Wells Fargo's Earnings Troubles Are Hidden In Plain Sight: Street Whispers

NEW YORK ( TheStreet) -- Wells Fargo ( WFC) investors beware: The bank's biggest issues don't involve accounting gimmicks or trillions of dollars in hidden risky bets. Instead, they are the same earnings time bomb that has everyone from regional lenders to Wall Street titans worried: Interest rates and the prospect a mortgage refinancing boom fizzles in early 2013.

Although a recent The Atlantic magazine article attempts to paint a picture of hidden mischief scattered throughout the bank's financial statements, investors should only really care about a Federal Reserve-fueled interest rate quandary that Wells Fargo faces this year and beyond. In fact, understanding Wells Fargo's earnings illustrates why the bank isn't the financial bogeyman some in the media might make it seem.

The core dilemma for Wells Fargo headed into the fourth quarter is whether fees the bank collects for underwriting and refinancing mortgages, in addition to other types of loans, will be able to offset a foreseeable decline in interest-based earnings, on the heels a third round of Federal Reserve easing unleashed in September that targeted the mortgage market.

In the wake of the Fed's intervention -- which sets a target of $40 billion a month in mortgage asset purchases -- rates offered by Freddie Mac and Fannie Mae have fallen to or near record low levels. Those low rates cast doubt on the spread between what Wells Fargo's earns on mortgages it owns and what it costs to fund the loans -- a business that often accounts for 50% of the bank's overall revenue.

On the flipside of the coin, record low rates have bolstered Wells Fargo's fee-based mortgage refinancing activity, which accounts for a big chunk of its remaining revenue and helped the bank to steady earnings growth in 2012.

The challenge for Wells Fargo, as TheStreet noted in September, is that a government-supported refinancing boom may peter out well before interest rates -- and spreads -- rise, putting the bank's impressive earnings growth at risk starting this year.

In the third quarter, a troubling interplay between interest-rate based earnings known as net interest margin, or income and fee based revenue was on full display as the San Francisco-based bank posted a greater than forecast decline in interest rate sensitive earnings, but saw revenue buffered by overall loan growth and fees earned from mortgage underwriting and refinancing.

In spite of record earnings, the quarter raised investor and analyst eyebrows, which remain headed into the fourth quarter.

On an earnings call and in subsequent investor presentations through 2012, Wells Fargo chief financial officer Tim Sloan repeatedly told investors that while the bank isn't ready to call a bottom in its net interest margin declines -- they fell a greater than expected 25-basis points in the third quarter -- he's confident the bank's lending growth and a set of fee based businesses, which includes trading and wealth management, will be able to drive growing interest income and earnings in coming quarters.

The jury is still out as Wells Fargo's largest investor Warren Buffett holds steady on his investment and many Wall Street analysts continue to point to the bank as a 2013 gainer, after years of industry outperformance.

The tension between interest income and underwriting fees highlights Wells Fargo's business model in basic terms, and it explains a $1.46 trillion bogeyman or prospective $60 billion loss that The Atlantic points to as a smoking gun in signaling out the bank's seemingly opaque earnings.

Notably, Wells Fargo earns an interest rate based spread on jumbo mortgages, commercial loans and other non-conforming loans it holds on its balance sheet. In contrast, the bank earns roughly a quarter of its fee revenue from underwriting, selling and servicing conforming mortgages that wind up at other banks, government sponsored housing entities such as Freddie Mac and Fannie Mae, or the general investor community.

Those underwritten and sold off loans mostly conforming residential mortgages are put into so-called Variable Interest Entities with roughly $1.5 trillion in assets that aren't fully reflected on Wells Fargo's balance sheet. Instead, they are referenced in the bank's annual reports and in quarterly Securities and Exchange Commission filings.

While The Atlantic characterizes those VIE's as risky mystery assets, Wells Fargo and other companies across the banking, healthcare, automotive and retail sectors are likely to call it basic accounting for securitized assets and leases, according to accountancy firm Deloitte.

For Wells Fargo investors, the trillion-dollar off-balance sheet securitization portfolio is far from a concealed risk. In fact, it was at the crux of the bank's third quarter earnings dilemma, was referenced at the opening of multiple investor presentations by CFO Sloan, and was even fully detailed in a financial supplement appended to third quarter earnings, which is required reading for all investors.

In Wells Fargo's uncertain Fed-fueled battle between booming mortgage refinancing fees and declining interest rate-based earnings, the bank's VIE's were at the heart of reported balance sheet growth and income statement woes.

Notably, Wells Fargo sacrificed some third quarter interest margin and surprised analysts to the downside because it held $9.8 billion of conforming mortgages it underwrote on balance sheet, instead of securitizing them off-balance sheet, in a move that cost the bank an estimated $200 million.

The $9.8 billion in capitalized loans and $200 in sacrificed fee income perfectly encapsulates Wells Fargo's dueling profit centers. The $200 of lost revenue equates to just over a 2% revenue margin on the $8.9 billion in underwritten mortgages. The margin is called a "net gain-on-sale margin" by Wall Street analysts.

As Wells Fargo said in its third quarter financial supplement and earnings call, capitalizing those assets drove the bulk of the bank's overall loan and balance sheet growth, in a move that may generate acceptable yield and stabilize interest margins in coming quarters.

Meanwhile the $60 billion in mystery losses, which the Atlantic states is "more than 40 percent of Wells Fargo's capital reserves," also is a matter of basic accounting.

Wells Fargo capitalizes roughly $50 billion of its $1.5 trillion in off-balance sheet securitizations because the bank is a servicer of the loans embedded in the securities it underwrites and is exposed to potential putbacks and repurchase risk.

The mortgage servicing asset and a reserve valuation are modified every quarter to account for changes in the perceived risk of loans Wells Fargo underwrites and securitizes. The $60 billion loss, Wells Fargo clearly states, represents the financial impact were servicing assets and collateral to fall to zero. " This required disclosure is not an indication of expected loss," states Wells Fargo.

As The Atlantic correctly points out, Wells Fargo has recently suffered accounting losses as its MSR valuation rises.

In the third quarter, the bank added $462 million to its repurchase reserve. KBW analyst Fred Cannon estimated, in a note reacting to earnings, that a similar reserve for Wells Fargo's risk hedging portfolio put overall reserve increases at $729 million for the third quarter.

Still, Wells Fargo highlights that its 7.32% delinquency and foreclosure rate is a best of breed in the mortgage industry, and is roughly 4% lower than competitors. In contrast to peers like Bank of America, Wells Fargo, despite being the nation's leading mortgage underwriter, has seen below average putback claims.

If a case for Wells Fargo's prudent underwriting sounds familiar, that's likely because Warren Buffett has long highlighted the bank's lending standards as reason it's among Berkshire Hathaway's top holdings. Contrary to what The Atlantic alludes, Buffett's likely very capable of reading Wells Fargo's quarterly and annual filings to square out the bank's overall mortgage underwriting risk.

And that is the point.

Modern banking is inherently complex and it does require a thorough reading of financial statements and earnings transcripts, two investing basics Buffett has long highlighted. Complex earnings and the requirement of careful analysis, however, does not prove an intent to mislead or trick investors.

Meanwhile, in the wake of Wells Fargo's muddled earnings picture TheStreet has questioned whether Buffett and other Wells Fargo investors may get blindsided by Fed-fueled interest rate risks that are in plain sight.

-- Written by Antoine Gara in New York

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