Wells Fargo Mortgage - A Problem Or Cash Cow?

By Chad Henage - July 5, 2012 | Tickers: JPM, USB, WFC | 0 Comments

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In a recent article by Reuters, Wells Fargo (NYSE: WFC) was taken to task for, ready for this, making too many mortgage loans. I read this and my first thought was: I'm confused, all I ever hear on the news is how banks aren't lending, and how difficult it is for borrowers to get a loan. Now a bank is going to be criticized for making too many loans? Having worked in two prior jobs with lending and mortgages, let me give Wells Fargo some credit for what it's doing, and also issue a word of caution to investors.

To understand the risk that this article discusses, you have to understand the simple way that a traditional bank makes money. I'm not talking about the esoteric bets that some financial institutions are making today, I'm talking about old fashioned banking. When a bank like Wells makes a mortgage loan, many times it's for a fixed interest rate. Just as an example, let's say that Wells originates a 30 year mortgage at 4%. While short-term rates are ridiculously low, and many savings accounts don't even pay 0.50%, this gives Wells the potential for an interest rate spread of say 3.5% (Wells recent interest rate spread was in fact 3.89% recently). How the bank does in the future depends on the direction of interest rates. If rates stay low as they are expected to for the next couple of years, then Wells makes a good living originating these loans. However, as the Reuters article pointed out, if short-term rates rise, the company could run into a problem. Short-term rates don't stay low forever. If these rates were to reach even 2%, Wells' interest rate spread would shrink from 3.89% to just 1.89%. This doesn't sound like a lot, but keep in mind we are talking the difference of two percent on billions of dollars of loans. A few points of interest on billions of dollars of loans equates to a loss of billions in earnings. So why isn't this quite the big deal that the article makes it out to be?

First, the article cites that Wells Fargo has about $312 billion of residential mortgages and home-equity loans on its books. These loans represent about 41% of the loan portfolio today, versus 38% of the portfolio in 2006. If you read over this, you are probably thinking the same thing I was, why are we making a big deal if this has only increased by 3% over the last six years? The second reason this isn't that big of a deal is, Wells Fargo is only keeping 10% of the loan in its portfolio. The remainder are packaged into securities that are then sold to investors. This maneuver is common in the mortgage industry, and once these mortgages are turned into securities and sold, the risk of these loans are sold to the investors as well. What most banks do is sell the securities, but maintain the servicing rights. This means the bank no longer keeps the loan risk, but the bank receives fee income by handling payments, coupon books, escrow accounts and the like. Third, the company has identified about $63 billion of old Wachovia loans that the company is actively trying to liquidate, because they don't fit into the company's risk management profile. As you can see, there is more to this “risk” than meets the eye.

All that being said, there is a real risk here to Wells Fargo shareholders, that being interest rate risk. Wells has decades of experience managing risk, and the bank says it's expanding because property values are low and underwriting criteria strict. However, this doesn't change the fact that interest rates are entirely unpredictable. If we know that a change in interest rates can cause a huge change in earnings, we need to know how strong Wells Fargo's balance sheet is. The reason the balance sheet comes into play is, if earnings took a hit for a long enough period, Wells might have to use cash or take on new debt to cover their costs. Let's look at Wells balance sheet relative to a few of their peers. Peter Lynch used to say that the most fundamental measure of a company's financial strength was their ratio of equity to assets, so we'll use that as our measuring stick:

(all numbers from last full year balance sheets) 

You can see that for the size of Wells Fargo, the company is growing its equity at nearly the same pace as the much smaller U.S. Bancorp. When you compare Wells Fargo to JPMorgan, there is really no comparison. Wells is not only growing their stockholders equity much faster, but the ratio to assets is much higher. The point is, with 31% more relative equity than JPMorgan, Wells Fargo is already in a better position to weather any storms resulting from their additional mortgage exposure. Knowing that Wells is in a better position today is nice, but what about the future?

Wells Fargo's ability to handle their future risk depends almost entirely on how fast interest rates move. If they move up slowly, Wells and other institutions should be able to use hedging strategies and offload what would be problem assets at a reasonable pace. If rates were to move up quickly, it wouldn't just be Wells that would have a challenge. Apparently analysts believe in Wells capabilities enough to predict the company will outgrow its competition. In the next few years, Wells is expected to grow earnings by over 11%, compared to about 10% for U.S. Bancorp, and 7% for JPMorgan. This should argue well for stockholders of Wells. As we've already seen, the company is growing their equity base faster than their competition. If the company outperforms going forward, not only should Wells' equity base continue to expand, but in theory the company could grow their dividend and share buybacks at a faster rate as well.

In the end, I'm inclined to agree with Wells Fargo management that they should use this time to expand their mortgage portfolio. I would like to see more of their loans packaged and not kept on the books though. Interest rate risk is real and a jump in rates would hurt the company's profitability. That being said, if you are going to own a bank stock, you want a company willing to aggressively take market share in a time when other banks are more concerned with risk management. With Wells selling for just over 10 times forward earnings, expected to grow at 11%, and paying a 2.6% dividend, it looks like the stock could be a good value. What do you think? Is Wells taking on too much risk expanding into the mortgage market now? Let me know in the comments section below.

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