Wells Fargo (WFC) has become one of Warren Buffett's favorite stocks - Berkshire Hathaway (BRK.A) now owns more of it than Coca-Cola (KO). On the other hand, some observers think the giant bank is too exposed to housing because of the huge volume of mortgages that it has been issuing.
Is Buffett right here? Is Wells Fargo really a great value, or is it a disaster waiting to happen? Around 72% of the mortgages the bank issued during the third quarter were refinanced. Refinanced mortgages can be a risky business. After all, many people are refinancing because their home values have fallen.
Wells Fargo is also facing a huge amount of litigation stemming from the mortgage meltdown. A lot of that litigation is still unresolved and might drag on for years, eating up a lot of the company's revenue. Does Wells Fargo have the revenue to cover the cost of the litigation and continue the high rate of refinancing?
The answer appears to be yes if you take a look at the bank's free cash flow. On September 30th Wells Fargo reported free cash flow of $14.81 billion. All of that mortgage refinancing is generating some serious cash at Wells Fargo. It also puts Wells in a much better position than Bank of America (BAC), which had a free cash flow of $9.07 billion, and far ahead of JPMorgan Chase (JPM), which reported a negative free cash flow of -$16.66 billion on September 30th. That's right - JPMorgan Chase lost nearly $17 billion in the first half of 2012 largely because of the London Whale trading fiasco.
Wells Fargo's strategy of becoming the nation's largest mortgage generator has paid off handsomely in other ways. The bank's revenue has nearly doubled since 2009, from $51.63 billion in December 2010 to $90.18 billion on September 30th, 2012. If this rate of increase keeps up, Wells Fargo's revenue might surpass Bank of America's in a few years.
The source of all that new revenue is also easy to see. Figures released on September 30th indicate that Wells Fargo generated $41.66 billion in cash from financing. The amount of cash Wells Fargo made from financing was over four times that of JPMorgan Chase, which made $8.96 billion in cash from financing in the same period. The numbers indicate that Wells Fargo's mortgage strategy is working and Bank of America's is not. Bank of America lost $65.73 billion from financing in the period that ended on September 30th.
The cash from financing figures alone justify Warren Buffett's faith in Wells Fargo. The company has managed to turn financing, particularly mortgage financing, into a mountain of cash in a pretty dismal economy.
Yet Wells Fargo still lags behind other big banks in one key area. It has a lot less cash on hand than any of its major rivals. On September 30th Wells Fargo had $178.02 billion in cash on hand while JPMorgan Chase had $886.73 billion in cash on hand on the same day. Citigroup (C) had $796.57 billion in cash on hand the same day, and even the ailing Bank of America had $567.49 billion in cash on hand.
The cash on hand figures highlight the risks that Wells Fargo has been taking lately. The company has fewer financial resources than other big banks yet it is taking bigger risks in the mortgage market. The company has even started issuing more home equity loans in the past year. The claim is that requirements for the loans are more stringent than in the last decade and that borrowers are more responsible. To Wells Fargo bears that will sound like déjà vu all over again.
Wells Fargo has figured out how to increase its business, but it is in a riskier position than other banks. Warren Buffett is taking a much bigger risk here than many of his fans will admit. Even though its revenues are rising, Wells Fargo is still on shaky ground.
Value investors will be well advised not follow Buffett's lead and splurge on Wells Fargo. The bank lacks the resources to cover the losses it may face if Buffett's predictions of a housing recovery don't come true.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.