Wells Fargo & Company (WFC) — Q2 2018 Earnings Call Transcript

Thank you, Regina. Good morning. Thank you for joining our call today where our CEO and President, Tim Sloan; and our CFO, John Shrewsberry, will discuss second quarter results and answer your questions. This call is being recorded. Before we get started, I would like to remind you that our second quarter earnings release and quarterly supplement are available on our website at wellsfargo.com. I'd also like to caution you that we may make forward-looking statements during today's call that are subject to risks and uncertainties. Factors that may cause actual results to differ materially from expectations are detailed in our SEC filings, including the Form 8-K filed today containing our earnings release and quarterly supplement. Information about any non-GAAP financial measures referenced, including a reconciliation of those measures to GAAP measures, can also be found in our SEC filings, in the earnings release and in the quarterly supplement available on our website. I will now turn the call over to our CEO and President, Tim Sloan.

Thanks, John. Good morning, and thank you all for being here today. I appreciate that it's a busy morning for many of you. We reported earnings of $5.2 billion in the second quarter, or $0.98 per diluted common share. Our results included a net discrete income tax expense of $0.10 per share. John will elaborate on this tax expense and other key items that affected our results later in the call. I want to focus on the transformational changes we are making to strengthen our company for our customers, team members, communities, and shareholders. This includes progress toward our six goals. We aim to transform our risk management practices at Wells Fargo, striving to not only meet but surpass regulatory expectations, ensuring we have the best risk management in the industry. We have a solid history of managing various risks, as evidenced by our 2018 CCAR results and credit quality. Nevertheless, we need to improve our management of other risks like compliance and operational risks, particularly concerning our foreign exchange and trust businesses, which we will discuss later in the call. As I mentioned on Investor Day, we're glad to have Mandy Norton on board as our new Chief Risk Officer, and she is already making a positive impact. While more work remains, I'm confident we will reach our risk management goals. We are also focused on enhancing the customer experience through several initiatives that leverage data and technology. In June, we launched a customer pilot of Control Tower, a digital tool that provides our customers with visibility and control over their payment account connections. Last year, we implemented automatic zero balance alerts for online banking customers, and we now issue over 30 million zero balance and customer-specified balance alerts monthly. We are also improving our in-branch customer service. In the second quarter, we completed the rollout of our customer relationship view tool, allowing tellers and bankers to engage in more meaningful conversations and refer customers to specialists for complex needs. We believe these interactions will enhance customer retention and strengthen relationships over time, ultimately driving growth. Our focus on innovation continues to generate value for our customers. We launched our online mortgage application in the first quarter, which accounted for 23% of all retail applications in June. In the second quarter, we introduced iPrint biometric log-on for our commercial customers, simplifying their experience. Small business banking deposit customers can now apply for card payments and processing equipment through a single online application at Wells Fargo Merchant Services, and we have standardized Merchant Services pricing for eligible small businesses. We have also enhanced the Propel Card, one of the top no-annual-fee rewards cards in the industry, and we look forward to starting card applications next week. As part of our commitment to positively impacting the communities we serve and promoting environmental sustainability, we announced a goal to provide $200 billion in financing for sustainable businesses and projects by 2030. The millions of hours our team members volunteer each year have earned Wells Fargo recognition as one of the 50 most community-minded companies in the U.S. according to the Points of Light organization. We also aim to lead in team member engagement, and our efforts to make Wells Fargo a better workplace are showing results with decreasing voluntary team member attrition, which is at its lowest level in over five years. We've successfully recruited high-caliber talent outside of Wells Fargo as well. In addition to our new Chief Risk Officer, we hired Lisa Frazier to lead our Innovation Group, who brings vast experience in digital disruption, customer experience, and product innovation. Earlier this week, David Galloreese, formerly of Walmart, joined us as our new Head of Human Resources. To deliver long-term value to our shareholders, we are dedicated to returning more capital to them. Our commitment was evident in our recent CCAR results, which included plans to increase our quarterly common stock dividend rate to $0.43 per share, pending board approval, and up to $24.5 billion in gross common stock repurchases over the next four quarters. The shareholder returns outlined in our 2018 Capital Plan are roughly 70% higher than our previous four-quarter capital actions. Our ability to significantly boost returns showcases the strength of our diverse business model, sound financial risk management, and robust capital position, built through stable earnings and reduced risk-weighted assets. We are also committed to operating more efficiently and are on track to achieve our goal of $4 billion in expense reductions by the end of 2019. In the second quarter, we launched our reestablished marketing effort, which is our largest advertising campaign ever. The campaign acknowledges our past issues, illustrates our progress, and showcases the ongoing changes at Wells Fargo. The reaction has been positive, and awareness from advertising continues to rise. As highlighted in our ads, our team members are dedicated to transforming Wells Fargo into a better company for all our stakeholders, and I am confident that we are headed in the right direction. John will now discuss our financial results in greater detail.

Thank you, Tim, and good morning, everyone. As Tim mentioned, we had a number of noteworthy items this quarter, which we've highlighted on Slide 2 of our supplement. Our earnings of $5.2 billion included $481 million net discrete income tax expense. This expense mostly related to state income taxes and was driven by the recent U.S. Supreme Court ruling in South Dakota versus Wayfair. While the ruling addressed whether a state can require an out-of-state seller to collect sales taxes or use taxes even when the seller lacks in-state physical presence, it has an income tax implication as well. Following the ruling, some of our affiliated entities may be considered to be taxable based on an economic presence in the state, even if they have no physical presence in the state. And while our effective income tax rate increased to 25.9% in the second quarter from this expense, we currently expect our effective income tax rate for the remainder of '18 to be approximately 19%, excluding the impact of any other future discrete items. Our results also included $619 million of operating losses primarily related to non-litigation expense for previously disclosed matters, which I'll highlight in more detail in the next page. We had a $479 million gain on the sale of $1.3 billion of Pick-a-Pay PCI mortgage loans; $214 million of other-than-temporary impairment on the announced sale of Wells Fargo's Asset Management 65% ownership stake in The Rock Creek Group; and a $150 million reserve release reflecting strong overall portfolio credit performance and lower balances. As we're highlighting on Page 3, operating losses in the second quarter were driven by customer remediation for previously disclosed matters, all of which have been referenced in our recent 10-Q and 10-K filings. I'll spend a moment updating you on these matters. The foreign exchange business has been under new leadership since October of '17. And after substantially completing an assessment with the assistance of a third party, the business is currently in the process of revising and implementing new policies, practices and procedures, including those related to pricing. In the second quarter, we accrued $171 million in customer remediation and rebate costs. We've been conducting an ongoing review related to certain of Wells Fargo's historical FX pricing practices. $31 million was accrued in the second quarter to remediate customers that may have received pricing inconsistent with commitments made to those customers. In addition, as part of our efforts to make things right and rebuild trust, we've examined rates historically charged to FX customers over a seven-year period and set aside $140 million in the second quarter to rebate customers where historic pricing, while consistent with contracts entered into with those customers, doesn't conform to our recently implemented standards and pricing. With respect to fee calculations in certain fiduciary and custody accounts in Wealth and Investment Management, we've determined that there have been instances of incorrect fees being applied to certain assets and accounts, resulting in both overcharges and undercharges to customers. In the second quarter, we accrued $114 million to refund customers that may have been overcharged at any time during the past seven years. The third-party review of customer accounts is ongoing to determine the extent of any additional necessary remediation, including with respect to additional accounts not yet reviewed. During the second quarter, we also accrued additional amounts for remediation related to past practices in our automobile lending business, including insurance-related products, and related to mortgage interest rate lock extensions. We believe remediation for mortgage interest rate locks is now substantially complete. In June, we received final approval on the class-action lawsuit settlement concerning improper sales practices, and the claims filing period for the settlement closed on July 7. We had previously accrued for the amount of this settlement. These actions are important steps in our efforts to rebuild trust. Turning to Page 4, as Tim highlighted, improving risk management across Wells Fargo is a top priority, including our compliance and operational risk management program. We're focused on satisfying the requirements of the Federal Reserve, OCC and CFPB consent orders. However, the asset cap related to the Federal Reserve's consent order has not impacted our ability to grow our core lending and deposit-taking businesses. The decline in the balance sheet in the second quarter primarily reflected lower deposits, driven by seasonality as well as commercial and Wealth and Investment Management customers allocating more cash to alternative, higher-rate liquid investments. I'll describe deposit trends in more detail later on the call. I'll be highlighting the income statement drivers on Page 5 throughout the call. So turning to loans on Page 6, average loans declined $6.9 billion from the first quarter. The decline in loan balances was not related to any actions we took in connection with the consent order, but was driven by opportunistic loan sales and continued reductions in auto, consumer real estate and commercial real estate. I'll highlight the specific drivers starting on Page 7. Commercial loans declined $291 million from the first quarter, despite C&I loans increasing $1.9 billion on growth in our Asset Backed Finance, Middle Market Banking and commercial capital business. The growth was more than offset by continued declines in Commercial Real Estate, primarily due to lower originations reflecting continued credit discipline and competitive, highly liquid financing markets as well as ongoing paydowns on existing and acquired loans. Of note, Wholesale Banking revolving line utilization has been substantially unchanged compared with a year ago at approximately 40%. Consumer loans declined $2.8 billion from the first quarter. First mortgage loans increased $343 million as high-quality, nonconforming loan origination growth was partially offset by $2.3 billion of lower Pick-a-Pay mortgage loans, including the sales of $1.3 billion of PCI loans. In addition, $507 million of nonconforming mortgage loan originations that otherwise would have been included in this portfolio were designated as held for sale in anticipation of future issuance of RMBS securities. Junior lien mortgage loans continued to decline as paydowns more than offset new originations. However, junior lien mortgage originations grew in the second quarter, up 15% from a year ago. Credit card loans increased $581 million from the first quarter. Balances increased $1.4 billion or 4% from a year ago. New accounts grew 7% from a year ago, driven by higher digital channel acquisitions. 43% of new card accounts were originated through digital channels in the second quarter. We expect credit card balances to continue to grow, bolstered by the launch of our new Propel Card next week and our continued focus on digital channel acquisition. Auto loans were down $1.9 billion from the first quarter due to expected continued runoff. Auto originations have stabilized over the past three quarters. We're positioned for originations to start to grow, and we currently expect portfolio balances to begin to grow by mid-2019. Other revolving credit and installment loans declined $376 million from the first quarter and included $68 million of loans transferred to held for sale as a result of previously announced branch divestitures. Balances in student lending and personal loans and lines continued to decline, but originations of personal loans and lines were up 8% from a year ago and reached their highest level since the third quarter of 2016. Average deposits declined $25.9 billion for the first quarter, driven by lower commercial deposits, including $13.5 billion from actions taken in response to the asset cap. Average consumer and small business banking deposits declined $1.4 billion as higher average Community Banking deposits were more than offset by lower deposits in Wealth and Investment Management as customers allocated more cash to alternative, higher-rate liquid investments. Our average deposit cost increased six basis points from the first quarter and was up 19 basis points from a year ago compared with a 75 basis point change in the Fed funds rate. The increase in our average deposit cost was driven by increases in commercial and Wealth and Investment Management deposit rates, while rates paid on consumer and small business banking deposits have not yet meaningfully responded to rate movements. Deposit betas continue to outperform our expectations. But as we highlighted at Investor Day, the cumulative beta over the last year was above our experience for the first 100 basis point move. Initial lags in repricing are expected to ultimately catch up to our historical experience. On Page 10, we provide details on period-end deposits, which declined $34.8 billion from the first quarter. There's typically a seasonal decline in deposits in the second quarter, which includes the impact of customer tax payments. Deposits were down $19.6 billion on a linked quarter basis a year ago. Wholesale Banking deposits declined $23.6 billion in the second quarter. Approximately 40% or $9.7 billion of this reduction was in financial institution deposits. As Neal Blinde, our Treasurer, discussed at Investor Day, financial institution deposits are by far our highest-cost deposits and our highest beta category. The decline in these deposits reflected temporary high levels of liquidity from the commercial payments business at the end of March as well as $3.9 million in actions taken in response to the asset cap. Wholesale Banking deposits also declined due to seasonality and commercial customers allocating more cash to alternative, higher-rate liquid investments. Consumer and small business banking deposits declined $20.2 billion from the first quarter, driven by seasonality as well as customers allocating more cash to alternative, higher-rate liquid investments. These declines were partially offset by $6.2 billion of higher Corporate Treasury deposits, including brokerage CDs as well as $2.8 billion of higher mortgage escrow balances. Net interest income in the second quarter increased $303 million from the first quarter. The drivers of the increase included $120 million less negative impact from hedge ineffectiveness accounting; approximately $105 million from balance sheet mix, repricing and variable income, largely driven by the net impact of rates and spreads; and approximately $80 million from one additional day in the quarter. Our NIM increased nine basis points to 2.93%, driven by a reduction in the proportion of lower-yielding assets, a less negative impact from hedge ineffectiveness accounting, and the net benefit of interest rate and spread movements. Noninterest income declined $752 million from a year ago, driven by lower mortgage revenue and a reduction of $210 million from businesses we sold during the past year, which also reduced expenses. Noninterest income declined $684 million from the first quarter. While deposit service charges had minimal impact to linked-quarter trends, they were down 9% from a year ago, so I want to provide more insight into these fees. I've highlighted in prior quarters the customer-friendly initiatives we've launched over the past year to help our consumer customers reduce fees, including Overdraft Rewind, which is an industry-leading feature that's helped over 1.3 million customers avoid overdraft charges. These initiatives were largely reflected in the amount of deposit service charges in the first quarter, so they didn't have a significant impact linked quarter. We've enhanced our efforts to help customers minimize standard monthly service fees through activities, such as direct deposit or debit card usage. Approximately 90% of our consumer checking customers do not pay a monthly fee, which is consistent with our goal of having more primary consumer checking customers. It's important to note that 46% of deposit service charges in the second quarter are from wholesale customers and are related to the Treasury Management fees they pay for services we provide to them. As market interest rates have risen over the past year, the earnings credit rate on noninterest-bearing deposits has modestly reduced these fees for wholesale customers, which were down $25 million from a year ago. We would expect this trend to continue if interest rates continue to rise. As a reminder, Treasury Management fees apply to noninterest-bearing deposit accounts, so the reduction in fees is an alternative to our paying interest. Mortgage banking revenue declined $164 million from the first quarter. Servicing income declined $62 million driven by higher prepayments. Residential mortgage originations increased $7 billion from the first quarter, but revenue declined $102 million due to a lower production margin. The production margin declined to 77 basis points as a result of increased pricing competition in both retail and correspondent channels. Given current market pricing trends, we would expect our production margin to remain near the current level in the third quarter. Gains from equity sales declined $488 million from the first quarter on lower unrealized gains and the impairment related to the announced sale of our ownership stake in RockCreek that I highlighted earlier. Other income was down $117 million from the first quarter. Our results in the second quarter included a $479 million gain on the sales of Pick-a-Pay PCI loans compared with a gain of $643 million from sales in the first quarter. Partially offsetting these declines was growth in card and other fees. Card fees increased $93 million from the first quarter on higher credit and debit card purchase volume. Other fees increased $46 million and included higher Commercial Real Estate brokerage commissions. Turning to expenses on Page 13. Expenses declined $1.1 billion from the first quarter, largely driven by lower operating losses and a decline from seasonally higher first quarter personnel expenses. Starting on Page 14, I'll explain our expense drivers in more detail. Compensation and benefits expense declined $447 million from the first quarter, which had seasonally higher personnel expense. Second quarter expenses included a full quarter impact from salary increases, higher deferred compensation and severance expense. Revenue-related expenses increased $59 million primarily from incentive compensation in Wells Fargo Securities and in home lending. Third-party services increased $151 million from higher contract services and legal expense. The $819 million decline in nondiscretionary, running-the-business expense was driven by lower operating losses on lower litigation accruals. The increase in discretionary running-the-business expense was driven by higher advertising expenses related to the launch of our reestablished campaign. Finally, infrastructure expenses declined $62 million from the first quarter, which is typically elevated equipment expense due to contract renewals. On Page 15, we show the drivers of the $441 million year-over-year increase in expenses. Compensation and benefits expense increased $265 million, primarily due to salary increases and higher severance, partially offset by the impact of the sale of Wells Fargo Insurance Services, which drove FTE reductions in Wholesale Banking. Our total FTEs were down 2% from a year ago and also reflected lower FTE in Community Banking and Consumer Lending. The increase in expenses was also driven by $269 million in higher operating losses, primarily related to customer remediation from previously disclosed matters that I highlighted earlier. These increases were partially offset by lower revenue-related and third-party services expense. We remain on track to achieve both our targeted $4 billion of expense reductions by the end of '19 and our expected range of $53.5 billion to $55.4 billion of expenses for 2018. As a reminder, our expected range of expenses for '18 includes approximately $600 million of typical operating losses, but excludes any outside litigation and remediation accruals and penalties. Turning to our segments on Page 16, Community Banking earnings increased $583 million from the first quarter, driven by lower operating losses, partially offset by higher income taxes from the net discrete income tax expense in the second quarter. On Page 17, we provide the Community Banking metrics. Teller and ATM transactions declined 5% from a year ago, reflecting continued customer migration to virtual channels, while digital secure sessions increased 17% from a year ago. In the second quarter, we consolidated 56 branches, and we're on track to consolidate approximately 300 branches this year. Additionally, we announced plans to divest 52 branches in Indiana, Ohio, Michigan and part of Wisconsin. Primary consumer checking customers have grown year-over-year for three consecutive quarters. In the second quarter, we continue to have improvements in primary customer retention. Growth in new checking customers overall was driven by digital, with 12% of new checking customers acquired from the digital channel. Growth in new checking customers also reflected the benefit of ongoing marketing initiatives. On Page 18, we highlight strong growth in credit and debit card purchase volume. General-purpose credit card purchase volume was up 7% from a year ago, and debit card purchase volume was up 9%. For the second consecutive year, we were ranked the number one debit card issuer by Nilson by both purchase volume and number of transactions. Both customer loyalty and overall satisfaction with most recent visit survey scores declined in the second quarter, which was driven by several factors, including recent events and a risk-based policy change affecting individuals making cash deposits into an account on which they're not a signer. Turning to Page 19, Wholesale Banking earnings declined $240 million from the first quarter, which included a $202 million gain on the sale of Wells Fargo Shareowner Services. Results in the second quarter included $171 million in operating losses related to the foreign exchange business, as I mentioned earlier. Wealth and Investment Management earnings declined $269 million from the first quarter, driven by the impairment from the announced sale of our ownership stake in RockCreek and $114 million of operating losses related to fee calculations in certain fiduciary and custody accounts, as I also mentioned earlier. Turning to Page 21, our strong credit results continued with our loss rate in the second quarter declining to 26 basis points of average loans, a historically low level. For the third consecutive quarter, all of our commercial and consumer real estate loan portfolios were in a net recovery position. Nonperforming assets declined $305 million from the first quarter, the ninth consecutive quarter of declines. We had a $150 million reserve release, reflecting strong credit performance and lower loan balances. Turning to Page 22, our estimated Common Equity Tier 1 ratio fully phased-in was 12%. We returned $4 billion to shareholders through common stock dividends and net share repurchases in the second quarter, including entering into a $1 billion forward repurchase transaction, which settled this week in the third quarter. Our 2018 Capital Plan, which includes up to $24.5 billion of gross common stock repurchases, reflects our goal of reducing our CET1 ratio to our internal target of 10% over the next 2 to 3 years. In the past, our quarterly common stock repurchases have been relatively evenly distributed over the 4-quarter period of a capital plan. However, given our high level of excess capital, our current plan, subject to market conditions and management discretion, is to use approximately 60% of the gross repurchase capacity under our capital plan during the second half of 2018. In summary, our second quarter results continued to reflect strong credit quality, liquidity, and capital. We grew net interest income, both linked quarter and year-over-year. We remain on track to meet our expense reduction expectations. As Tim highlighted, we continue to transform Wells Fargo and make progress on our six goals. And we'll now take your questions.

John, I was wondering, in terms of the net interest income, is the $12.5 billion that you did this quarter, is that a fair jumping-off point for us to think about going forward? And what would be the puts and takes for the ability to grow NII from that level that we should keep in mind?

I believe this is a good starting point. The main factors to consider will be the developments in both deposit and loan growth driven by different influences. Specifically, we need to look at retail deposit betas, which have been exceeding our expectations and past performance measures. Additionally, although not immediate, we should pay attention to what occurs at the longer end of the curve as we continue to invest excess liquidity from our bond portfolio. It's also important to note that hedge ineffectiveness accounting now affects a portion of interest income, which was a significant factor this quarter. This aspect may fluctuate from quarter to quarter and is somewhat challenging to predict. However, the initial items I mentioned will be the primary drivers of the results.

And in terms of excess liquidity, do you feel like you have a fair amount now relative to what you need for regulatory purposes, and it's just a question of the pricing and rates available that dictate how much you put to work?

I believe that is correct. Our liquidity coverage ratios and other important regulatory liquidity measures are very robust, and we have calculated excess liquidity that can be utilized. For instance, if loan demand increases, we can easily accommodate that. Additionally, we have discussed previously the distinction between cash and the duration of the bond portfolio. Currently, the additional return for the risk taken is smaller due to a flatter yield curve. Being patient while we wait for more favorable entry points is less costly now because we are earning more on cash. Lastly, we do assess and stress-test the sensitivity of OCI regarding potential significant shifts in long-term and short-term rates. However, this should not hinder us from redeploying if long rates rise, given our accumulating excess liquidity or the amortization of our current bond portfolio.

Okay. And then on the loan growth side, the two areas that you're really experiencing runoff. Auto, it sounds like you might have pushed out the time frame for that to start growing until mid-next year. But do you expect the pace of its decline to slow so you're not losing $2 billion a quarter or seeing to decline? And then also on home equity, should that pace start slowing?

I believe home equity is unlikely to slow down. Even with a 15% year-over-year increase, which we find encouraging, those figures are still relatively modest. The current home equity business is not as strong as the decline we are seeing from the pre-crisis home equity portfolio, which is now amortizing. Regarding auto loans, I expect origination levels to remain steady or potentially increase. The key factor will be the rate at which we are amortizing the more established portfolio. It is difficult to predict exactly when the trend will shift, whether it will happen later this year, early next year, or a bit further into next year, but we will need to examine the originations on a quarterly basis. Overall, I am pleased that we have stabilized and we are now viewing our origination path as one that is set to grow.

I have a question on the capital return. Obviously, very strong result for you in CCAR. You're still the bank with the most excess capital after the test and the results. Could you just give us a sense as to how you came up with the ask that you did? And how you think about deploying the rest of the excess capital? Would you go for a top-up this year? Or does that have to wait until the consent order gets lifted? Your thoughts on all there.

We are very pleased with the results. As we've indicated, we aim to reach our 10% target within the next 2 to 3 years, and this is an important first step towards that goal. I noted that our strategy for repurchases will be somewhat more front-loaded than it has been historically, given our substantial excess capital. It's unlikely that we will seek a top-up. Our approach involves conducting a thorough assessment of our risks, creating a scenario that we believe is significantly adverse, and evaluating our earnings stream against that scenario to determine the amount of capital we can remove. Based on our calculations, we believe we have the right level of capital to operate our business effectively. We will monitor the upcoming quarters for developments in RWA growth, earnings growth, or volatility, but I wouldn't anticipate making changes midstream as we will be focused on executing our capital plan. Conditions may shift, but that's my viewpoint at this time.

Yes, Betsy, I want to expand on John's comment. We're really pleased with the 70% increase compared to last year. However, it's crucial to highlight that when considering capital policy, we must adopt a long-term perspective rather than a short-term one. The CCAR plans we submit to the Fed span multiple years, and we are managing our business with that timeframe in mind. This is why John, Neal, and I have discussed reducing our capital to approximately 10% over the next 2 to 3 years. We will continue to manage our capital appropriately with a long-term view. I want to reiterate what John mentioned: the likelihood of us taking any further action this year is very low.

One more thing to mention is that we are currently in the comment period for the stress capital buffer. The industry doesn't yet know how this will affect us, particularly in terms of potential year-to-year volatility. There is a lack of transparency regarding how the regulatory community calculates these outcomes. This uncertainty poses a bit of a challenge for everyone until we gain a clearer understanding.

I appreciate the commentary on sort of the movements within the loan portfolio. I guess, just as you guys see it, I know there's at least some concern that balances are just sort of leaving, to a certain extent, involuntarily. But I guess, as you guys see it, you've been pretty clear on whether CRE or auto, those intentional runoff. On an aggregate basis, how do you see the runoff being sort of conscious versus involuntary as you guys look at things from the inside?

It really varies depending on the portfolio, so it's difficult to describe it overall. However, the pace of the involuntary runoff related to some of the Pick-a-Pay and home equity will continue. The consumer real estate portfolio is performing well. We were pleased to see, as John mentioned, that home equity originations have increased both quarter-over-quarter and year-over-year, which is encouraging since we hadn't seen that in a while. I'm also emphasizing, as John said, in the auto sector, we believe we've reached a turning point, and we should be able to grow originations from here. As John indicated earlier regarding the overall portfolio growth, we expect this to occur in the first half of next year, though the exact timing is uncertain. We will keep an eye on the Pick-a-Pay portfolio, and if there are opportunities to sell it at favorable prices, as we have done in recent quarters, we'll pursue those. On the origination front, we plan to continue to operate as Wells Fargo has traditionally done, ensuring our underwriting is sound. We face some headwinds in certain portfolios, such as Commercial Real Estate, but we have encountered similar challenges throughout our history, and we will navigate through them. Overall, we feel positive about the areas we can control for portfolio growth. The credit card segment is quite interesting; we've seen a year-over-year growth of about 4% with the new card, and we anticipate that number to rise, which is a good sign. I know that was a lengthy response to your question, but overall, we have moved past the home equity stage and the ongoing runoff in the residential mortgage portfolio, and we are optimistic about future growth.

Okay. That's perfect. And if I could switch to the mortgage business for just a second. I mean, that seems to be proving to be maybe a more challenging quarter than we would have thought, even with the anticipation of some softness. I wonder if you can speak to sort of competitive dynamics. I think we all might have hoped that maybe some excess capacity would rationalize itself a little more quickly. Doesn't seem to be happening, at least this quarter. So any top-level thoughts you have there would be helpful.

Yes, I'll start. John, jump in. I think historically when you look at periods of overcapacity in the mortgage business, the rationalization doesn't naturally clearly occur in the second and the third quarter because those are the quarters where you see the most originations. So my guess, and it's just a guess, is that we will probably see more rationalization in the fourth quarter of this year and the first quarter of next year if the same level of demand for first mortgages continues. Again, this is a cyclical business. We've seen this before. We'll see it again. I think the real benefit from our model, unlike maybe a monoline mortgage-only originator, is we've got the balance sheet product. We've got the for-sale product. We've got a servicing business, and then we provide financing in our wholesale business to mortgage originators. Having that diversified business model is really helpful when you're going through a period of overcapacity.

Going back to what you mentioned to Betsy about the potential for increased earnings, I wanted to inquire about the outlook for fees excluding mortgage income. We understand the cyclical nature of that business, but there has been considerable volatility in fee income even when mortgage is excluded. As we consider stabilizing earnings for Wells Fargo in the next two years, the range has been between $32 billion and $35 billion. How should we view fees excluding mortgage?

There will always be some volatility in gains from equity securities and trading assets, so let's set that aside for now. Some of the fluctuations you've observed in our fee line have also been due to the sale of certain businesses, such as the commercial insurance business, which is a one-time event, so we can exclude that. The proactive and consumer-friendly decisions we've made have significantly affected our service charges on deposit accounts, which saw a 9% decrease year-over-year. The change from the first to the second quarter reflects a moderation of that impact. This is one area I believe will likely see growth over time. Although we may not see this growth materialize in the third quarter, we expect it to increase in the future. In terms of trust and investment fees, we anticipate continued growth. We had a strong quarter in Investment Banking, which was excellent. Additionally, we've seen impressive growth in the card segment, particularly with the new Propel Card, which we believe will contribute to that growth. However, it’s clear that mortgage originations have faced some pressure on net gains.

As we consider the situation, I acknowledge that for your peers of a similar size, given your larger investment banking and trading operations, investors often expect a more responsive adjustment to expenses in relation to fees. I'm curious, as we look at the possibility of reaching either the lower or upper end of your fee projections, how should we interpret the flexibility of expenses? Specifically, if fees continue to underperform, will there be a corresponding reduction in compensation, or does your model not operate in that manner?

No, it works that way in our model, and it has to operate like that. If we are not generating revenues, we must cut expenses. In the first quarter or the second quarter, that was not the situation we encountered. However, I believe Michael DeVito and Mary Mack are effectively managing expenses in the mortgage sector. It's crucial to plan for the current environment and hope for improvement, but you definitely need to make those decisions. I’m not sure, John, if you have any additional thoughts on that.

I want to emphasize that our current situation with fee income is influencing our efforts to minimize overall fixed expenses. This is somewhat distinct from the question regarding revenue-related expenses on the fee side. If fee income remains under pressure and does not grow at an acceptable rate, we will need to further reduce core expenses.

Question on the expenses. I just want to confirm the numbers. The $53.5 billion to $54.5 billion includes $600 million of operating loss, which is below your previous losses, including the $800 million in the first quarter. You seem to be on track for the target you set. However, what are the actual expenses on a like-for-like basis for the first half? I would like to understand what you need to achieve in the second half to meet the high or low end of that range.

I haven't calculated the exact figures, but I can say that the forecast after two quarters indicates we should end up between $53.5 billion and $54.5 billion, including the $600 million loss you mentioned. We can break that down later, but it does depend on our performance in the second half and the challenges in the current forecast.

Okay. We can discuss that later. However, there's definitely a lot of noise in these results and in the first quarter as well. I'm looking at something like $1.08 on a core basis, after adjusting for the number of one-time events you mentioned. It seems like the ROTCE, based on that, is at the lower end, if not slightly below your 14% to 17% guidance. Could you share your level of confidence that we're, if not at the lowest point, close to it in terms of when we might see a significant increase in earnings potential and your assurance that this will start to happen in the second half?

We presented a simulation at Investor Day that outlines the expected expense trajectory for this year, the next year, and the year after that, which depends on various revenue assumptions. These include factors like the mix of fees and rates and how sensitive those rates are to changes in the curve. The recently approved Capital Plan also plays a role in the expected return on equity. We are very confident that we can achieve a 15% return on equity and a 17% return on tangible common equity as indicated in our simulation. It is possible for these figures to improve depending on revenue developments, although we didn't factor in much revenue growth initially since we believe we can more easily deliver on our commitments with lower revenue expectations. How the second half of the year and 2019 unfolds will bear out our expense discussions. There may still be unexpected costs or operating losses that exceed the $600 million threshold we mentioned, but that remains the path we are pursuing. At the same time, we are aiming to grow revenue in every feasible category, which we consider a reasonable expectation.

Okay. Just a final question. I think someone asked you about Pick-a-Pay additional sales going forward. Regarding the sale of the Puerto Rico assets, is that expected to be approved for the third quarter?

It's expected to close on August 1. The buyer had a regulatory approval that they had to achieve, and they've announced that they've reached that.

Could you provide insights on borrower demand within the commercial and industrial sectors, specifically across different groups such as large corporations, middle markets, and small businesses? Are you observing any increases in demand in one of these segments that might be counterbalanced by decreases elsewhere? Additionally, could you elaborate on the foreign growth that contributed significantly to this quarter's expansion?

The demand in the commercial and industrial sector is good, but not exceptional. Corporate demand is mostly focused on specific transaction deals, influenced by several acquisitions and mergers, making it feel somewhat sporadic compared to previous cycles. However, we experienced growth in our middle-market banking business, which remains strong, and small business demand is similarly good but not outstanding. The capital finance sector, particularly for equipment, was very robust, as medium-sized and small businesses are leveraging tax write-off opportunities from the new Tax Act, which could benefit the economy in the long run. We also see promising prospects in our asset-backed finance business across various industries, with no single dominant factor driving that growth. On the downside, our financial institutions business saw a decline, mainly due to decreased demand from financial firms outside the U.S. Overall, I would characterize the commercial and industrial sector as good but not great, reflecting an economy growing around three percent.

I mentioned in my comments that our average drawn rate on revolving credit facility has been about 40% not only year-over-year, but basically at every month throughout the year. That's on $500 billion worth of commitments, so a broad swathe of every business, every industry. It's mostly U.S. but a range of regional geographies, et cetera, not much movement in people's utilization of available credit.

And that's really driven by the fact that so many of our customers are just so liquid today, which is one of the reasons why credit quality is so good.

Okay. No, that was very helpful. And then just a quick question on the Pick-a-Pay. I mean, I guess, what's the motivation behind selling that portfolio down? I mean, it's a 12% yield now. I understand there was a fairly large gain on the piece that you just did sell. But as you look forward, how do you think about that relative to what you need for NII and trying to grow NII and selling it down becomes a headwind at that point?

Yes. Go ahead, John.

Yes, it's a good question. We designated this portfolio as noncore a long time ago. It consists of borrowers who have improved since we originally acquired the portfolio during the merger with Wachovia, but they still do not match the credit quality of our average prime jumbo borrower. This is a lower credit quality mortgage portfolio. In the current market, where the demand for yield is high, we compare how many years of net interest income we are essentially capturing upfront from those willing to pay today for the higher yields. At times, it has made sense to sell. This demand may decrease, and we would be fine holding onto those portfolios over time. It’s partly driven by economic factors and opportunistic decisions, and it’s a recognition that this is a noncore portfolio. It’s not something we would originate today or for ourselves. Over time, we intend for it to decline to zero.

I have a few questions regarding the wealth management side. I would like to know your updated thoughts on the attrition in the business. Are the people leaving still those you would have been fine with departing, as you mentioned that some of those departures were acceptable? Or are you observing an increase in attrition that is beginning to put some pressure on the top line?

Yes, I wouldn't say it's a concern for us. The aging and retirement of financial advisors constitutes about 30% to 40% of the population, and the attrition is primarily due to retirements, which we have been preparing for. Additionally, we experienced a one-time impact when Wachovia acquired A.G. Edwards, as a 10-year agreement expired in the second quarter. We noticed a slight uptick in attrition there. Overall, from the first quarter to the second quarter, we are down by less than 200 financial advisors, but the quality of those remaining has actually improved. This is a challenge that the industry faces since the average experience level of financial advisors is somewhat older than that of an average banker. We will continue to address this. Our focus is on ensuring we have the right transition measures in place, which Jon Weiss and David Kowach are committed to, as we develop new financial advisors under a salary and bonus structure. We're also investing in digital solutions like Intuitive Investor to provide the new generation of investors with more options alongside a high-quality traditional financial advisory model.

Got it. All right. And then on that front or at least on the investment front, either personnel or technology, when it comes to the expense saves that you're looking for, are you still good with $2 billion in 2019 falling to the bottom line?

Yes, we are. In terms of our overall expenses for 2019, the guidance of $52 billion to $53 billion reflects our approach to run rate expenses, investment expenses, and everything else involved.

Okay, all right. Lastly, John, you mentioned the stress capital buffer factor and assessing the deployment opportunity. Do you have any initial thoughts on its impact? I'm assuming you've examined it to some extent. What does this mean for the quantification of your excess capital? Based on our preliminary calculations, it seems like it could be a significant hit for many banks.

It's too soon to tell because we're still at the NPR stage, and a lot could change. We submitted our own comment letter back. It's posted on the Fed's website, so you can get our institutional thoughts on what they might do next with their proposal. I agree that as we looked at the expected impact on everybody, it would appear to be a little bit higher than what folks have targeted for a CET1 level today. Having said that, I think maybe because of our business model, the initial calculated impact to us is probably at the lower end of that range, especially for the larger banks. I think it's too soon to tell. We could all use a little bit more transparency to understand where the numbers are really coming from. At the margin, we have a bias against having really volatile year-to-year capital levels if business models aren't really changing and absent an actual realized change in the economic environment. It doesn't feel like we're there yet, so that's what we're shooting for.

John, you guys obviously had a nice increase in the net interest margin in the quarter. I think you mentioned that one of the benefits was the less negative impact of hedge ineffectiveness. Can you quantify for us how many basis points that was of the increase?

Three.

Okay. And going forward, will that continue to grow incrementally? Or is it now established and won't really affect us going forward?

As it was declining, what's most important is the situation with our highest-cost deposits that remain in cash as we have become more liquid. We've observed changes in the balance sheet as some higher beta deposits have decreased. These had been diminishing our net interest margin. While they generated net interest income, they lowered the margin. A reduction in these deposits would improve the margin, even if net interest income might decrease slightly. These factors are important to consider for quarter-to-quarter developments. It's challenging to predict hedge ineffectiveness, as it is influenced by the relationship between LIBOR and OIS, along with other factors that affect net interest margin. Additionally, our decision to deploy cash into loans and the rates we offer for deposits will also have an effect. We should be watching the retail deposit repricing trend in the industry, which has been quite low so far. If anything, this will impact both net interest income and net interest margin in the short term as we will need to pay more for those types of deposits moving forward, which hasn't occurred yet.

Okay. I see. And speaking of deposits, I think you guys identified in your wealth management area some of the customers took their deposits to move them into higher-yielding alternative deposits. Do you have products that you can offer to them so they don't leave the bank, they could stay in the bank, though I know it would cost you more money to keep them?

We have a very big money market mutual fund complex in Wells Fargo Asset Management. That is the first place that when it's appropriate for a customer to be moving some liquidity out of their bank account into an asset management instrument, we want to be the ones to do that for them.

But just to emphasize, the platform is an open architecture platform, and we've talked about FAs a little bit earlier. Our advisers are providing appropriate advice for our customers in terms of what makes sense for that customer and client. Sometimes it's to a Wells Fargo mutual fund money market and sometimes it's to treasuries or whatever makes the most sense for that customer. We've got the broad product set if the customer wants to maintain those balances at Wells Fargo.

I see. And Tim, in one of your answers, you had talked about, historically, Wells has seen the commercial real estate competition or headwinds. Can you give us a little more color of what you're seeing today, whether it's lower yields on loans or underwriting standards are actually weakening where loan-to-values are higher? How does it compare at this point in the cycle to your memory of past cycles?

Good question. What we're seeing is, overall, kind of a slowing of construction activity. When you look at the detail we provided in the supplement about the Commercial Real Estate business, we've seen a decline in construction opportunities. That's not atypical at this point in a cycle, that's for sure. There's a real constraint in terms of, candidly, availability of labor and underlying commodity prices have increased. That's affected the pace of new home construction. That's a little bit different than in prior cycles at this time, I would say. I think overall in terms of kind of the many perm type commercial real estate loan, we are seeing a deterioration in underwriting standards. It's been occurring for some time, so I wouldn't say that it's necessarily accelerating. I wouldn't describe it as anywhere close to that. You need to be prudent when you're lending short on a very long-term asset.

Incidentally, as it relates to underwriting standards, it's not all bank-to-bank competition. The competition here is as broad as it's ever been with life companies, mortgage REITs, other asset management types of vehicles, sovereign wealth funds. Any pool of capital that's out there looking for return has got its finger in the pot of commercial real estate finance. One item Tim didn't mention, which will be one of the tests as we go through this cycle, is retailer-related commercial real estate, so malls and shopping centers, given the focus that folks have on the strength or the ability to compete with different types of retailers. That's probably one of the single individual stripes of risk that is mostly in play in commercial real estate these days.

Great. And just lastly, John, you've been very clear on the expense guidance for the next two years. If I recall, I think in your fourth quarter assumptions, the FDIC surcharges will come out not just for you, but for the industry. Can you give us an update where that stands, if that timeline is still good and how much that will be for you folks?

Yes. So I think the industry originally estimated that, that surcharge would have run its course by the end of Q2 of this year. Now it looks like it's going to run through Q3 of this year. The annual benefit to Wells Fargo from the FDIC surcharge is about $300 million, so we'll be missing a quarter of that benefit in this year because it's pushed out a quarter.

You mentioned earlier that the consent order has not impacted your growth. Loans have clearly not been increasing, and the balance sheet continues to decline significantly below the threshold required to comply with the consent order. Are you in a position where you feel comfortable with the balance sheet, or are you aiming to just maintain a manageable size? If current trends persist, what do you anticipate will happen to the balance sheet size moving forward?

Well, I think we're out there competing for deposits, the type of deposits that makes sense for us, those that provide the most liquidity benefit. We're competing for loans day in and day out. That's what's going to drive the size of the balance sheet. We've talked about the competition for loans and the fact that we've got some portfolios running down on purpose, some where we've tapped the brakes like commercial real estate and auto, although we're probably more open for business in auto than we have been over the last several quarters. We're not growing RWA or GAAP assets at any exciting pace. What happens with customers on the deposit side, what happens with customers on the loan side is going to drive what the right size is for our balance sheet. There are some businesses where we can put on balance sheet for securities financing or other things that probably run up GAAP balances and leverage a little bit faster than that natural loan growth activity. There's never a forecast or an approach to try and drive the size of the balance sheet larger. We can operate under $2 trillion for, frankly, a good long time and be very increasingly profitable and serve all the customers that we have.

Yes. My follow-up is regarding the efficiency of the balance sheet. Are you still in the process of removing lower quality or non-quality deposits? We've seen a significant decline in the foreign offices and a few other areas. How close are you to achieving maximum efficiency?

We're not operating at max efficiency because there's no pressure to do that. We're still serving many of those customers in that area. If it ever came down to a decision between one type of customer deposit, for example, to take or another, there are other levers to pull. But it's just not a constraint that's weighing on the company at this time.

Wells has been investing heavily in compliance and operational risk as well as IT. Is there a way for you to quantify the number of maybe FTE adds you've made there over the last year?

On the risk side, I think one of the highlights that we've provided at Investor Day is that we had added about 2,000 folks, team members in the risk function year-over-year.

Which is disproportionately in operational risk and compliance.

Okay. Do you have a number for maybe or a concentration of your FTEs that are revenue generating versus sort of your back-office support, when it would include the compliance, risk and IT and then maybe how that would compare to a year ago or three years ago?

Sales, service and operations probably account for between 70% and 75% of our headcount. Staff and technology and whatever other means are between 25% and 30% of headcount. That hasn't changed very much.

Could you provide an update on the timing for the asset cap? How long do you anticipate it will take? What are your current thoughts on this?

Vivek, no change in the update from Investor Day and that we're working very constructively with the Fed. We've gotten some very thoughtful feedback from them. Our expectation is that sometime in the first half of next year, we'll be able to move through that. The point to emphasize there is that our goal is not to just meet expectations so we can get the asset cap lifted. Our goal is to make the fundamental investments and changes that we need to make in how we manage operational and compliance risk at the company. That's the goal, and that's where we're focused, but no update from a timing standpoint.

Okay. John, a question for you. As I look at your RWA, it was flat. Your total assets were down on a period-end basis. So any color on where you saw some increase in the risk weighting on the balance sheet?

I would think of it more as the GAAP assets that came down had very low risk weights, because we're running down high runoff factor deposits where the asset side is sitting in cash. What remains is something akin to the same RWA that was already there. That's the easiest way to think about it.

Got it. One last question regarding wealth management. I heard you mention earlier that wealth management clients' deposits are moving. However, when I look at your wealth management client assets, I see they were down. Can you clarify what the difference is and what's going on there?

Yes. I don't believe that every dollar from a money market mutual fund would have remained with Wells Fargo. Some of it did, as Tim mentioned, but there are various factors at play. Market fluctuations and customer movements also contribute. The Rock Creek AWM is categorized under asset management, not wealth management. I observed that wealth client assets have increased by 3% year-over-year, although they dipped slightly from the previous quarter. There's nothing specific to attribute that to.

A portion went into other assets that we're managing. A portion went outside the company. Again, if that's the right thing for the client, that's fine.

I wanted to ask you a more strategic question. I was reflecting on your comments about service charges on deposits and how you've become more customer-friendly. At this point, you have the opportunity to position yourself competitively against your rivals. However, you are also facing other challenges from the headlines and various issues. In the long run, once you navigate through these difficulties, the positioning you have established could make a significant difference. As you have navigated these changes and enhanced your customer friendliness in various areas, do you believe your pricing has become more favorable compared to the market, to the extent that it could eventually influence the industry once those other pressures are alleviated?

Yes, Marty, that's a great question. Our priority is to provide our customers with information that helps them manage their finances better, supporting our vision to assist them in achieving financial success. We believe that sharing this information with our customers is essential for long-term success. As we've mentioned, this approach has temporarily reduced our deposit service charges. From my viewpoint, I'm willing to accept short-term revenue impacts to invest in offering the right products, services, and information for our customers. Our Overdraft Rewind feature and our real-time and balance alerts capabilities are definitely leading the industry. We believe that over time, this will give us a competitive edge. We will keep investing in technology and services.

Let me throw, as my follow-up, a specific example of we've been able to put interest on DDAs. As the ECRs are all going up and some of these deposits are beginning to flee, would that ever be a concept in the sense of another kind of game changer that would be customer-friendly that might give you a competitive advantage if you started to re-shift the way you look at those accounts?

Well, specifically on the treasury side, you mean? The driver on the treasury side, even though price is important, it's much more important to provide the breadth of products and services and to invest in technology because you're generally dealing with sophisticated businesses. For example, that's why we introduced the biometric iPrint, right, so that treasurers and money managers can move things more quickly and have more safety and security. Historically, we've always ranked at the top in the treasury management business in terms of our capabilities. We think there, the focus should be much less about price and much more about continuing to invest in technology and services.

That's a part of the business that assists commercial customers in their operations. It aids them in their procurement to payment process and helps them reduce their receivables cycle. This leads to a decrease in the necessity for working capital in their operations. That's the added value, and we don't intend to depart from that.

Great. Well, I want to thank everybody for your time and for your questions. I know it's been a very busy morning for all of you. I do also want to take the opportunity to thank our 265,000 team members. I think we've got the best team in the business. They're working very hard to not only serve our customers but meet and exceed our six goals. So again, thank you very much, and thank you for your trust in Wells Fargo.