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Wells Fargo Earnings: Rising Profits, Rising Pressure (Update 2)

Updated from 12:34 a.m ET to include fund manager comments and additional data throughout.

NEW YORK ( TheStreet) -- Wells Fargo (WFC - Get Report) on Friday reported its thirteenth straight rise in quarterly profits, exceeding expectations that the nation's top mortgage lender would see its profit fall on a slowing in refinancing activity.

Although Wells Fargo's rising profits may give some like the Warren Buffett's Berkshire Hathaway (BRK.A) -- the bank's largest shareholder -- continued confidence that its business model is diversified and closely aligned with a recovering U.S. housing market, the bank's earnings nevertheless highlight many long-standing concerns.

Fundamental strength at Wells Fargo is underscored by the bank's record $5.2 billion quarterly profit and a string of rising earnings that surpasses competitors such as JPMorgan (JPM - Get Report), Citigroup (C - Get Report) and Bank of America (BAC - Get Report), highlighting the consistency of the bank's business model.

Those record earnings, however, don't put to rest concerns among analysts and investors regarding falling interest margins and the sustainability of earnings derived from mortgage refinancing.

As such, Wells Fargo may stand as the most prominent example of the challenges the banking industry faces in the low-interest rate environment created by the Federal Reserve.

The San Francisco-based lender reported better-than-expected earnings of $5.2 billion, on revenue of $21.3 billion, generally beating estimates of $4.75 billion and $21.5 billion respectively.

Adjusted first-quarter earnings of 92 cents a share beat the consensus estimate of 88 cents, according to analyst forecasts compiled by Bloomberg.

Wells Fargo shares fell less than 1% to $37.21 in Friday trading.

Bill Smead, head of investment manager Smead Capital, said a Friday drop in Wells Fargo's shares indicated the financial sector may have been overbought headed into first-quarter earnings.

While Smead said his fund is fully invested in financials and isn't buying Wells Fargo shares at this time, he remains optimistic the bank will continue to benefit from a rising economy and the prospect of dividend increases in 2013.

Investors mystified by Wells Fargo's consistent earnings growth to new records, and its relative share price underperformance over the past 12 months, need not look beyond a financial metric called net interest margin and a decline in mortgage banking income.

The bank's net interest margin -- the spread between the average yield on loans and investments and the average cost for deposits and borrowings -- fell 8 basis points to the lowest level in about eight years.

Chief financial officer Tim Sloan said on an earnings call that three basis points in the margin decline came from deposit inflows, while the rest of declines came from lower variable income and a re-pricing of loans on the bank's balance sheet.

Net interest income makes up roughly 50% of Wells Fargo's revenue. As higher yielding assets such as those picked up as part of the company's 2008 acquisition of Wachovia run off the bank's balance sheet, they are being replaced by assets carrying a much lower yield, pressuring overall margins.

Marty Mosby, a large cap banking analyst with Guggenheim Securities, said in an April interview prior to earnings that net interest margin declines of three-to-four basis points would signal a stabilization for Wells Fargo. Instead, margins fell more than expected to eight year lows of 3.48%.

Overall, the margin decline and a near 9% drop in mortgage banking revenue are the reason the shares traded off in the wake of record earnings.

Prior to earnings, Mosby said an earnings beat would hinge on flat mortgage banking earnings, were the bank to increase new home loans and end a program to hold some originations on the balance sheet. Wells Fargo, however, retained $3.4 billion in mortgage loans, forgoing approximately $112 million in revenue.

Evercore Partners analyst Andrew Marquardt forecast a 4 basis point NIM drop, and foresaw a 7% drop in mortgage revenue vs. declines in excess of 10% at other large cap banks such as JPMorgan.

Morgan Stanley analyst Betsy Graseck said in a client note that Wells Fargo's gain-on-sale margins could augur well for the earnings of SunTrust Bank (STI), while below-expectation trust asset growth could indicate headwinds for Bank of New York Mellon (BK), Northern Trust (NRT) and State Street (STT).
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