Wells Fargo: A Plagued Stock With Serious Risks For Investors

| About: Wells Fargo (WFC)

Wells Fargo (NYSE:WFC) is the largest consumer lender in the United States. The stock trades around $26, with a year low of $22.58 and the high is $34.25.

Results for the recent quarter ended September 30, 2011, indicate the bank had a $4.1 billion profit. Its revenue fell to $19.6 billion from $20.9 billion last year. The increase in profit is attributed to gains in its lending deposit division. The decrease in revenue reflects the industry’s struggles with initiating growth and the fears of another recession in the U.S. The profit numbers were impressive given the banking industry’s efforts to shake off the mortgage crisis of 2008 and volatility in capital markets in 2011.

Studies conducted by Stanford University measure the value of stocks based on the measurement of five factors from the financial information: If the company’s return on assets is higher than last year’s, if the cash flow from operations is greater than the net income, if long term debt has decreased from last year, the current ratio is greater than last year and the number of outstanding shares has decreased from last year, the stock is of good value based on these measurements.

Wells Fargo’s September 30th 2011 numbers indicate that the return on assets this year is 1.25%, up from .98% last year. Cash flow from operations of $33.76 billion is higher than the net income of $14.37 billion. Long term debt has decreased from $3.735 billion last year to $145 billion this year. The number of shares outstanding has increased to 5,325.4 billion from 5,252.9 billion last year. Data with respect to the current ratio (ability of assets to cover short term liabilities), gross margin and asset turnover are not available. The stock has been punished by the market, and it may be the result of fears over what is unseen as opposed to what information is available.

In effect, it is not really possible to measure the value of the shares because of the information that is unavailable. In addition, while the lack of data is reason to be wary, the anticipation of the impact of a protracted slow recovery may have on the lending practices of Wells Fargo is cause for concern.

As with many financial institutions, Wells Fargo has a portfolio of mortgages and other loans that are considered to be Purchased Credit Impaired (PCI) loans. A substantial portion of PCI loans were acquired in Wells Fargo’s 2008 takeover of Wachovia. Many of these loans are held in single purpose entities (SPEs). SPEs are a very difficult aspect of all reporting company financial information. SPEs are difficult to value because the entity and its assets do not appear on the balance sheet, they usually have no independent management, a trustee performs all administrative functions and serves as a liaison between the SPE and the parties that created it (which are usually all the same people and/or corporations).

In 2009, Wells Fargo was ordered by regulators to correct reporting deficiencies in residential loan servicing and foreclosure practices by January 2010. Its September 30th, 2011 10Q states that: “the company continues to work with regulators to comply; however, civil money penalties have not been assessed at this time.” Changes in the future servicing and foreclosure costs are estimated in the 10Q, and these estimates include the impact from the regulatory order. It seems likely that these changes will increase costs in risk mitigating activities, including the restructuring of long term debt and commercial loans.

Also in the 10Q is a policy statement which gives six points of consideration: the allowance for credit losses; the PCI loans; valuation of residential mortgage servicing rights; liability for mortgage loan repurchased losses; fair valuation of financed investments; and, income taxes. The statement goes on to say that management has to make difficult, subjective and complex judgments about uncertain matters which it is likely that amounts reported would be materially different under different conditions using different assumptions. In other words, it is still a guessing game based on broader economic criteria and capital markets ability to provide instruments that will mitigate the risk of the non-performing loan portfolios.

Wells Fargo uses trading programs based on simulations to mitigate its mortgage banking, interest rate and market risk. Because the change in value of adjusted rate mortgages (AMRs) may not be offset by Treasury and LIBOR index based financial instrument, interest rate swaps for instruments of equal value are traded, that essentially blanks the risk. The danger in this is the liquidity and volatility of interest rate swaps. Wells Fargo’s activities in the trading of securities and derivatives resulted in losses of $442 million at September 30, 2011 as opposed to gains of $1.1 billion for the same period in 2010. The market risk portion of the simulations obviously did not take into account the capital markets gyrations in 2011.

On September 30, 2011, the allowance for credit losses on certain PCI loans was $302 million. The company realized $184 million from SPE’s containing PCI loans. In addition, Wells Fargo transferred $318 million to accredited (subject to guarantees from Freddie Mac, Fannie Mae and Ginnie Mae and therefore do not a negative impact on the balance sheet) from non accredited and absorbed a $1.6 billion loss from PCIs. The allowance is necessary to absorb credit related decreases since acquisition in cash flows is expected to be collected and primarily relates to PCI loans.

Banks that received bailout money were obliged to set aside billions of dollars as loan reserves in anticipation of defaults. Banks are now withdrawing from these reserves to shore up earnings. Wells Fargo reported that its 2010 fourth-quarter earnings rose 21 percent, helped by an improving loan portfolio and withdrawals from its capital reserves. In essence, earnings are exaggerated by monies available from reserves instead of by increases in revenue.

On January 7, 2011, it was reported that despite strong documentation controls with respect to foreclosures, an activity that has plagued other large mortgage lenders, Wells Fargo still faces problems with respect to its mortgage portfolio. A Massachusetts court convicted Wells Fargo of wrongly foreclosing on two homes because it could not prove that it owned the mortgages. The result of this conviction was that regulators in all 50 States investigated the validity of hundreds of thousands of foreclosures made in recent years.

It seems that despite Wells Fargo’s reputation for having more stringent lending practices than other consumer lenders, it will continue to be plagued by the portfolios of PCIs and the practice of holding these loans in SPEs. In addition, the roller coaster ride that has been the capital markets in 2011 has not reflected well on Wells Fargo’s income and earnings. A change in direction in its risk mitigating strategies, more transparency in its financial reporting, less reliance on dipping into loan reserves and a move towards increasing deposits to consumers is in order before the stock can be considered a buy for value investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.