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Don't Be Fooled, the Wells Fargo Earnings Report Is Very Good

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Have you heard the news? It's opposite day!

This morning, the nation's fourth largest bank by assets, Wells Fargo (NYSE: WFC  ) , reported record earnings for both the final quarter of 2012 and the entire year itself. Great news right? Wrong! Not only are shares in the company down in intraday trading, but the news sparked a sell-off in the financial sector overall.

What gives?
The answer is simple, if not a bit opaque. Despite essentially minting money, Wells Fargo reported that its fourth-quarter net interest margin, NIM, decreased by 10 basis points from the preceding period.

Now, don't get me wrong. This figure is a pivotal metric for any bank, and particularly for one like Wells Fargo, which looks to loans for the overwhelming majority of its income -- as opposed to, say, a JPMorgan Chase (NYSE: JPM  ) , which has an equally robust investment-banking business.

However, and please trust me when I say this, the market's decision to punish its shares as a result of this decrease is ludicrous. If you dig a bit further into the Wells Fargo earnings report (link opens PDF), you'll see that most of the decrease in the bank's NIM (8 out of the 10 basis points) relates to a growth in deposits -- an extremely positive development that will pay-off in spades down the road.

To understand why this is, it's helpful to think of a bank as a highly leveraged hedge fund -- albeit one that's also highly regulated. Leveraged funds turn a profit by borrowing money at low shorter-duration interest rates and then investing that same money at higher longer-duration rates. The NIM is a tailored average of the difference, or spread, between the cost of the former and the yield of the latter.

Suffice it to say, the lower the cost of funds, the better. And it's here where deposits matter, as they're literally the cheapest source of funding available. In Wells Fargo's case, it pays less than 0.10% to borrow the $550 billion that sits in its customers savings and interest-bearings checking accounts. And it pays absolutely nothing on the $287 billion that customers have deposited in demand accounts -- your typical checking account, that is.

Consequently, once the credit markets fully recover and lending genuinely picks up, Wells Fargo will be able to more fully leverage this impressive deposit base -- second only to Bank of America's (NYSE: BAC  ) in aggregate size -- to its shareholders' pecuniary advantage. It just takes a little patience -- something the market evidently doesn't have today.

Enough about the bad, already!
I'd be remiss if I were to leave you with only the purportedly "bad" figures from the Wells Fargo earnings report, as the overwhelming majority of it was exceedingly positive.

No better figures sum this up than its actual earnings. For the fourth quarter, Wells Fargo earned a staggering $5.1 billion, or $0.91 per share. This represented a 24% increase over the same period in 2011. Meanwhile, for the year, it reported net income of $18.9 billion, a 19% improvement compared to 2011.

While the source of its profits was roughly evenly split between the bank's community and wholesale divisions, it owes a significant portion to its total domination in the home-lending space. As you can see below, Wells Fargo controlled nearly a third of the domestic mortgage origination market in the third quarter of 2012 -- click here to see my take on that earnings report.

Sources: The figures for Wells Fargo, JPMorgan, Bank of America, and US Bancorp come from their respective quarterly filings. Data for Quicken Loans is from Mortgage Daily. A previous version of this figure was published here.

To give you an idea of the scale here, in the fourth quarter alone, Wells Fargo originated $125 billion in mortgages, spawning $3.1 billion in fees. And although the former figure is less than the $139 billion from the preceding quarter, it's still a ridiculously high number and blows away competitors like JPMorgan, which originated $47 billion in mortgages in the third quarter of last year, and Bank of America and Citigroup (NYSE: C  ) , both of which have curtailed their home-lending operations of late.

In addition, Wells Fargo continued to notch victories on both the credit quality and capital fronts. Losses from bad loans in 2012 fell by 20% year over year, and nonperforming assets declined by 6%. At the same time, the company's Basel III Tier 1 common equity ratio improved to 8.18% -- this is still behind the likes of Bank of America and Citigroup, but is there any question about which is the best among the three here?

So why are Wells Fargo's shares trading lower again?
To sum it up, despite the market's reaction to the Wells Fargo earnings report, it's my opinion that the results were resoundingly positive. Added to this, moreover, is the high likelihood that the bank will increase its dividend this year, and there's little to be dissatisfied about if you own shares of this lending giant.

If you're nevertheless wondering whether or not Wells Fargo is a buy or sell, I encourage you to download our new in-depth report on the lender. Among other things, it details the biggest opportunities and threats facing the company and ends with a overarching position on its stock. To download your own copy of this valuable report while it's still available, simply click here now.

Read/Post Comments (2) | Recommend This Article (10)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 11, 2013, at 3:00 PM, TEBuddy wrote:

    Maybe its down simply because it is so high invested in home loans. That are likely to go into foreclosure in a year or two.

  • Report this Comment On January 11, 2013, at 7:37 PM, xetn wrote:

    " To understand why this is, it's helpful to think of a bank as a highly leveraged hedge fund -- albeit one that's also highly regulated. Leveraged funds turn a profit by borrowing money at low shorter-duration interest rates and then investing that same money at higher longer-duration rates. "

    You could also think of it as a fraudulent counterfeiter who takes 90+ percent to its depositer's money (which it gets virtually without cost) and loans it out at whatever the market will bear in interest. It borrows short (demand deposits) and lends long. Since most borrowers do not take the loan proceeds as cash, the proceeds are normally deposited to a demand account which allows another 90+ percent to be loaned.

    If and when the other banks start lending their excess reserves which have been staking up at the Fed, we will start seeing rapid price inflation.

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