Warren Buffett's Wells Fargo Investment Hinges on Bernanke

NEW YORK (TheStreet) -- After Wells Fargo (WFC) posted generally mixed third-quarter earnings and a fall in key interest rate-based revenue that augurs poorly for 2013, the bank's largest investor Warren Buffett of Berkshire Hathaway (BRK.A) faces one of his biggest post-crisis investing challenges.

Should the 'Oracle of Omaha' stick it out with Wells Fargo - the top lender to the recovering U.S. housing market - and fight the Federal Reserve on the impact or falling interest rates on bank earnings? Or should Buffett begin to cash his chips in on what's been a successful bank stock recovery trade that's outperformed other highly watched financial sector investors?

After announcing a third round of monetary easing - known as QE3 - the Fed's efforts to stimulate risk taking and overall asset prices such as homes, stocks and bonds are creating a quagmire for the nation's largest lenders like Wells Fargo, JPMorgan (JPM) and Bank of America (BAC ).

Giving a boost to the economy by way of cheap money and low rates is helping to drive a housing market recovery and a stock market surge that creates big revenue opportunities for large cap banks. However, low interest rates are eating into interest margins, a key driver of bank earnings.

In the third quarter, analysts expected that for Wells Fargo a mortgage lending boom would offset the deleterious impact of low rates. They were wrong.

In Friday trading, Wells Fargo shares fell over 2.5% to $34.25, underperforming the market as investors absorbed an earnings report that showed the bank's overall mortgage lending growth stalled since the second quarter and interest margins fell far more than forecast.

Wells Fargo's revenue rose 8.1% from a year earlier and mortgage banking income rose to $2.81 billion, up 53% from 2011 levels and in line with second quarter numbers. But amid growing optimism on a housing recovery, the bank's $86 million drop in mortgage revenue from the prior quarter failed to impress. Meanwhile, interest margins fell by 25 basis points, a larger amount than the 17 basis point drop chief financial officer Tim Sloan forecast in September.

Overall, the San Francisco- based lender reported third-quarter earnings of $4.94 billion or 88 cents a share, beating estimates of 87 cents, according to analyst forecasts compiled by Bloomberg. Revenue came in at 21.2 billion, slightly beating estimates of $20.9 billion.

Some analysts downplayed Wells Fargo's earnings beat and honed in on what could be a troubling dynamic between slowing mortgage origination growth and falling interest rates. "The beat relative to our expectations was entirely driven by lower loan loss provisioning - rather than higher mortgage banking income," wrote Stifel Nicolaus analyst Christopher Mutascio in a Friday note to clients.

The analyst stressed the importance of continued loan growth on Wells Fargo's earnings outlook. "More importantly, mortgage banking income is not offsetting the impact of [net interest margin] compression," wrote Mutascio.

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