half of 2004, compared with 1.67% for the first half of 2003. ROE was 19.94% in the first half of 2004, compared with 19.71% for the first half of 2003.
Net interest income on a taxable-equivalent basis was $4.25 billion and $8.33 billion for the second quarter and first half of 2004, compared with $3.99 billion and $7.86 billion for the same periods of 2003. Net interest income for second quarter 2004 increased 7% compared with the prior year on 12% earning asset growth, partially offset by a decline in the net interest margin. The net interest margin was 4.83% and 4.89% for the second quarter and first half of 2004, compared with 5.09% and 5.18% for the same periods of 2003.
Noninterest income was $3.20 billion and $6.30 billion for the second quarter and first half of 2004, respectively, compared with $2.96 billion and $5.79 billion for the same periods of 2003. Second quarter 2004 noninterest income was reduced by $222 million of losses taken to reposition the balance sheet to further increase earning asset yields. The growth in fee income reflected strength in trust and investment fees, deposit service charges, credit card fees, loan fees and insurance.
Revenue, the sum of net interest income and noninterest income, increased 7% to $7.43 billion in second quarter 2004 from $6.93 billion in second quarter 2003. Second quarter 2004 revenue was reduced by $222 million, or 3%, by the losses taken on asset repositioning actions taken in the quarter. Revenue growth in the quarter was broad based with strong results from most of our businesses, including consumer deposits and loans, payment processing, insurance brokerage, trust and investments, including private client services, small business, corporate banking, mortgage banking and consumer finance. Revenue increased 7% to $14.57 billion in the first half of 2004 from $13.61 billion in the first half of 2003, including the $222 million reduction in revenue associated with the balance sheet repositioning actions in second quarter 2004.
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Noninterest expense was $4.35 billion and $8.38 billion for the second quarter and first half of 2004, respectively, compared with $4.16 billion and $8.11 billion for the same periods of 2003. Substantially all of the increase in noninterest expense of $195 million from second quarter 2003 to second quarter 2004 was due to the debt repurchase cost of $176 million. The efficiency ratio was 58.6% in second quarter 2004 and 56.4% in first quarter 2004. The reduction in revenue and increase in expenses from the balance sheet repositioning actions taken during the quarter accounted for 400 basis points of the 58.6% efficiency ratio in second quarter 2004.
During second quarter 2004, net charge-offs were $390 million, or .59% of average total loans (annualized), compared with $415 million, or .81%, during second quarter 2003. The provision for loan losses, which exceeded net charge-offs by $50 million, was $440 million and $844 million in the second quarter and first half of 2004, compared with $421 million and $831 million in the second quarter and first half of 2003. The allowance for loan losses was $3.94 billion, or 1.46% of total loans, at June 30, 2004, compared with $3.89 billion, or 1.54%, at December 31, 2003 and $3.85 billion, or 1.82%, at June 30, 2003. The increase in the allowance for loan losses was necessary given the substantial growth of our consumer portfolio, particularly related to Wells Fargo Financial.
At June 30, 2004, total nonaccrual loans were $1.38 billion, or .51% of total loans, compared with $1.46 billion, or .58%, at December 31, 2003 and $1.56 billion, or .74%, at June 30, 2003. Foreclosed assets were $235 million at June 30, 2004, compared with $198 million at December 31, 2003 and $190 million at June 30, 2003.
The ratio of stockholders’ equity to total assets was 8.44% at June 30, 2004, compared with 8.89% at December 31, 2003 and 8.72% at June 30, 2003. Our total risk-based capital (RBC) ratio at June 30, 2004 was 11.86% and our Tier 1 RBC ratio was 8.24%, exceeding the minimum regulatory guidelines of 8% and 4%, respectively, for bank holding companies. Our RBC ratios at June 30, 2003 were 11.50% and 7.98%, respectively. Our Tier 1 leverage ratios were 6.84% and 6.58% at June 30, 2004 and June 30, 2003, respectively, exceeding the minimum regulatory guideline of 3% for bank holding companies.
Recent Accounting Standards
On December 8, 2003, President Bush signed the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Act). The Act introduces a prescription drug benefit under Medicare as well as a federal subsidy to plan sponsors that provide a benefit that is at least equivalent to Medicare. On January 12, 2004, the Financial Accounting Standards Board (FASB) issued Staff Position 106-1 (FSP 106-1),Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003, which includes a provision that allows a plan sponsor a one-time election to defer accounting for the Act. This election must be made before net periodic postretirement benefit costs for the period that includes the Act’s enactment date are first included in reported financial information. If deferral is elected, that election may not be changed and the deferral continues to apply until authoritative guidance on the accounting for the federal subsidy is issued. We have elected to defer accounting for the Act until authoritative guidance is issued; therefore, the net periodic postretirement benefit cost in our second quarter 2004 financial statements does not reflect the effects of the Act on our postretirement health care plans. Specific authoritative guidance on the accounting for the federal subsidy has been issued through FASB Staff Position 106-2 (FSP 106-2), Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and
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Modernization Act of 2003, which was issued in May 2004 and is effective for us in third quarter 2004. When FSP 106-2 becomes effective, it will supersede FSP 106-1. Based on the guidance in FSP 106-2, we estimate that the accounting for the Act will not have a material effect on our financial statements.
On December 12, 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position 03-3 (SOP 03-3), Accounting for Certain Loans or Debt Securities Acquired in a Transfer, which addresses the accounting for certain loans acquired in a transfer when it is probable, at acquisition, that the investor will be unable to collect all contractually required payments receivable. SOP 03-3 is to be applied prospectively, effective for loans acquired in years beginning after December 15, 2004. We estimate that the adoption of SOP 03-3 will not have a material effect on our financial statements.
At its June 30-July 1, 2004 meeting, the Emerging Issues Task Force of the FASB (EITF) reached a tentative consensus on EITF Issue No. 04-8,The Effect of Contingently Convertible Debt on Diluted Earnings Per Share, that is consistent with a proposed amendment of Financial Accounting Standards No. 128 (FAS 128), Earnings Per Share, that, if adopted in its current form by the FASB, would require us to include in total diluted shares those common shares from convertible debt instruments despite our intent to settle the principal amount (accreted value) in cash and despite the fact that all contingencies permitting conversion have not been satisfied. We are currently evaluating whether the proposed amendment to FAS 128 will be applicable to our contingently convertible debentures issued on April 15, 2003, and, if so, the potential impact of the proposed amendment on our financial statements.
On July 16, 2004, the FASB ratified the decisions reached by the EITF with respect to Issue 02-14, Whether the Equity Method of Accounting Applies When an Investor Does Not Have an Investment in Voting Stock of an Investee but Exercises Significant Influence through Other Means. The EITF reached a consensus that an investor should apply the equity method of accounting when it has investments in either common stock or “in-substance common stock” of a corporation, provided that the investor has the ability to exercise significant influence over the operating and financial policies of the investee. In-substance common stock, as defined in the consensus, is an investment that has risk and reward characteristics, among other factors, that are substantially the same as common stock. The equity method of accounting must be applied for all investments in which the investor exercises significant influence over the investee and that qualify as in-substance common stock for reporting periods beginning after September 15, 2004. We do not anticipate the adoption will have a material effect on our financial statements.
CRITICAL ACCOUNTING POLICIES
Our significant accounting policies are fundamental to understanding our results of operations and financial condition, because some accounting policies require that we use estimates and assumptions that may affect the value of our assets or liabilities and financial results. Three of these policies are critical because they require management to make difficult, subjective and complex judgments about matters that are inherently uncertain and because it is likely that materially different amounts would be reported under different conditions or using different assumptions. These policies govern the allowance for loan losses, the valuation of mortgage servicing rights and pension accounting. Management has reviewed and approved these critical accounting policies and has discussed these policies with the Audit and Examination Committee.
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These policies are described in “Financial Review — Critical Accounting Policies” and Note 1 (Summary of Significant Accounting Policies) to Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2003 (2003 Form 10-K).
EARNINGS PERFORMANCE
NET INTEREST INCOME
Net interest income is the interest earned on debt securities, loans (including yield-related loan fees) and other interest-earning assets minus the interest paid for deposits and long-term and short-term debt. The net interest margin is the average yield on earning assets minus the average interest rate paid for deposits and our other sources of funding, such as debt. Net interest income and the net interest margin are presented on a taxable-equivalent basis to consistently reflect income from taxable and tax-exempt loans and securities based on a 35% marginal tax rate.
Net interest income on a taxable-equivalent basis increased to $4.25 billion in second quarter 2004 from $3.99 billion in second quarter 2003, an increase of 7%. The increase was primarily due to strong growth in loans, particularly in adjustable rate mortgage loans, and lower core deposits costs. These factors were partially offset by reduced loan yields as new loans were added below the portfolio average.
The net interest margin decreased to 4.83% in second quarter 2004 from 5.09% in second quarter 2003. The decrease was primarily due to lower loan yields following strong consumer loan growth, particularly in adjustable rate mortgage loans, which resulted in the addition of new loans with yields below the existing portfolio average. In addition, investment portfolio yields declined from second quarter 2003. The yield in second quarter 2003 included recognition of discounts on mortgage-backed securities that prepaid in that quarter. The net interest margin was down 11 basis points from first quarter 2004 to second quarter 2004, primarily due to substantial growth in earning assets during the quarter, including the mortgage warehouse and renewed growth in commercial and commercial real estate loans.
Individual components of net interest income and the net interest margin are presented in the rate/yield table on pages 8 and 9.
Average earning assets increased $38.2 billion in second quarter 2004 from the same period in 2003 due to an increase in average loans and debt securities available for sale, primarily offset by a decline in average mortgages held for sale. Loans averaged $266.2 billion in second quarter 2004, compared with $204.8 billion in second quarter 2003. Average mortgages held for sale decreased to $36.8 billion in second quarter 2004 from $65.5 billion in second quarter 2003 due to a decline in residential mortgage refinance activity. Debt securities available for sale averaged $32.1 billion in second quarter 2004 and $24.2 billion in second quarter 2003.
Average core deposits are an important contributor to growth in net interest income and the net interest margin. This low-cost source of funding rose 9% from a year ago. Average core deposits were $224.9 billion and $205.4 billion and funded 54.8% of our average total assets in second quarter 2004 and 2003, respectively. Average mortgage escrow deposits were $16.8 billion for second quarter 2004, down $4.0 billion from a year ago. Excluding mortgage escrow deposits, total average core deposits for second quarter 2004 grew $23.5 billion, or 13%, from a year ago. While average savings certificates of deposit declined to $18.7 billion in second quarter 2004
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AVERAGE BALANCES, YIELDS AND RATES PAID (TAXABLE-EQUIVALENT BASIS) (1) (2)
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from $21.4 billion in second quarter 2003, average noninterest-bearing checking accounts and other core deposit categories increased from $184.0 billion in second quarter 2003 to $206.2 billion in second quarter 2004 reflecting growth in both commercial and consumer accounts. Total average interest-bearing deposits increased to $182.3 billion in second quarter 2004 from $161.7 billion in second quarter 2003.
NONINTEREST INCOME
Service charges on deposit accounts increased 9% due to continued growth in primary checking accounts and increased activity.
We earn trust, investment and IRA fees from managing and administering assets, which include mutual funds, corporate trust, personal trust, employee benefit trust and agency assets. At June 30, 2004, these assets totaled approximately $625 billion, up 16% from $539 billion at June 30, 2003. Generally, these fees are based on the market value of the assets that are managed, administered, or both. The increase in trust, investment and IRA fees of 19% for second quarter 2004 compared with second quarter 2003 was primarily due to growth in assets driven by a higher equity market valuation, our successful efforts to grow these businesses and modest fill-in acquisitions.
During second quarter 2004, we announced our pending acquisition of $27 billion in mutual fund assets and $7 billion in institutional investment accounts from Strong Financial Corporation
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(Strong). The asset management businesses of Strong include 70 mutual funds. We expect to complete this acquisition by first quarter 2005.
Additionally, we receive commissions and other fees for providing services to retail and discount brokerage customers. At June 30, 2004 and 2003, brokerage balances were approximately $75 billion and $67 billion, respectively. Generally, these fees are based on the number of transactions executed at the customer’s direction.
Credit card fees increased 9% and 7% for the second quarter and first half of 2004, respectively, predominantly due to an increase in credit card accounts and credit and debit card transaction volume.
Mortgage banking noninterest income was $493 million and $808 million in the second quarter and first half of 2004, compared with $543 million and $1,104 million in the same periods of 2003. Net servicing fees reflected income of $461 million and $627 million in the second quarter and first half of 2004, respectively, compared with losses of $741 million and $1,184 million in the same periods of 2003. Servicing fees are presented net of amortization and impairment of mortgage servicing rights (MSRs) and gains and losses from hedge ineffectiveness, which are all influenced by both the level and direction of mortgage interest rates. The increase in net servicing fees in 2004, compared with the prior year, reflected a higher level of loans serviced for others and lower levels of MSRs amortization. In addition, to reflect the higher value of our MSRs (due to higher interest rates), we reversed $585 million of the MSRs valuation allowance in second quarter 2004, compared with an impairment provision of $620 million in second quarter 2003. The reversal of the valuation allowance for second quarter 2004 was offset by net hedge losses of $210 million and the provision in the prior year was offset by net hedge gains of $107 million. For the first half of 2004, we recorded a net reversal of the valuation allowance of $185 million compared with a provision of $1,212 million in 2003, offset by net hedge losses of $17 million and net hedge gains of $309 million for the same periods. (For further discussion of hedge accounting for MSRs see Note 18 (Derivatives — Fair Value Hedges) to Financial Statements.)
Net gains on mortgage loan origination/sales activities reflected a loss of $52 million in second quarter 2004 and a net gain of $46 million for the first half of 2004, compared with net gains of $1,165 million and $2,078 million, respectively, for the comparable periods of 2003. The lower level of gains in 2004 compared with 2003 reflected lower origination volume and a decrease in margins due primarily to the increase in interest rates and lower consumer demand. Originations during the second quarter 2004 declined to $96 billion from $135 billion in second quarter 2003. For the first half of 2004, originations totaled $161 billion compared with $238 billion in 2003. The second quarter 2004 net loss of $52 million reflected $161 million of losses connected with the sale of $10.5 billion of adjustable rate mortgages as part of our balance sheet repositioning actions.
See “Financial Review — Critical Accounting Policies — Mortgage Servicing Rights Valuation” in our 2003 Form 10-K for the method used to evaluate MSRs for impairment and to determine if such impairment is other-than-temporary.
The increase in insurance fees was due to increased demand for crop and other loan-based insurance products, as well as continued cross-selling of all insurance products.
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Net losses on debt securities available for sale were $61 million and $28 million in the second quarter and first half of 2004, compared with net gains of $20 million and $38 million in the same periods of 2003. The losses for second quarter 2004 were connected with the sale of approximately $3.5 billion of securities as part of our balance sheet repositioning actions. Net gains from equity investments were $81 million and $176 million in the second quarter and first half of 2004, compared with net losses of $47 million and $145 million in the same periods of 2003.
We routinely review our investment portfolios and recognize impairment write-downs based primarily on issuer-specific factors and results. We also consider general economic and market conditions, including industries in which venture capital investments are made, and adverse changes affecting the availability of venture capital. We determine impairment based on all of the information available at the time of the assessment, but new information or economic developments in the future could result in recognition of additional impairment.
NONINTEREST EXPENSE
Noninterest expense was $4.4 billion in second quarter 2004, compared with $4.2 billion in second quarter 2003. The 5% increase in noninterest expense in second quarter 2004, compared with a year ago was due to higher salaries and benefits of $181 million and the $176 million in debt repurchase costs, primarily offset by a decrease in Home Mortgage production costs.
OPERATING SEGMENT RESULTS
Our lines of business for management reporting consist of Community Banking, Wholesale Banking and Wells Fargo Financial.
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Community Banking’s net income increased 24% to $1,316 million in second quarter 2004 from $1,059 million in second quarter 2003. Net income increased 17% to $2,483 million for the first half of 2004 from $2,117 million from the first half of 2003. Net interest income increased to $2,989 million in second quarter 2004 from $2,865 million in second quarter 2003, primarily due to growth in consumer and 1-4 family loans and deposits, partially offset by a decrease in mortgages held for sale and a decline in net interest margin. Average loans in Community Banking grew 37% and average core deposits grew 8% from second quarter 2003. The provision for loan losses was $213 million in second quarter 2004 and $227 million in second quarter 2003. Noninterest income for second quarter 2004 increased by $173 million over second quarter 2003 due to broad-based increases across most businesses, partially offset by the $222 million of losses related to the sales of securities and ARMs. Noninterest expense decreased by $74 million in second quarter 2004 over second quarter 2003 due to a decline in mortgage origination volume.
Wholesale Banking’s net income was $385 million in second quarter 2004, compared with $345 million in second quarter 2003. Net income was $833 million for the first half of 2004, compared with $693 million in the first half of 2003, an increase of 20%. The provision for loan losses decreased by $28 million from $46 million in second quarter 2003 to $18 million in second quarter 2004. Noninterest income increased 10% to $720 million and 18% to $1,548 million in the second quarter and first half of 2004, respectively, from $656 million and $1,309 million in the same periods of 2003 primarily due to higher income in insurance brokerage, trust and investment fees, external fees and commissions and capital markets-related activity. Noninterest expense increased 4% to $663 million and 6% to $1,332 million in the second quarter and first half of 2004, respectively, from $636 million and $1,256 million in the same periods of 2003. The increase for both the quarter and year to date was largely due to higher salaries and employee benefits.
Wells Fargo Financial’s net income was $105 million in second quarter 2004 compared with $110 million for second quarter 2003, a decrease of 5%. Net income was $241 million for the first half of 2004 and $212 million for the same period in 2003. Net interest income increased 24% to $680 million for second quarter 2004 from $550 million for second quarter 2003 due to growth in average loans. Net interest income increased 23% for the first half of 2004 compared with the same period in 2003. Noninterest income decreased $11 million, or 12%, from second quarter 2003 to second quarter 2004, primarily due to a decrease of $9 million in gains on sales of investment securities and mark-to-market gains related to interest-rate swaps. Noninterest expense increased $66 million, or 21%, from second quarter 2003 to second quarter 2004, primarily due to increases in salaries, employee benefits and other costs relating to business expansion. The provision for loan losses increased by $61 million and $87 million in the second quarter and first half of 2004, respectively, compared with the same periods of 2003. The provision for loan losses of $50 million above net charge-offs reflected the sustained growth of Wells Fargo Financial’s consumer portfolio.
For a more complete description of our operating segments, including additional financial information and the underlying management accounting process, see Note 12 (Operating Segments) to Financial Statements.
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BALANCE SHEET ANALYSIS
A comparison between second quarter 2004 and second quarter 2003 balance sheets is presented below.
SECURITIES AVAILABLE FOR SALE
Our securities available for sale portfolio includes both debt and marketable equity securities. We hold debt securities available for sale primarily for liquidity, interest rate risk management and yield enhancement purposes. Accordingly, this portfolio primarily includes very liquid, high quality federal agency debt securities. At June 30, 2004, we held $36.0 billion of debt securities available for sale, compared with $24.0 billion at June 30, 2003. We had a net unrealized gain on debt securities available for sale of $.9 billion and $1.5 billion at June 30, 2004 and June 30, 2003, respectively.
The weighted-average expected maturity of debt securities available for sale was 5.7 years at June 30, 2004. Since 78% of this portfolio is mortgage-backed securities, the expected remaining maturity may differ from contractual maturity because borrowers may have the right to prepay obligations before the underlying mortgages mature.
The estimated effect of a 200 basis point increase or decrease in interest rates on the fair value and the expected remaining maturity of the mortgage-backed securities available for sale portfolio is shown below.
MORTGAGE-BACKED SECURITIES
See Note 3 (Securities Available for Sale) to Financial Statements for securities available for sale by security type.
LOAN PORTFOLIO
A comparative schedule of average loan balances is included in the table on pages 8 and 9; quarter-end balances are in Note 4 (Loans and Allowance for Loan Losses) to Financial Statements.
Loans averaged $266.2 billion in second quarter 2004, compared with $204.8 billion in second quarter 2003, an increase of 30%. Total loans at June 30, 2004 were $269.7 billion, compared with $211.4 billion at June 30, 2003, an increase of 28%. Average 1-4 family first mortgages and junior liens increased $39.1 billion and $11.6 billion, respectively, in second quarter 2004 compared with a year ago. Average commercial and commercial real estate loans increased $5.1 billion in second quarter 2004 compared with a year ago with loan growth broad-based
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across virtually all of our segments, including small business, middle market, commercial real estate, leasing, trade finance and asset-based lending. Average mortgages held for sale decreased to $36.8 billion in second quarter 2004, from $65.5 billion a year ago due to lower origination volume.
DEPOSITS
The increase in average deposits of $25.3 billion from $238.6 billion in second quarter 2003 to $263.9 billion in second quarter 2004 was primarily due to $17.0 billion growth in market rate and other savings deposits and reflected increased product sales.
OFF-BALANCE SHEET ARRANGEMENTS AND AGGREGATE CONTRACTUAL OBLIGATIONS
In the ordinary course of business, we engage in financial transactions that are not recorded on the balance sheet, or may be recorded on the balance sheet in amounts that are different than the full contract or notional amount of the transaction. We also enter into certain contractual obligations. For additional information on off-balance sheet arrangements and other contractual obligations see “Financial Review — Off-Balance Sheet Arrangements and Aggregate Contractual Obligations” in our 2003 Form 10-K and Note 16 (Guarantees) to Financial Statements.
RISK MANAGEMENT
CREDIT RISK MANAGEMENT PROCESS
Our credit risk management process provides for decentralized management and accountability by our lines of business. Our overall credit process includes comprehensive credit policies, frequent and detailed risk measurement and modeling, and a continual loan audit review process. In addition, regulatory examiners review and perform detailed tests of our credit underwriting, loan administration and allowance processes.
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Nonaccrual Loans and Other Assets
The following table shows the comparative data for nonaccrual loans and other assets. We generally place loans on nonaccrual status (1) when they are 90 days (120 days with respect to real estate 1-4 family first and junior lien mortgages) past due for interest or principal (unless both well-secured and in the process of collection), (2) when the full and timely collection of interest or principal becomes uncertain or (3) when part of the principal balance has been charged off. Note 1 (Summary of Significant Accounting Policies) to Financial Statements in our 2003 Form 10-K describes our accounting policy for nonaccrual loans.
NONACCRUAL LOANS AND OTHER ASSETS
We expect that the amount of nonaccrual loans will change due to portfolio growth, routine problem loan recognition and resolution through collections, sales or charge-offs. The performance of any loan can be affected by external factors, such as economic conditions, or factors particular to a borrower, such as actions of a borrower’s management.
Loans 90 Days or More Past Due and Still Accruing
Loans included in this category are 90 days or more past due as to interest or principal and still accruing, because they are (1) well-secured and in the process of collection or (2) real estate 1-4 family first mortgage loans or consumer loans exempt under regulatory rules from being classified as nonaccrual.
The total of loans 90 days past due and still accruing was $2,382 million, $2,337 million and $626 million at June 30, 2004, December 31, 2003 and June 30, 2003, respectively. At June 30, 2004 and December 31, 2003, the total included $1,700 million and $1,641 million, respectively, in advances pursuant to our servicing agreements to Government National
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Mortgage Association (GNMA) mortgage pools whose repayments are insured by the Federal Housing Administration or guaranteed by the Department of Veterans Affairs. Prior to clarifying guidance issued in 2003 as to classification as loans, GNMA advances were included in other assets.
LOANS 90 DAYS OR MORE PAST DUE AND STILL ACCRUING(EXCLUDING INSURED/GUARANTEED GNMA ADVANCES)
Allowance for Loan Losses
The allowance for loan losses is management’s estimate of credit losses inherent in the loan portfolio, including unfunded commitments, at the balance sheet date. We assume that the allowance for loan losses as a percentage of charge-offs and nonperforming loans will change at different points in time based on credit performance, loan mix and collateral values. The analysis of the changes in the allowance for loan losses, including charge-offs and recoveries by loan category, is presented in Note 4 (Loans and Allowance for Loan Losses) to Financial Statements.
We consider the allowance for loan losses of $3.94 billion adequate to cover credit losses inherent in the loan portfolio, including unfunded commitments, at June 30, 2004. The process for determining the adequacy of the allowance for loan losses is critical to our financial results. It requires management to make difficult, subjective and complex judgments, as a result of the need to make estimates about the effect of matters that are uncertain. See “Financial Review — Critical Accounting Policies — Allowance for Loan Losses” in our 2003 Form 10-K. Therefore, we cannot provide assurance that, in any particular period, we will not have sizeable loan losses in relation to the amount reserved. We may need to significantly increase the allowance for loan losses, considering current factors at the time, including economic conditions and ongoing internal and external examination processes. Our process for determining the adequacy of the allowance for loan losses is discussed in Note 5 (Loans and Allowance for Loan Losses) to Financial Statements in our 2003 Form 10-K.
ASSET/LIABILITY AND MARKET RISK MANAGEMENT
Asset/liability management involves the evaluation, monitoring and management of interest rate risk, market risk, liquidity and funding. The Corporate Asset/Liability Management Committee (Corporate ALCO) — which oversees these risks and reports periodically to the Finance
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Committee of the Board of Directors — consists of senior financial and business executives. Each of our principal business groups — Community Banking (including Mortgage Banking), Wholesale Banking and Wells Fargo Financial - have individual asset/liability management committees and processes linked to the Corporate ALCO process.
Interest Rate Risk
Interest rate risk, which potentially can have a significant earnings impact, is an integral part of being a financial intermediary. We are subject to interest rate risk because:
We assess interest rate risk by comparing our most likely earnings plan with various earnings models using many interest rate scenarios that differ in the direction of interest rate changes, the degree of change over time, the speed of change and the projected shape of the yield curve. For example, if we assume an increase of 425 basis points in the federal funds rate from its level at June 30, 2004 to the end of 2005 and an increase of 215 basis points in the 10 year Constant Maturity Treasury bond yield during the same period, estimated earnings at risk would be within 3% of our most likely earnings plan through the end of 2005. The potential variances in any individual quarter can vary by more than that amount, depending on the actual path of interest rates. Simulation estimates depend on, and will change with, the size and mix of our actual and projected balance sheet at the time of each simulation.
We use exchange-traded and over-the-counter interest rate derivatives to hedge our interest rate exposures. The credit risk amount and estimated net fair values of these derivatives as of June 30, 2004 and December 31, 2003 are presented in Note 18 (Derivatives) to Financial Statements. We use derivatives for asset/liability management in three ways:
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Mortgage Banking Interest Rate Risk
We originate, fund and service mortgage loans, which subjects us to a number of risks, including credit, liquidity and interest rate risks. We manage credit and liquidity risk by selling or securitizing most of the mortgage loans we originate. Changes in interest rates, however, may have a significant effect on mortgage banking income in any quarter and over time. Interest rates impact both the value of the mortgage servicing rights (MSRs), which is adjusted to the lower of cost or fair value, and the future earnings of the mortgage business, which are driven by origination volume and the duration of our servicing. We manage both risks by hedging the impact of interest rates on the value of the MSRs using derivatives, combined with the “natural hedge” provided by the origination and servicing components of the mortgage business; however, we do not hedge 100% of these two risks.
We hedge a significant portion of the value of our MSRs against a change in interest rates with derivatives. The principal source of risk in this hedging process is the risk that changes in the value of the hedging contracts may not match changes in the value of the hedged portion of our MSRs for any given change in long-term interest rates.
The value of our MSRs is influenced primarily by prepayment speed assumptions affecting the duration of the mortgage loans to which our MSRs relate. Changes in long-term interest rates affect these prepayment speed assumptions. For example, a decrease in long-term rates would accelerate prepayment speed assumptions as borrowers refinance their existing mortgage loans and decrease the value of the MSRs. In contrast, prepayment speed assumptions would tend to slow in a rising interest rate environment and increase the value of the MSRs.
For a given decline in interest rates, a portion of the potential reduction in the value of our MSRs is offset by estimated increases in origination and servicing fees over time from new mortgage activity or refinancing associated with that decline in interest rates. With much lower long-term interest rates, the decline in the value of our MSRs and the effect on net income would be immediate whereas the additional origination and servicing fee income accrues over time. Under generally accepted accounting principles (GAAP), impairment of our MSRs, due to a decrease in long-term rates or other reasons, is charged to earnings through an increase to the valuation allowance.
In scenarios of sustained increases in long-term interest rates, origination fees may eventually decline as refinancing activity slows. In such higher interest rate scenarios, the duration of the servicing portfolio may lengthen. In such circumstances, we may reduce periodic amortization of MSRs, and may recover some or all of the previously established valuation allowance.
Our MSRs totaled $8.5 billion, net of a valuation allowance of $1.6 billion, at June 30, 2004, and $3.8 billion, net of a valuation allowance of $2.6 billion, at June 30, 2003. The increase in MSRs was primarily due to the growth in the servicing portfolio resulting from originations and purchases, and changes in MSRs due to the impact of higher interest rates. The decrease in the level of the valuation allowance reflected writedowns on MSRs in third quarter 2003 and first quarter 2004, and a reversal of allowance in second quarter 2004. Our MSRs were 1.37% of mortgage loans serviced for others at June 30, 2004, compared with 1.15% at December 31, 2003 and .73% at June 30, 2003.
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Market Risk — Trading Activities
From a market risk perspective, our net income is exposed to changes in interest rates, credit spreads, foreign exchange rates, equity and commodity prices and their implied volatilities. The primary purpose of our trading businesses is to accommodate customers in the management of their market price risks. Also, we take positions based on market expectations or to benefit from price differences between financial instruments and markets, subject to risk limits established and monitored by Corporate ALCO. All securities, loans, foreign exchange transactions, commodity transactions and derivatives - transacted with customers or used to hedge capital market transactions with customers — are carried at fair value. The Institutional Risk Committee establishes and monitors counterparty risk limits. The notional or contractual amount, credit risk amount and estimated net fair value of all customer accommodation derivatives at June 30, 2004 and December 31, 2003 are included in Note 18 (Derivatives) to Financial Statements. Open, “at risk” positions for all trading business are monitored by Corporate ALCO.
The standardized approach for monitoring and reporting market risk for the trading activities is the value-at-risk (VAR) metrics complemented with factor analysis and stress testing. Value-at-risk measures the worst expected loss over a given time interval and within a given confidence interval. We measure and report daily VAR at 99% confidence interval based on actual changes in rates and prices over the past 250 days. The analysis captures all financial instruments that are considered trading positions. The average one day VAR throughout second quarter 2004 was $23 million, with a lower bound of $12 million and an upper bound of $56 million.
Market Risk — Equity Markets
We are directly and indirectly affected by changes in the equity markets. We make and manage direct equity investments in start-up businesses, emerging growth companies, management buy-outs, acquisitions and corporate recapitalizations. We also invest in non-affiliated funds that make similar private equity investments. These private equity investments are made within capital allocations approved by management and the Board of Directors. The Board reviews business developments, key risks and historical returns for the private equity investments at least annually. Management reviews these investments at least quarterly and assesses them for possible other-than-temporary impairment. For nonmarketable investments, the analysis is based on facts and circumstances of each individual investment and the expectations for that investment’s cash flows and capital needs, the viability of its business model and our exit strategy. Private equity investments totaled $1,716 million at June 30, 2004 and $1,704 million at June 30, 2003.
We also have marketable equity securities in the available for sale investment portfolio, including securities relating to our venture capital activities. We manage these investments within capital risk limits approved by management and the Board and monitored by Corporate ALCO. Gains and losses on these securities are recognized in net income when realized and, in addition, other-than-temporary impairment may be periodically recorded. The initial indicator of impairment for marketable equity securities is a sustained decline in market price below the amount recorded for that investment. We consider a variety of factors, such as the length of time and the extent to which the market value has been less than cost; the issuer’s financial condition, capital strength, and near-term prospects; any recent events specific to that issuer and economic conditions of its industry; and, to a lesser degree, our investment horizon in relationship to an
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anticipated near-term recovery in the stock price, if any. At June 30, 2004, the fair value of marketable equity securities was $757 million and cost was $468 million, compared with $610 million and $527 million, respectively, at June 30, 2003.
Changes in equity market prices may also indirectly affect our net income (1) by affecting the value of third party assets under management and, hence, fee income, (2) by affecting particular borrowers, whose ability to repay principal and/or interest may be affected by the stock market, or (3) by affecting brokerage activity, related commission income and other business activities. Each business line monitors and manages these indirect risks.
Liquidity and Funding
The objective of effective liquidity management is to ensure that we can meet customer loan requests, customer deposit maturities/withdrawals and other cash commitments efficiently under both normal operating conditions and under unpredictable circumstances of industry or market stress. To achieve this objective, Corporate ALCO establishes and monitors liquidity guidelines that require sufficient asset-based liquidity to cover potential funding requirements and to avoid over-dependence on volatile, less reliable funding markets. We set liquidity management guidelines for both the consolidated balance sheet as well as for the Parent specifically to ensure that the Parent is a source of strength for its regulated, deposit-taking banking subsidiaries. Debt securities in the securities available for sale portfolio provide asset liquidity, in addition to the immediately liquid resources of cash and due from banks and federal funds sold and securities purchased under resale agreements. Asset liquidity is further enhanced by our ability to sell or securitize loans in secondary markets through whole-loan sales and securitizations.
Core customer deposits have historically provided a sizeable source of relatively stable and low-cost funds. The remaining assets were funded by long-term debt, deposits in foreign offices, short-term borrowings (federal funds purchased and securities sold under repurchase agreements, commercial paper and other short-term borrowings) and trust preferred securities.
Liquidity is also available through our ability to raise funds in a variety of domestic and international money and capital markets. We access capital markets for long-term funding by issuing registered debt, private placements and asset-based secured funding. In September 2003, Moody’s Investors Service raised Wells Fargo Bank, N.A.’s rating to “Aaa,” its highest investment grade, from “Aa1” and raised the Company’s senior debt rating to “Aa1” from “Aa2.” In October 2003, Standard & Poor’s Ratings Service raised the counterparty ratings on the Company to “AA-minus/A-1-plus” from “A-plus/A-1” and the revised outlook for the Company to stable from positive. Rating agencies base their ratings on many quantitative and qualitative factors, including capital adequacy, liquidity, asset quality, business mix and level and quality of earnings.
In June 2004, we repurchased and retired approximately $2.2 billion of previously issued long-term debt of the Company for a cost of $2.4 billion. The debt retired had a weighted-average coupon of 6.20%, well above our current issuance cost. This balance sheet repositioning activity was intended to reduce future funding costs.
Parent. In March 2003, the Parent registered with the Securities and Exchange Commission (SEC) for issuance of $15.3 billion in senior and subordinated notes and preferred and common
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securities. In April 2004, the Parent filed a registration statement with the SEC for issuance of an additional $20 billion in senior and subordinated notes, preferred stock and other securities. During the second quarter and first six months of 2004, the Parent issued a total of $1.1 billion and $7.2 billion, respectively, of senior and subordinated notes. Second quarter 2004 activity included issuance of $.5 billion in junior subordinated debentures and $.5 billion in subordinated debt. At June 30, 2004, the Parent’s remaining issuance capacity under effective registration statements was $21.9 billion. In August 2004, the Parent issued $750 million in senior notes. The Parent also issued $2.5 billion in private placements in second quarter 2004. We used the proceeds from securities issued in the first six months of 2004 for general corporate purposes and expect that the proceeds in the future will also be used for general corporate purposes. The Parent also issues commercial paper and has a $1 billion back-up credit facility. (See Note 8 (Guaranteed Preferred Beneficial Interests in Company’s Subordinated Debentures) to Financial Statements for additional information.)
Bank Note Program. In March 2003, Wells Fargo Bank, N.A. established a $50 billion bank note program under which it may issue up to $20 billion in short-term senior notes outstanding at any time and up to a total of $30 billion in long-term senior and subordinated notes. This program updates and supercedes the bank note program established in February 2001. Securities are issued under this program as private placements in accordance with Office of the Comptroller of the Currency (OCC) regulations. During the second quarter and first six months of 2004, Wells Fargo Bank, N.A. issued $850 million and $5.0 billion, respectively, in senior long-term notes. At June 30, 2004, the remaining issuance authority under the long-term portion was $9.9 billion. In July 2004, Wells Fargo Bank, N.A., issued $100 million in senior long-term notes.
Wells Fargo Financial. In November 2003, Wells Fargo Financial Canada Corporation (WFFCC), a wholly-owned Canadian subsidiary of Wells Fargo Financial, Inc. (WFFI), qualified for distribution with the provincial securities exchanges in Canada $1.5 billion (Canadian) in senior debt. During second quarter 2004, WFFCC issued $200 million (Canadian) in senior debt, leaving, at June 30, 2004, a total of $1.3 billion (Canadian) available for issuance.
CAPITAL MANAGEMENT
We have an active program for managing stockholder capital. Our objective is to produce above market long-term returns by opportunistically using capital when returns are perceived to be high and issuing/accumulating capital when such costs are perceived to be low.
We use capital to fund organic growth, acquire banks and other financial services companies, pay dividends and repurchase our shares. During the first half of 2004, consolidated assets increased by $33 billion, or 8%.
From time to time our Board of Directors authorizes the Company to repurchase shares of its common stock. Although we announce when our Board authorizes share repurchases, we typically do not give any public notice before we repurchase our shares. Various factors determine the amount and timing of our share repurchases, including our capital requirements, the number of shares we expect to issue for acquisitions and employee benefit plans, market conditions (including the trading price of our stock), and legal considerations. These factors can change at any time, and there can be no assurance as to the number of shares we will repurchase or when we will repurchase them.
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Historically, our policy has been to repurchase shares under the “safe harbor” conditions of Rule 10b-18 of the Exchange Act including a limitation on the daily volume of repurchases. In November 2003, the SEC amended Rule 10b-18 to impose an additional daily volume limitation on share repurchases during a pending merger or acquisition in which shares of our stock will constitute some or all of the consideration. Our management may determine that during a pending stock merger or acquisition when the safe harbor would otherwise be available, it is in the Company’s best interest to repurchase shares in excess of this additional daily volume limitation. In such cases, we intend to repurchase shares in compliance with the other conditions of the safe harbor, including the standing daily volume limitation that applies whether or not there is a pending stock merger or acquisition.
During 2002, the Board of Directors authorized the repurchase of up to 50 million additional shares of our outstanding common stock. In April 2004, the Board authorized the repurchase of up to 25 million additional shares of common stock. During the first half of 2004, we repurchased approximately 29 million shares of our common stock. At June 30, 2004, the total remaining common stock repurchase authority under outstanding authorizations was approximately 22 million shares. (For additional information regarding share repurchases and repurchase authorizations, see Part II Item 2 on page 65.) Total common stock dividend payments in the first half of 2004 were $1.5 billion. In July 2004, the Board of Directors authorized a quarterly common stock dividend of 48 cents per share, an increase of 3 cents per share, or 7%, from the prior quarter.
Our potential sources of capital include retained earnings, and issuances of common and preferred stock and subordinated debt. In the first half of 2004, retained earnings increased $1.8 billion, predominantly as a result of net income of $3.5 billion less dividends of $1.5 billion. In the first half of 2004, we issued $882 million of common stock under various employee benefit and director plans and under our dividend reinvestment program.
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FACTORS THAT MAY AFFECT FUTURE RESULTS
We make forward-looking statements in this report and in other reports and proxy statements we file with the SEC. In addition, our senior management might make forward-looking statements orally to analysts, investors, the media and others.
Forward-looking statements include:
In this report, for example, we make forward-looking statements discussing our expectations about:
Forward-looking statements discuss matters that are not historical facts. Because they discuss future events or conditions, forward-looking statements often include words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “plan,” “project,” “target,” “can,” “could,” “may,” “should,” “will,” “would” or similar expressions. Do not unduly rely on forward-looking statements. They give our expectations about the future and are not guarantees. Forward-looking statements speak only as of the date they are made, and we might not update them to reflect changes that occur after that date.
There are several factors-many beyond our control-that could cause results to differ significantly from our expectations. Some of these factors are described below. Other factors, such as credit, market, operational, liquidity, interest rate and other risks, are described elsewhere in this report (see, for example, “Balance Sheet Analysis” and “Asset/Liability and Market Risk Management”). Factors relating to regulation and supervision are described in our 2003 Form 10-K. Any factor described in this report or in our 2003 Form 10-K could by itself, or together with one or more other factors, adversely affect our business, results of operations or financial condition. There are also other factors that we have not described in this report or in our 2003 Form 10-K that could cause results to differ from our expectations.
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Industry Factors
As a financial services company, our earnings are significantly affected by general business and economic conditions.
General business and economic conditions in the United States and abroad affect our business and earnings. These conditions include short-term and long-term interest rates, inflation, monetary supply, fluctuations in both debt and equity capital markets, and the strength of the U.S. economy and the local economies in which we operate. For example, an economic downturn, increase in unemployment, increase in interest rates or other event that decreases household or corporate incomes or increases household or corporate expenses could decrease the demand for loan and non-loan products and services and increase the number of customers who fail to pay interest or principal on their loans.
Geopolitical conditions can also affect our earnings. Acts or threats of terrorism, actions taken by the U.S. or other governments in response to acts or threats of terrorism and/or military conflicts, could affect business and economic conditions in the U.S. and abroad. The terrorist attacks in 2001, for example, caused an immediate decrease in air travel, which affected the airline industry, lodging, gaming and tourism.
We discuss other business and economic conditions in more detail elsewhere in this report.
The fiscal and monetary policies of the federal government and its agencies significantly affect our earnings.
The Board of Governors of the Federal Reserve System regulates the supply of money and credit in the United States. Its policies determine in large part our cost of funds for lending and investing and the return we earn on those loans and investments, both of which affect our net interest margin. They also can materially affect the value of financial instruments we hold, such as debt securities. Its policies also can affect our borrowers, increasing their borrowing costs and potentially increasing the risk that they may fail to repay their loans. Changes in Federal Reserve Board policies are beyond our control and can be hard to predict.
The financial services industry is highly competitive.
We operate in a highly competitive industry that could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Banks, securities firms and insurance companies can now combine to offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking. Recently, a number of foreign banks have acquired financial services companies in the United States, further increasing competition in the U.S. market. Also, technology has lowered barriers to entry and made it possible for nonbanks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Many of our competitors have fewer regulatory constraints and some have lower cost structures.
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We are heavily regulated by federal and state agencies.
The holding company, its subsidiary banks and many of its nonbank subsidiaries are heavily regulated at the federal and state levels. This regulation is to protect depositors, federal deposit insurance funds and the banking system as a whole, not security holders. Congress and state legislatures and federal and state regulatory agencies continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies, including interpretation or implementation of statutes, regulations or policies, could affect us in substantial and unpredictable ways including limiting the types of financial services and products we may offer and/or increasing the ability of nonbanks to offer competing financial services and products. Also, if we do not comply with laws, regulations or policies, we could receive regulatory sanctions and incur damage to our reputation. For more information, refer to the “Regulation and Supervision” and to Notes 3 (Cash, Loan and Dividend Restrictions) and 26 (Regulatory and Agency Capital Requirements) to Financial Statements in our 2003 Form 10-K.
Future legislation could change our competitive position.
Legislation is from time to time introduced in the Congress, including proposals to substantially change the financial institution regulatory system and to expand or contract the powers of banking institutions and bank holding companies. This legislation may change banking statutes and our operating environment in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. We cannot predict whether any of this potential legislation will be enacted, and if enacted, the effect that it, or any regulations, would have on our financial condition or results of operations.
We depend on the accuracy and completeness of information about customers and counterparties.
In deciding whether to extend credit or enter into other transactions with customers and counterparties, we may rely on information furnished to us by or on behalf of the customers and counterparties, including financial statements and other financial information. We also may rely on representations of the customers and counterparties as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors. For example, in deciding whether to extend credit, we may assume that a customer’s audited financial statements conform with GAAP and present fairly, in all material respects, the financial condition, results of operations and cash flows of the customer. We also may rely on the audit report covering those financial statements. Our financial condition and results of operations could be negatively affected by relying on financial statements that do not comply with GAAP or that are materially misleading.
Consumers may decide not to use banks to complete their financial transactions.
Technology and other changes now allow parties to complete financial transactions without banks. For example, consumers can pay bills and transfer funds directly without banks. The process of eliminating banks as intermediaries, known as “disintermediation,” could result in the loss of fee income, as well as the loss of customer deposits and income generated from those deposits.
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Company Factors
Maintaining or increasing our market share depends on market acceptance of new products and services.
Our success depends, in part, on our ability to adapt our products and services to evolving industry standards. There is increasing pressure to provide products and services at lower prices. This can reduce our net interest margin and revenues from our fee-based products and services. In addition, the widespread adoption of new technologies, including internet services, could require us to make substantial expenditures to modify or adapt our existing products and services. We might not be successful in introducing new products and services, achieving market acceptance of our products and services, or developing and maintaining loyal customers.
Negative public opinion could damage our reputation and adversely impact our earnings.
Reputation risk, or the risk to our earnings and capital from negative public opinion, is inherent in our business. Negative public opinion can result from our actual or alleged conduct in any number of activities, including lending practices, corporate governance and acquisitions, and from actions taken by government regulators and community organizations in response to those activities. Negative public opinion can adversely affect our ability to keep and attract customers and can expose us to litigation and regulatory action. Because virtually all our businesses operate under the “Wells Fargo” brand, actual or alleged conduct by one business can result in negative public opinion about other Wells Fargo businesses. Although we take steps to minimize reputation risk in dealing with our customers and communities, as a large diversified financial services company with a relatively high industry profile, the risk will always be present in our organization.
The holding company relies on dividends from its subsidiaries for most of its revenue.
The holding company is a separate and distinct legal entity from its subsidiaries. It receives substantially all of its revenue from dividends from its subsidiaries. These dividends are the principal source of funds to pay dividends on the holding company’s common and preferred stock and interest and principal on its debt. Various federal and/or state laws and regulations limit the amount of dividends that our bank and certain of our nonbank subsidiaries may pay to the holding company. Also, the holding company’s right to participate in a distribution of assets upon a subsidiary’s liquidation or reorganization is subject to the prior claims of the subsidiary’s creditors. For more information, refer to “Regulation and Supervision—Dividend Restrictions” and “—Holding Company Structure” in our 2003 Form 10-K.
Our accounting policies and methods are key to how we report our financial condition and results of operations. They may require management to make estimates about matters that are uncertain.
Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. Our management must exercise judgment in selecting and applying many of these accounting policies and methods so they comply with generally accepted accounting principles and reflect management’s judgment of the most appropriate manner to report our financial condition and results. In some cases, management must select the accounting policy or method to apply from two or more alternatives, any of which might be reasonable under the circumstances yet might result in our reporting materially different amounts than
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would have been reported under a different alternative. Note 1 (Summary of Significant Accounting Policies) to Financial Statements in our 2003 Form 10-K describes our significant accounting policies.
Three accounting policies are critical to presenting our financial condition and results. They require management to make difficult, subjective or complex judgments about matters that are uncertain. Materially different amounts could be reported under different conditions or using different assumptions. These critical accounting policies relate to: (1) the allowance for loan losses, (2) the valuation of mortgage servicing rights, and (3) pension accounting. Because of the uncertainty of estimates about these matters, we cannot provide any assurance that we will not:
For more information, see “Critical Accounting Policies” in our 2003 Form 10-K and refer in this report to “Balance Sheet Analysis” and “Asset/Liability and Market Risk Management.”
Changes in accounting standards could materially impact our financial statements.
From time to time the Financial Accounting Standards Board (FASB) changes the financial accounting and reporting standards that govern the preparation of our financial statements. These changes can be hard to predict and can materially impact how we record and report our financial condition and results of operations. In some cases, we could be required to apply a new or revised standard retroactively, resulting in our restating prior period financial statements.
We have businesses other than banking.
We are a diversified financial services company. In addition to banking, we provide insurance, investments, mortgages and consumer finance. Although we believe our diversity helps lessen the impact on the Company when downturns affect any one segment of our industry, it also means our earnings could be subject to different risks and uncertainties. We discuss some examples below.
Merchant Banking. Our merchant banking business, which includes venture capital investments, has a much greater risk of capital losses than our traditional banking business. Also, it is difficult to predict the timing of any gains from this business. Realization of gains from our venture capital investments depends on a number of factors-many beyond our control-including general economic conditions, the prospects of the companies in which we invest, when these companies go public, the size of our position relative to the public float, and whether we are subject to any resale restrictions. Factors, such as a slowdown in consumer demand or a decline in capital spending, could result in declines in the values of our publicly-traded and private equity securities. If we determine that the declines are other-than-temporary, we will recognize impairment charges. Also, we will realize losses to the extent we sell securities at less than book value. For more information, see in this report “Balance Sheet Analysis-Securities Available for Sale.”
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Mortgage Banking. The effect of interest rates on our mortgage business can be large and complex. Changes in interest rates can affect loan origination fees and loan servicing fees, which account for a significant portion of mortgage-related revenues. A decline in mortgage rates generally increases the demand for mortgage loans as borrowers refinance, but also generally leads to accelerated payoffs in our mortgage servicing portfolio. Conversely, in a constant or increasing rate environment, we would expect fewer loans to be refinanced and a decline in payoffs in our servicing portfolio. We use dynamic, sophisticated models to assess the effect of interest rates on mortgage fees, amortization of mortgage servicing rights, and the value of mortgage servicing rights. The estimates of net income and fair value produced by these models, however, depend on assumptions of future loan demand, prepayment speeds and other factors that may overstate or understate actual experience. We use derivatives to hedge the value of our servicing portfolio but they do not cover the full value of the portfolio. We cannot assure that the hedges will offset significant decreases in the value of the portfolio. For more information, see in our 2003 Form 10-K “Critical Accounting Policies-Valuation of Mortgage Servicing Rights” and in this report “Asset /Liability and Market Risk Management.”
We rely on other companies to provide key components of our business infrastructure.
Third parties provide key components of our business infrastructure such as internet connections and network access. Any disruption in internet, network access or other voice or data communication services provided by these third parties or any failure of these third parties to handle current or higher volumes of use could adversely affect our ability to deliver products and services to our customers and otherwise to conduct our business. Technological or financial difficulties of a third party service provider could adversely affect our business to the extent those difficulties result in the interruption or discontinuation of services provided by that party.
We have an active acquisition program.
We regularly explore opportunities to acquire financial institutions and other financial services providers. We cannot predict the number, size or timing of acquisitions. We typically do not comment publicly on a possible acquisition or business combination until we have signed a definitive agreement.
Our ability to complete an acquisition generally is subject to regulatory approval. We cannot be certain when or if, or on what terms and conditions, any required regulatory approvals will be granted. We might be required to sell banks or branches as a condition to receiving regulatory approval.
Difficulty in integrating an acquired company may cause us not to realize expected revenue increases, cost savings, increases in geographic or product presence, and/or other projected benefits from the acquisition. The integration could result in higher than expected deposit attrition (run-off), loss of key employees, disruption of our business or the business of the acquired company, or otherwise adversely affect our ability to maintain relationships with customers and employees or achieve the anticipated benefits of the acquisition. Also, the negative effect of any divestitures required by regulatory authorities in acquisitions or business combinations may be greater than expected.
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Legislative Risk
Our business model depends on sharing information among the family of companies owned by Wells Fargo to better satisfy our customers’ needs. Laws that restrict the ability of our companies to share information about customers could negatively affect our revenue and profit.
Our business could suffer if we fail to attract and retain skilled people.
Our success depends, in large part, on our ability to attract and retain key people. Competition for the best people in most activities we engage in can be intense. We may not be able to hire the best people or to keep them.
Our stock price can be volatile.
Our stock price can fluctuate widely in response to a variety of factors including:
General market fluctuations, industry factors and general economic and political conditions and events, such as terrorist attacks, economic slowdowns or recessions, interest rate changes, credit loss trends or currency fluctuations, also could cause our stock price to decrease regardless of our operating results.
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CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
As required by SEC rules, the Company’s management evaluated the effectiveness, as of June 30, 2004, of the Company’s disclosure controls and procedures. The Company’s chief executive officer and chief financial officer participated in the evaluation. Based on this evaluation, the Company’s chief executive officer and chief financial officer concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2004.
Internal Control Over Financial Reporting
No change occurred during second quarter 2004 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
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WELLS FARGO & COMPANY AND SUBSIDIARIESCONSOLIDATED STATEMENT OF INCOME
The accompanying notes are an integral part of these statements.
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WELLS FARGO & COMPANY AND SUBSIDIARIESCONSOLIDATED BALANCE SHEET
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WELLS FARGO & COMPANY AND SUBSIDIARIESCONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITYAND COMPREHENSIVE INCOME
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WELLS FARGO & COMPANY AND SUBSIDIARIESCONSOLIDATED STATEMENT OF CASH FLOWS
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1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Wells Fargo & Company is a diversified financial services company. We provide banking, insurance, investments, mortgage banking and consumer finance through stores, the internet and other distribution channels to consumers, businesses and institutions in all 50 states of the U.S. and in other countries. When we refer to “the Company,” “we,” “our” and “us” in this Form 10-Q, we mean Wells Fargo & Company and Subsidiaries (consolidated). Wells Fargo & Company (the Parent) is a financial holding company and a bank holding company.
Our accounting and reporting policies conform with generally accepted accounting principles (GAAP) and practices in the financial services industry. To prepare the financial statements in conformity with GAAP, management must make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and income and expenses during the reporting period.
The information furnished in these unaudited interim statements reflects all adjustments that are, in the opinion of management, necessary for a fair statement of the results for the periods presented. These adjustments are of a normal recurring nature, unless otherwise disclosed in this Form 10-Q. The results of operations in the interim statements do not necessarily indicate the results that may be expected for the full year. The interim financial information should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 (2003 Form 10-K).
Descriptions of our significant accounting policies are included in Note 1 (Summary of Significant Accounting Policies) to Financial Statements in our 2003 Form 10-K. There have been no significant changes to these policies.
STOCK-BASED COMPENSATION
We have several stock-based employee compensation plans, which are described more fully in Note 14 (Common Stock and Stock Plans) to Financial Statements in our 2003 Form 10-K. As permitted by Statement of Financial Accounting Standards No. 123 (FAS 123), Accounting for Stock-Based Compensation, we have elected to continue applying the intrinsic value method of Accounting Principles Board Opinion 25, Accounting for Stock Issued to Employees, in accounting for stock-based employee compensation plans. Pro forma net income and earnings per common share information is provided in the following table, as if we accounted for employee stock option plans under the fair value method of FAS 123.
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Total stock-based employee compensation was higher under the fair value method in the first half of 2004 compared with the first half of 2003. Stock options granted in our February 2004 grant, under our Long-Term Incentive Compensation Plan (the Plan), fully vested upon grant, resulting in full recognition of stock-based compensation expense for the 2004 annual grant under the fair value method in the table above. Stock options granted in our 2003, 2002 and 2001 annual grants under the Plan vest over a three-year period, and expense reflected in the table for these grants is recognized over the vesting period.
2. BUSINESS COMBINATIONS
We regularly explore opportunities to acquire financial services companies and businesses. Generally, we do not make a public announcement about an acquisition opportunity until a definitive agreement has been signed.
In the six months ended June 30, 2004, we completed acquisitions of six insurance brokerage businesses and one payroll services business with a total of approximately $65 million in assets.
At June 30, 2004, we had one pending business combination, the acquisition of $27 billion in mutual fund assets and $7 billion in institutional investment accounts from Strong Financial Corporation (Strong). The asset management businesses of Strong include 70 mutual funds. We expect to complete this acquisition by first quarter 2005.
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3. SECURITIES AVAILABLE FOR SALE
The following table provides the cost and fair value for the major categories of securities available for sale carried at fair value. There were no securities classified as held to maturity at June 30, 2004 or 2003.
The following table provides the components of the estimated unrealized net gains on securities available for sale. The estimated unrealized net gains on securities available for sale are reported on an after-tax basis as a component of cumulative other comprehensive income.
The following table shows the realized net gains (losses) on the sales of securities from the securities available for sale portfolio, including marketable equity securities.
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4. LOANS AND ALLOWANCE FOR LOAN LOSSES
A summary of the major categories of loans outstanding is shown in the table below. Outstanding loan balances are net of unearned income, including net deferred loan fees, of $3,531 million, $3,430 million and $3,784 million, at June 30, 2004, December 31, 2003 and June 30, 2003, respectively.
The average recorded investment in impaired loans during second quarter 2004 and 2003 was $515 million and $696 million, respectively, and $544 million and $670 million in the first half of 2004 and 2003, respectively.
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Changes in the allowance for loan losses were:
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5. OTHER ASSETS
Trading assets are predominantly securities, including corporate debt, U.S. government agency obligations and the fair value of derivatives held for customer accommodation purposes.
Income related to trading assets and nonmarketable equity investments was:
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6. INTANGIBLE ASSETS
The gross carrying amount of intangible assets and accumulated amortization at June 30, 2004 and 2003 was:
As of June 30, 2004, the current year and estimated future amortization expense for amortized intangible assets was:
We based the projections of amortization expense for mortgage servicing rights shown above on existing asset balances and the existing interest rate environment as of June 30, 2004. Future amortization expense may be significantly different depending upon changes in the mortgage servicing portfolio, mortgage interest rates and market conditions. We based the projections of amortization expense for core deposit intangibles shown above on existing asset balances at June 30, 2004. Future amortization expense may vary based on additional core deposit intangibles acquired through business combinations.
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7. GOODWILL
The following table summarizes the changes in the carrying amount of goodwill as allocated to our operating segments for goodwill impairment analysis.
For our goodwill impairment analysis, we allocate all of the goodwill to the individual operating segments. For management reporting we do not allocate all of the goodwill to the individual operating segments: some is allocated at the enterprise level. See Note 12 for further information on management reporting. The balances of goodwill for management reporting are:
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We have wholly-owned trusts (the Trusts) that were formed to issue trust preferred securities and related common securities of the Trusts. At December 31, 2003, as a result of the adoption of Financial Accounting Standards Board Interpretation No. 46, Consolidation of Variable Interest Entities, we deconsolidated the Trusts. The $3.8 billion of junior subordinated debentures issued by the Company to the Trusts were reflected as long-term debt in the consolidated balance sheet at December 31, 2003. The common stock issued by the Trusts was recorded in other assets in the consolidated balance sheet at December 31, 2003. Because the Trusts are (1) wholly-owned finance subsidiary issuers of securities, have no operating histories or independent operations and are not engaged in and do not propose to engage in any activity other than holding as trust assets the corresponding junior subordinated debentures of Wells Fargo and issuing the trust securities, and (2) the securities were fully and unconditionally guaranteed by the parent company, the Trusts will not file periodic reports with the Securities and Exchange Commission under the Securities Exchange Act of 1934. Payments on the junior subordinated debentures are generally made from cash provided by operating activities, which include dividends receivable from subsidiaries. See Note 3 (Cash, Loan and Dividend Restrictions) to Financial Statements in our 2003 Form 10-K for a discussion of certain federal and state regulatory limitations on dividends.
Prior to December 31, 2003, the Trusts were consolidated subsidiaries and were included in liabilities in the consolidated balance sheet, as “Guaranteed preferred beneficial interests in Company’s subordinated debentures.” The common securities and subordinated debentures, along with the related income effects were eliminated in the consolidated financial statements.
The subordinated debentures issued to the Trusts, less the common securities of the Trusts, equals the amount of trust preferred securities outstanding, and continued to qualify as Tier 1 capital under guidance issued by the Federal Reserve Board. Information with respect to the Trusts is as follows:
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9. PREFERRED STOCK
We are authorized to issue 20 million shares of preferred stock and 4 million shares of preference stock, both without par value. Preferred shares outstanding rank senior to common shares both as to dividends and liquidation preference but have no general voting rights. We have not issued any preference shares under this authorization.
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10. EMPLOYEE BENEFITS
We sponsor noncontributory qualified defined benefit retirement plans including the Cash Balance Plan. The Cash Balance Plan is an active plan, which covers eligible employees (except employees of certain subsidiaries).
We do not expect that we will be required to make a minimum contribution in 2004 for our Cash Balance Plan. The maximum contribution amount for the Cash Balance Plan is the maximum deductible contribution under the Internal Revenue Code. The Company will determine whether or not to make a contribution later this year based on various factors, including the maximum amount of tax deductible contribution and 2004 asset performance.
The net periodic benefit cost for the second quarter and first half of 2004 and 2003 was:
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11. EARNINGS PER COMMON SHARE
The table below shows earnings per common share and diluted earnings per common share and reconciles the numerator and denominator of both earnings per common share calculations.
At June 30, 2004 and 2003, options to purchase 2.7 million and 35.5 million shares, respectively, were outstanding but not included in the calculation of earnings per share because the exercise price was higher than the market price, and therefore they were antidilutive.
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12. OPERATING SEGMENTS
We have three lines of business for management reporting: Community Banking, Wholesale Banking and Wells Fargo Financial. The results for these lines of business are based on our management accounting process, which assigns balance sheet and income statement items to each responsible operating segment. This process is dynamic and, unlike financial accounting, there is no comprehensive, authoritative guidance for management accounting equivalent to generally accepted accounting principles. The management accounting process measures the performance of the operating segments based on our management structure and is not necessarily comparable with similar information for other financial services companies. We define our operating segments by product type and customer segments. If the management structure and/or the allocation process changes, allocations, transfers and assignments may change. In that case, results for prior periods would be restated for comparability.
The Community Banking Group offers a complete line of diversified financial products and services to consumers and small businesses with annual sales generally up to $10 million in which the owner generally is the financial decision maker. Community Banking also offers investment management and other services to retail customers and high net worth individuals, insurance, securities brokerage through affiliates and venture capital financing. These products and services include Wells Fargo Funds®, a family of mutual funds, as well as personal trust, employee benefit trust and agency assets. Loan products include lines of credit, equity lines and loans, equipment and transportation (auto, recreational vehicle and marine) loans, education loans, origination and purchase of residential mortgage loans and servicing of mortgage loans and credit cards. Other credit products and financial services available to small businesses and their owners include receivables and inventory financing, equipment leases, real estate financing, Small Business Administration financing, venture capital financing, cash management, payroll services, retirement plans, medical savings accounts and credit and debit card processing. Consumer and business deposit products include checking accounts, savings deposits, market rate accounts, Individual Retirement Accounts (IRAs), time deposits and debit cards.
Community Banking serves customers through a wide range of channels, which include traditional banking stores, in-store banking centers, business centers and ATMs. Also, PhoneBankSM centers and the National Business Banking Center provide 24-hour telephone service. Online banking services include single sign-on to online banking, bill pay and brokerage, as well as online banking for small business.
The Wholesale Banking Group serves businesses across the United States with annual sales generally in excess of $10 million. Wholesale Banking provides a complete line of commercial, corporate and real estate banking products and services. These include traditional commercial loans and lines of credit, letters of credit, asset-based lending, equipment leasing, mezzanine financing, high-yield debt, international trade facilities, foreign exchange services, treasury management, investment management, institutional fixed income and equity sales, online/electronic products, insurance brokerage services and investment banking services. Wholesale Banking includes the majority ownership interest in the Wells Fargo HSBC Trade Bank, which provides trade financing, letters of credit and collection services and is sometimes supported by the Export-Import Bank of the United States (a public agency of the United States offering export finance support for American-made products). Wholesale Banking also supports the commercial real estate market with products and services such as construction loans for
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commercial and residential development, land acquisition and development loans, secured and unsecured lines of credit, interim financing arrangements for completed structures, rehabilitation loans, affordable housing loans and letters of credit, permanent loans for securitization, commercial real estate loan servicing and real estate and mortgage brokerage services.
Wells Fargo Financial includes consumer finance and auto finance operations. Consumer finance operations make direct consumer and real estate loans to individuals and purchase sales finance contracts from retail merchants from offices throughout the United States, Canada and in the Caribbean. Automobile finance operations specialize in purchasing sales finance contracts directly from automobile dealers and making loans secured by automobiles in the United States, Canada and Puerto Rico. Wells Fargo Financial also provides credit cards and lease and other commercial financing.
The Other Column consists of Corporate level investment activities and balances and unallocated goodwill held at the enterprise level. This column also includes separately identified transactions recorded at the enterprise level for management reporting.
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13. VARIABLE INTEREST ENTITIES
We are a variable interest holder in certain special-purpose entities that are consolidated because we will absorb a majority of each entity’s expected losses, receive a majority of each entity’s expected returns or both. We do not hold a majority voting interest in these entities. These entities were formed to invest in securities and to securitize real estate investment trust securities and had approximately $4 billion in total assets at June 30, 2004, compared with $5 billion at December 31, 2003. The primary activities of these entities consist of acquiring and disposing of, and investing and reinvesting in securities, and issuing beneficial interests secured by those securities to investors. The creditors of substantially all of these consolidated entities have no recourse against us.
We hold variable interests greater than 20% but less than 50% in certain special-purpose entities formed to provide affordable housing and to securitize high-yield corporate debt that had approximately $3 billion in total assets at June 30, 2004, compared with $2 billion at December 31, 2003. We are not required to consolidate these entities. Our maximum exposure to loss related to these unconsolidated entities was approximately $700 million at June 30, 2004 and $450 million at December 31, 2003.
14. MORTGAGE BANKING ACTIVITIES
Mortgage banking activities, included in the Community Banking and Wholesale Banking operating segments, consist of residential and commercial mortgage originations and servicing.
The components of mortgage banking noninterest income were:
Each quarter, we evaluate mortgage servicing rights (MSRs) for possible impairment based on the difference between the carrying amount and current fair value of the MSRs. If a temporary impairment exists, we establish a valuation allowance for any excess of amortized cost, as adjusted for hedge accounting, over the current fair value through a charge to income. We have a policy of reviewing MSRs for other-than-temporary impairment each quarter and recognize a direct write-down when the recoverability of a recorded valuation allowance is determined to be remote. Unlike a valuation allowance, a direct write-down permanently reduces the carrying value of the MSRs and the valuation allowance, precluding subsequent reversals. (See Note 1 (Summary of Significant Accounting Policies — Transfer and Servicing of Financial Assets) to Financial Statements in our 2003 Form 10-K for additional discussion of our policy for valuation of MSRs.)
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Net gains (losses) on mortgage loan origination/sales activities reflect the periodic evaluation of our portfolios, which are carried at the lower of cost or market value. Mortgages held for sale include residential mortgages that were originated in accordance with secondary market pricing and underwriting standards and certain mortgages originated initially for investment and not underwritten to secondary market standards.
This table summarizes the changes in mortgage servicing rights:
The components of the managed servicing portfolio were:
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15. CONDENSED CONSOLIDATING FINANCIAL STATEMENTS
Following are the condensed consolidating financial statements of the Parent and Wells Fargo Financial Inc. and its wholly-owned subsidiaries (WFFI). The Wells Fargo Financial business segment for management reporting (See Note 12) consists of WFFI and other affiliated consumer finance entities managed by WFFI that are included within other consolidating subsidiaries in the following tables.
Condensed Consolidating Statement of Income
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Condensed Consolidating Balance Sheet
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Condensed Consolidating Statement of Cash Flows
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16. GUARANTEES
Significant guarantees that we provide to third parties include standby letters of credit, various indemnification agreements, guarantees accounted for as derivatives, contingent consideration related to business combinations and contingent performance guarantees.
We issue standby letters of credit, which include performance and financial guarantees, for customers in connection with contracts between the customers and third parties. Standby letters of credit assure that the third parties will receive specified funds if customers fail to meet their contractual obligations. We are obliged to make payment if a customer defaults. Standby letters of credit were $8.5 billion and $8.3 billion at June 30, 2004 and December 31, 2003, respectively, including financial guarantees of $4.8 billion and $4.7 billion, respectively, that we had issued or purchased participations in. Standby letters of credit are reported net of participations sold to other institutions of $1.6 billion and $1.5 billion at June 30, 2004 and December 31, 2003, respectively. We consider the credit risk in standby letters of credit in determining the allowance for loan losses. Deferred fees for these standby letters of credit were not significant to our financial statements. We also had commitments for commercial and similar letters of credit of $870 million and $810 million at June 30, 2004 and December 31, 2003, respectively.
We enter into indemnification agreements in the ordinary course of business under which we agree to indemnify third parties against any damages, losses and expenses incurred in connection with legal and other proceedings arising from relationships or transactions with us. These relationships or transactions include those arising from service as a director or officer of the Company, underwriting agreements relating to our securities, securities lending, acquisition agreements, and various other business transactions or arrangements. Because the extent of our obligations under these agreements depends entirely upon the occurrence of future events, our potential future liability under these agreements is not determinable.
We write options, floors and caps. Options are exercisable based on favorable market conditions. Periodic settlements occur on floors and caps based on market conditions. At June 30, 2004 and December 31, 2003, the fair value of the written options liability in our balance sheet was $486 million and $382 million, respectively, and the written floors and caps liability was $213 million for both period ends. Our ultimate obligation under written options, floors and caps is based on future market conditions and is only quantifiable at settlement. We offset substantially all options written to customers with purchased options; we enter into other written options to mitigate balance sheet risk.
We also enter into credit default swaps under which we buy protection from or sell protection to a counterparty in the event of default of a reference obligation. The carrying amount of the contracts sold was a $6 million liability at June 30, 2004 and a $5 million liability at December 31, 2003. The maximum amount we would be required to pay under the swaps in which we sold protection, assuming all reference obligations default at a total loss, without recoveries, was $2.6 billion and $2.7 billion at June 30, 2004 and December 31, 2003, respectively. We purchased $2.7 billion and $2.8 billion of protection to mitigate the exposure at June 30, 2004 and December 31, 2003, respectively. Almost all of the protection purchases offset (i.e., use the same reference obligation and maturity) the contracts in which we are providing protection to a counterparty.
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In connection with certain brokerage, asset management and insurance agency acquisitions we have made, the terms of the acquisition agreements provide for deferred payments or additional consideration based on certain performance targets. At June 30, 2004 and December 31, 2003, the amount of contingent consideration we expected to pay was not significant to our financial statements.
We have entered into various contingent performance guarantees through credit risk participation arrangements with terms ranging from 1 to 30 years. We will be required to make payments under these guarantees if a customer defaults on its obligation to perform under certain credit agreements with third parties. Because the extent of our obligations under these guarantees depends entirely on future events, our potential future liability under these agreements is not fully determinable, however our exposure under most of the agreements can be quantified and for those agreements our exposure was contractually limited to an aggregate liability of approximately $373 million at June 30, 2004 and $330 million at December 31, 2003.
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17. REGULATORY AND AGENCY CAPITAL REQUIREMENTS
The Company and each of its subsidiary banks are subject to various regulatory capital adequacy requirements administered by the Federal Reserve Board and the Office of the Comptroller of the Currency, respectively.
On December 31, 2003, we deconsolidated our wholly-owned trusts (the Trusts) that were formed to issue trust preferred securities and related common securities of the Trusts. The $3.8 billion of junior subordinated debentures were reflected as long-term debt on the consolidated balance sheet at December 31, 2003. (See Note 8.) The subordinated debentures issued to the Trusts, less the common securities of the Trusts, continue to qualify as Tier 1 capital under guidance issued by the Federal Reserve Board.
Wells Fargo Bank, N.A., through its mortgage banking division, is an approved seller/servicer, and is required to maintain minimum levels of shareholders’ equity, as specified by various agencies, including the United States Department of Housing and Urban Development, Government National Mortgage Association, Federal Home Loan Mortgage Corporation and Federal National Mortgage Association. At June 30, 2004, Wells Fargo Bank, N.A., met these requirements.
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18. DERIVATIVES
Fair Value Hedges
We use derivatives to manage the risk of changes in the fair value of mortgage servicing rights and other retained interests. Derivative gains or losses caused by changes in market factors not related to the hedged risk (volatility) and the spread between spot and forward rates priced into the derivative contracts (the passage of time) are excluded from the evaluation of hedge effectiveness, but are reflected in earnings. The change in value of derivatives excluded from the assessment of hedge effectiveness was a net gain of $6 million and $351 million in the second quarter and first half of 2004, respectively, compared with a net gain of $301 million and $649 million in the same periods of 2003. The ineffective portion of the change in value of these derivatives was a net loss of $210 million and $17 million in the second quarter and first half of 2004, respectively, compared with a net gain of $107 million and $309 million in the same periods of 2003. The net derivative loss of $204 million and net derivative gain of $334 million in the second quarter and first half of 2004, respectively, are included in “Servicing fees, net of provision for impairment and amortization” in Note 14.
We also use derivatives to hedge changes in fair value of certain of our commercial real estate mortgages due to changes in LIBOR interest rates. We originate a portion of these loans with the intent to sell them. The ineffective portion of these fair value hedges was a net loss of $5 million and $10 million in the second quarter and first half of 2004, respectively, and $5 million and $11 million in the same periods of 2003, respectively, recorded as part of mortgage banking noninterest income in the statement of income. For the commercial real estate hedges, all parts of each derivatives gain or loss are included in the assessment of hedge effectiveness.
We also enter into interest rate swaps, designated as fair value hedges, to convert certain of our fixed-rate long-term debt to floating-rate debt. The ineffective part of these fair value hedges was not significant in the second quarter or first half of 2004 or 2003. For long-term debt, all parts of each derivative’s gain or loss are included in the assessment of hedge effectiveness.
At June 30, 2004, all designated fair value hedges continued to qualify as fair value hedges.
Cash Flow Hedges
We use derivatives to convert floating-rate loans and certain of our floating-rate senior debt to fixed rates and to hedge forecasted sales of mortgage loans. We recognized a net gain of $47 million and $33 million in the second quarter and first half of 2004, respectively, and a net loss of $16 million and $54 million in the same periods of 2003, respectively, which represents the total ineffectiveness of cash flow hedges. Net gains and losses on derivatives resulting from ineffectiveness are included in the line item in which the hedged item’s effect in earnings is recorded. All parts of gain or loss on these derivatives are included in the assessment of hedge effectiveness. As of June 30, 2004, all designated cash flow hedges continued to qualify as cash flow hedges.
At June 30, 2004, we expected that $74 million of deferred net losses on derivatives in other comprehensive income will be reclassified as earnings during the next twelve months, compared with $138 million of deferred net gains at June 30, 2003. Derivative gains or losses recorded to
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other comprehensive income are reclassified to earnings in the period the hedged item impacts earnings. We are hedging our exposure to the variability of future cash flows for all forecasted transactions for a maximum of two years for floating-rate loans, one year for forecasted sales of mortgage loans and ten years for long-term debt.
Derivative Financial Instruments — Summary Information
The total credit risk amount and estimated net fair value for derivatives at June 30, 2004 and December 31, 2003 were:
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PART II — OTHER INFORMATION
The following table shows Company repurchases of its common stock for each calendar month in the quarter ended June 30, 2004.
The Company held its Annual Meeting of Stockholders on April 27, 2004. There were 1,699,548,460 shares of common stock outstanding and entitled to vote at the meeting. A total of 1,473,672,937 shares of common stock were represented at the meeting in person or by proxy, representing 86.7% of the shares outstanding and entitled to vote at the meeting.
At the meeting, stockholders:
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The voting results for each matter were:
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
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