The Biggest Risks Facing Wells Fargo Right Now

The name Wells Fargo  (NYSE: WFC  ) is practically synonymous with quality when it comes to the biggest banks in the U.S. Stacked against the likes of Bank of America  (NYSE: BAC  ) and Citigroup  (NYSE: C  ) , Wells essentially skated through the financial crisis.

But that doesn't give investors an excuse to fall asleep at the wheel. There are plenty of potential risks that Wells Fargo still faces as we move further into the brave new post-crisis world, but these three should be front and center for investors.

Standard financial risks
Regardless of how well a bank is run, there are still two risks that haunt virtually every financial institution. The first is interest rate risk. Traditional lenders like Wells Fargo turn a profit by borrowing funds at low short-term interest rates -- typically from depositors like you and me -- and then loaning those funds out to borrowers at higher and often longer-term interest rates. The difference between the two is known as the interest rate spread or, more specifically, the net interest margin, and the physical proceeds are the net interest income. In Wells Fargo's case, the latter accounts for anywhere between $10.5 billion and $11 billion, or more than half of its total revenue each quarter.

Interest rate risk is, accordingly, the risk that the relationship between long- and short-term interest rates contracts or, even worse, inverts entirely. Although this seems to happen every decade or so, expanding and contracting in a rough and countercyclical pattern to the business cycle, the good news is that Wells Fargo has remained profitable throughout. In addition, the Federal Reserve has committed itself publicly to keeping short-term rates low for the foreseeable future, effectively guaranteeing profits for an operation like Wells Fargo.

The second is credit risk. A famous Texas-based investor who specializes in distressed banks – and has made so much money doing so that a college football stadium now bears his name -- once said that banks generally go broke for one reason: they make bad loans. In other words, banks go broke because they're bad at managing credit risk -- the risk that a debtor won't repay his or her borrowed funds.

Losses associated with bad loans have literally piled up at the nation's largest lenders since the financial crisis, Wells Fargo being no exception. In the last four calendar years, Wells Fargo has charged-off a total of $55 billion in bad loans. While this pales in comparison to the $105 billion charged-off by Bank of America over the same period, it's nevertheless five times the figure that it charged off in the four years preceding the crisis.

Fortunately, the good news is that all of the evidence points to an improvement on this score. Since peaking at 3.7% two years ago, the percentage of Wells Fargo's nonperforming loans to total loans has fallen to 2.6%. Quarterly net charge-offs have been cut in half relative to the peak. And provisions for loan losses are even starting to change direction, as Wells Fargo has begun to selectively release provisions as credit conditions continue to mend.

Legal Risks
All of the major banks have been sued to varying degrees of success by a variety of claimants since the financial crisis. While Wells Fargo emerges intermittently less scathed by the ongoing battles, it's by no means impervious to them.

Most recently, Wells Fargo was one of five mortgage servicers involved in the historic National Mortgage Settlement, which resolved state and federal investigations against the nation's five largest mortgage servicers for faulty and/or fraudulent foreclosure practices. For its part, Wells Fargo agreed in February to pay $1.01 billion to the federal and state governments, and provide $4.34 billion in relief to borrowers in the form of principal writedowns and refinancings, among other things. Four months later, Wells Fargo agreed to pay $175 million to settle accusations that its independent brokers had discriminated against black and Hispanic borrowers during the housing boom.

The most troubling lawsuits remaining concern Wells Fargo's mortgage origination practices prior to 2008. In September, a group of mortgage-backed securities holders sent Wells Fargo and Morgan Stanley  (NYSE: MS  ) "notices of nonperformance," claiming that the companies had failed to comply with contractual obligations to repurchase faulty mortgages that had been securitized and then sold to institutional investors.

The action is virtually identical to one that Bank of America settled for $8.5 billion. According to The Wall Street Journal: "Any settlement would apply to the full unpaid principal balances of $45 billion." This compares to $174 billion in bonds covered in the action against B of A. At the beginning of October, moreover, the federal government filed a lawsuit against Wells Fargo accusing it of faulty mortgage origination practices, and requesting "hundreds of millions of dollars" in relief.

Ultimately, while Wells Fargo is profitable enough to absorb these litigation costs, cases like these will secrete profits from shareholders until they're finally resolved and put in the rearview mirror.

Regulatory Risks
The final type of risk confronting Wells Fargo relates to post-financial crisis legislation and the associated regulations that have gradually eroded banks' bottom lines. In 2010, regulations limited how banks assess overdraft fees on debit card transactions. In 2011, new legislation reduced the interchange fees that banks charge for debit card transactions. And, in the most recent quarter, the Office of the Comptroller of the Currency, one of three federal banking regulators, issued guidance that obligated banks to reclassify billions of dollars in performing consumer loans to non-accrual status, and charge-off a similar amount of residential mortgages.

Going forward, the primary regulatory risks are twofold. First, the so-called Volker Rule, set to take effect sometime in the near future, will ostensibly limit proprietary trading by federally-insured depository institutions like Wells Fargo. And, second, heightened capital requirements, known as Basel III, will start phasing in over the next few years. Fortunately, the former won't impact Wells Fargo in any significant way, as it gets little to no revenue from trading activities. And, in a presentation earlier this year, Wells Fargo's Executive Vice President and Treasurer, Paul Ackerman, noted that the target capital structure, even under Basel III, is "expected to support ROEs of 12% to 15% depending on [the] rate environment."

Buy despite the risks?

Are the risks outlined above enough to derail the Wells Fargo train? To help you figure out whether Wells Fargo is a buy today, I invite you to download our premium research report from one of The Motley Fool's top banking analysts. Click here now for instant access to this in-depth take on Wells Fargo.


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