Ride The Housing Market Higher With This Mortgage King

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Wells Fargo's (NYSE: WFC) earnings rose by nearly 50% to $37 billion during the third quarter of 2012, up from $25 billion in the third quarter of 2011. The reason that earnings increased was because Wells Fargo mortgage originations increased dramatically. The catalyst for the increase was an improving job market, record low interest rates, and a robust housing market. Many home owners are refinancing their mortgages to take advantage of the low interest rates, and the number of new housing starts is at a four year high. In November, permits, a proxy for future construction, climbed 3.6 percent to an annual rate of 899,000, the most since July 2008. This is a sure sign that the U.S. housing market recovery will extend into 2013.

Wells Fargo is best positioned to benefit from the exploding housing market because it is the biggest home loan provider in the U.S. with over 33% of the market. That is more than three times the share of its closest competitor JPMorgan (NYSE: JPM), which accounted for 10%. Wells Fargo executives are not satisfied with the company's current market share, and hope to improve it through what has been described by experts as “aggressive, but careful lending." Wells Fargo has a head start on JPMorgan, and two of the banks that once competed with Wells Fargo, Bank of America (NYSE: BAC) and Citigroup (NYSE: C), are no longer aggressively competing in the mortgage market. Bank of America lost $40 billion as a result of its purchase of Countrywide Financial, and as a result, it is very guarded in the way that it conducts its home mortgage business. It has tightened its lending requirements and no longer works with mortgage brokers or corresponding lenders. Citigroup was also wounded by subpar mortgages, and it has also tightened its lending requirements and chosen to stop working with mortgage brokers. 

Wells Fargo also has an advantage over its competitors because it is financially stronger. Its operating margin of 39.3% and profit margin of 23% are stronger than Bank of America, Citigroup, JPMorgan and Goldman Sachs. Wells Fargo has benefited from its conservative lending practices, and that is the reason that it now has the financial strength to take advantage of the growing mortgage market. As of September 30, Wells Fargo's Tier 1 common equity 3 under Basel I increased $4.1 billion to $105.8 billion, with Tier 1 common equity ratio of 10.06 percent under Basel I. The estimated Tier 1 common equity ratio is 8.02 percent under the current Basel III capital proposals. This means that Wells Fargo should have no problem achieving its capital requirements. Wells Fargo's Tier 1 capital ratio of 11.69% is higher than its competitors, including JPMorgan whose Tier 1 capital ratio is 11.3%. 

The weakness in Wells Fargo's financial picture is its net interest margin (NIM). As of September 30th, the bank's NIM (The difference between the amount that the bank pays to depositors and lenders and what it collects on loans) was 3.66%, down from 3.91% in the prior quarter. The drop in the NIM was seen as a red flag by investors, and has held down the stock price. However, Wells Fargo's CFO, Tim Sloan, defended the banks relatively low NIM. He said "We don't spend a lot of time focused on managing to that margin." He indicated that the bank could have increased net margins by issuing higher margin low quality loans, but that it has chosen to go against that. That type of decision making is one of the reasons why I believe that Wells Fargo is the best long-term investment amongst the large banks. 

Positive developments that could affect Wells Fargo’s future 

On December 19, Wells Fargo acquired a minority stake in The Rock Creek Group, a Washington, D.C.-based fund-of-hedge-funds provider overseeing $7 billion. The San Francisco-based bank is working to reshape its business to boost services that cater to the wealthy, a move that may allow it to avoid the brunt of new financial regulations. 

Negative developments that could affect Wells Fargo’s future 

On October 9, Wells Fargo was sued by the U.S. for hundreds of millions of dollars. In the lawsuit filed in Federal District Court in Manhattan, the prosecutors accused Wells Fargo, the country’s largest originator of home loans, of defrauding the government for more than a decade. The prosecutor’s alleged that the bank recklessly issued mortgages and then made false certifications about their condition to the Federal Housing Administration, a government agency that insured them, the complaint said.  The complaint follows similar cases against other lenders, including Citigroup Inc. and Deutsche Bank AG. (DBK) 

On September 11, 2011, Wells Fargo was included in a suit pitting the country’s most powerful banks against the full force of the United States government, as federal regulators filed suits against 17 financial institutions that sold the mortgage giants Fannie Mae and Freddie Mac nearly $200 billion in mortgage-backed securities that later soured.

Conclusion 

Wells Fargo had nearly 50% year-over-year third quarter earnings growth.  It was the banks sixth consecutive quarter of record income and earnings per share. Wells Fargo's earnings will continue in the upward trend in the fourth quarter. With a price to book ratio of 1.28 and a price to earnings ratio of 11 Wells Fargo is priced at a premium to its competitors. Bank of America’s price to book ratio is 0.56, Citigroup’s price to book ratio is 0.62 JPMorgan’s price to book ratio is 0.87 and Goldman Sachs price to book ratio 0.91. Wells Fargo sells at a premium to its competitors, but with its record of earnings growth, it is clear that it is the best pick amongst large bank stocks, and the best long-term investment.


StockCroc1 has no positions in the stocks mentioned above. The Motley Fool owns shares of Citigroup Inc. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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