Wells Fargo Credit Book in the Spotlight

Wells Fargo ( WFC) will be hard-pressed to repeat the upside surprise of its first-quarter earnings report when it unveils its second-quarter results Wednesday.

Three months ago, Wells burst out of the gate with an early report of first-quarter earnings that were far beyond the most optimistic investor's expectations. But its second-quarter report comes as investors have become far less impressed by headline figures, and are instead focused on the deteriorating credit quality in bank loan books.

Wells may not suffer as much as competitors, because it assumed early on that loans would go bad -- not just bad, but really bad.

So, instead of jumping into subprime, it held to stricter lending standards before the crisis took hold. And when Wells acquired Wachovia last year, it wrote down the troubled bank's bad debt to subterranean levels to reflect its assumptions about what might be coming down the economic pike. In fact, Wells has already booked gains on that bad debt because of how far it was written down, and may have added more value last quarter as the markets further improved.
A Busy Second Quarter for Banks

No analyst expects the San Francisco-based bank to report a loss, according to Thomson Reuters, and the average profit estimate stands at 34 cents per share. But there's no ignoring the fact that Wells' portfolio of loans will be negatively impacted by the recession, as unemployment keeps rising, and more consumers fink on loan payments.

Credit Suisse analyst Moshe Orenbuch expects the firm to write off $3.7 billion worth of bad loans, up from $3.2 billion last quarter and $1.5 billion a year ago. He predicts that the firm will build reserves by $1.6 billion, bringing Wells' prediction of near-term losses to $5.2 billion.

Nonetheless, Orenbuch expects Wells to report a profit of 37 cents per share, due to "strong" mortgage banking results. In a counterintuitive twist, the very business that set off the economic crisis is now helping Wells and major competitors like Bank of America ( BAC), JPMorgan Chase ( JPM) and Citigroup ( C), because of government initiatives to drive down interest rates and spur borrowers into the market with incentives for refinancing and first-time buyers.

KBW analyst Frederick Cannon holds the highest earnings prediction for Wells, at 50 cents per share, predicting "another strong mortgage quarter." He lifted estimates through 2010, based on expectations of higher mortgage revenue.

But mortgage demand recently abated as interest rates came up from lows in the spring. It has led some to question how sustainable the mortgage business is as a driver of bottom-line results in upcoming quarters. Stifel Nicolaus analyst Chris Mutascio is instead focused on net interest margins , which most expect to remain strong in the next few quarters, despite headwinds further down the line.

He is also scrutinizing investment banking results, after BofA, JPMorgan and Goldman Sachs posted impressive results largely because of their capital-markets businesses, which can be profitable but volatile. Wells recently said it is expanding its own division , holding onto large portions of Wachovia's network that it once deemed disposable.

The last factor on Mutascio's mind is cost savings from the Wachovia acquisition. Wells management had estimated Wachovia cost savings at $5 billion annually, once the bank is fully integrated, and while Mutascio says the firm is "clearly...in the very early stages" of this process, clues to its progress will be a "key" focal point.

"In the end, our focus on Wells Fargo's second-quarter results will be on offsets," Mutascio says in a recent report. "Does the company have offsets to the potential for a second half decline in mortgage banking? We think it does, but the results (and outlooks) of the line items above will either support or refute our thesis."

Of course the last looming question for Wells is the Troubled Asset Relief Program, and how long it will take the bank to pay back $25 billion in bailout funds that management has insisted it didn't need in the first place.

Regulators determined that Wells needed to boost Tier 1 capital levels by $13.7 billion before it could apply to do so. The bank's response was typical of the disdain Wells has shown at times for the government's heavy-handedness in the financial crisis: It raised much less capital than competitors did through stock offerings, preferred-to-common swaps and asset sales. Instead, Wells said, it would generate the remaining capital internally, largely through earnings, despite indications that the Federal Reserve is opposed to banks being too reliant on that strategy.

"They're a little bit more willing to stand up to the criticism and say, 'Hey Mr. Regulator, thanks for telling me how to run my business, now how about you let us do it?'" says Jeff Markunas, portfolio manager of the RidgeWorth Large Cap Core Fund, which invests in bank stocks.

BofA said last week that it will likely be required to repay the bailout funds in a piecemeal fashion, which Wells may also have to do . Either way, a key question for Wells is how long it will take the firm to get out from under the government's wing, as competitors like JPMorgan, Goldman Sachs ( GS) and Morgan Stanley ( MS) have begun to do, and start earning as a truly independent company again.

But Wells management may not provide many details on progress. While it held a Q&A session with analysts after stress-test results were released in early May, Wells will offer its typical pre-recorded review by CFO Howard Atkins on Wednesday at 8:30 a.m. EDT.

"Wells Fargo never tells you anything during the quarter," says Markunas. "You call a line and it's a recorded message, and it's like the Wizard of Oz -- there's no question from behind the curtains."