Wells Fargo Expects Interest Rates to Rise Quickly in Future

In its quarterly conference call, Wells Fargo stated that they expect interest rates to rise in the future and to rise at a potentially very fast pace. Below is a partial transcript from the conference call.

Bank Analyst: just a follow-up question on rates. I just wanted to understand, Howard (Wells Fargo CFO), how you are thinking about the impact of the Fed exit on the fixed-income market and how you are planning on managing the balance sheet for that?

Howard Atkins: Well, that is a good question, Betsy, and the Fed obviously is active in buying MBS. And despite the fact that the yield curve is as positively sloped as it is right now, their active purchases is a factor that is, in some senses, artificially keeping long MBS yields lower than they might otherwise be. At some point presumably, they will either gradually or more quickly reverse course and that could lead to an increase in mortgage interest rates. And as I mentioned a couple of times in my remarks, in possible preparation for that, we have been keeping our powder dry, in effect underinvesting this large base of core deposits that we have for the possibility that that reverses course.

Analyst: So you might get some OCI hit near term, but dry powder leads you to a better outlook for earnings, is that the way to think about it?

Atkins: Yes, again, while the mortgage business is showing good results right now, in effect, on the portfolio side, the investment portfolio, we, in effect, are giving up some current income. We don't believe in the carry trade and we do want to preserve some powder in case rates do go up and we'll have the powder at that point, we will invest the powder at that point to offset some -- whatever is going on in the mortgage business.

John Stumpf, Wells CEO: I see this as the classic short-term view of the business and long-term view of the business. 400 basis points or something like that, which you make in the carry trade today is very attractive. But we think it is the wrong decision long term because we think the bias is for higher rates, not for lower rates and we are willing to wait for that to happen. We think that is the better trade.

Atkins: we are effectively giving up 400 basis points today for possibly a year or so, maybe plus or minus, to avoid the potential risk of a larger number of basis points for 30 years. So the last thing we want to do is get stuck with securities at these low levels of interest rates.

Stumpf: Because I think when rates move, they are probably going to move at some speed and I don't think it's going to be maybe a quarter. It could be more than that and it could happen relatively quickly.

Atkins: this is the same thing that we did back in 2002, 2003 when interest rates were also at cyclical low points just before they went up a lot. What we are doing now is not very different from the way the Company has always managed itself.

So, let's translate this to English. Wells Fargo is not investing in the carry trade that is making so many banks so much money right now. The way the carry trade works, is that the banks borrow money at the Fed for virtually 0%, or even from their depositors at virtually 0%, and then invest this money in MBSs, which pay 4.5%. This difference in yield - almost 4.5% - if profit for the bank. The carry trade works as long as easy, cheap short term financing is available, and long-term interest rates do not rise. If short term rate spike along with long term rates, then banks cannot roll over their funding to finance the MBS purchases. At the same time, the value of the MBS they hold will drop in value.

What Wells means by keeping its powder dry is that it doesn't want to play that game. It expects rates to rise and the carry trade to come to an end. Instead, it is waiting for mortgage and other loan rates to go up and will then invest at those higher rates (i.e. make more loans). Atkins says this explicitly in the call: [Wells approach is] "to invest when long-term yields are high, not when the carry trade looks good. In effect, we are currently giving up current income, to preserve the flexibility to add to the portfolio at higher rates for even more income going forward."