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.

For now, the Fed's low rate policies seem to be a negative for earnings expectations on Wells Fargo. Management said on a conference call with analysts that although it is growing mortgage lending sharply in 2012, third quarter loan demand was less than expected.

In fact, Wells Fargo's decision to put some mortgages on its balance sheet instead of selling them for added revenue could be seen as the bank ceding some third quarter earnings in an effort to minimize the blow of falling rates.

The real question for Buffett and Wells Fargo investors is what to expect next? A housing recovery could continue to heat up and, on balance, outweigh the negatives of low rates - or Wells may continue disappoint after being a ballast to the banking sector.

Were Buffett to stick it out on Wells Fargo, he could be seen as fighting the Fed on the impact of its policies on bank earnings. Were he to begin paring a near 8% stake in the lender, it could signal a big switch in his overall investing strategy.

On Friday, KBW analyst Fred Cannon told CNBC that Wells Fargo's weakness can be attributed to the Fed and the analyst recommended capital markets focused players like Citigroup ( C), Goldman Sachs ( GS) and Morgan Stanley ( MS), echoing previous statements. Such a financial sector rotation would counter Buffett's post-crisis bank investing strategy, which was to put billions behind Main Street lenders like Wells over risky and volatile investment banks.

Since the crisis, Buffett's been one of the most consistently right minded supporters of a recovery in U.S. stocks and the shares of America's traditional lenders. Meanwhile, amid a big 2012 market rally, he's also been correct to read the Fed's loose policies as reason to be invested in stocks over bonds . With Wells Fargo, Buffett's facing some Fed fire, even if his general consensus isn't to fight the central bank.

Predicting Warren Buffett's next move is a fun but oftentimes futile effort; however, amid a hitch in the 'Oracle's' overall bank investing and 'bet on America' strategy, the biggest change may not come in his holding of Wells Fargo shares. Look for Buffett to take improving earnings per share math at Goldman Sachs as reason for him to begin putting money behind the common stock of Wall Street titans.

-- Written by Antoine Gara in New York