3 Risks Wells Fargo & Co Investors Should Watch Out For

Wells Fargo (NYSE: WFC  ) has a strong reputation for excellence in the financial industry, and investors are looking forward to seeing more positive results from the bank when it releases its latest quarterly results on Friday. Even though the financial giant has surpassed JPMorgan Chase (NYSE: JPM  ) and Bank of America (NYSE: BAC  ) in terms of market capitalization, Wells Fargo still faces risks it needs to overcome in order to ensure its continued leadership position in the banking industry.

To help you understand those risks, all companies in the stock market are required to identify what they see as their most important risk factors when they file their annual reports with the Securities and Exchange Commission. Let's take a look at three of the biggest risks Wells Fargo identified for shareholders to consider, to help guide your analysis of its coming earnings results.

WFC Chart

1. Changing economic conditions have huge implications for Wells Fargo's business lines.
Wells Fargo, JPMorgan Chase, Bank of America, and the entire banking industry have to deal with the threats posed by various changes in economic conditions. The most obvious is that if the U.S. economy weakens in key areas like employment and housing, it would potentially hurt key banking businesses. Wells Fargo notes that rising home prices and stronger employment conditions have helped it reduce its allowances for credit losses and generally improved the quality of its loan portfolio. Yet the bank also notes the economic recovery has been "slow and uneven," citing the U.S. government shutdown and other fiscally related matters as potential stumbling blocks to future growth. If home prices start to fall, or unemployment bounces back, then Wells Fargo could have to add to loss provisions, cutting earnings.

At the same time, though, economic strength has its own dangers. As the economy accelerates, the Federal Reserve is more likely to increase interest rates, and the resulting flattening of the yield curve would hurt Wells Fargo's net interest margins and therefore pressure the profits of its core banking business. Rising rates in response to economic strength would also continue to hurt refinancing volume, which relies on falling rates to entice borrowers into giving up their old mortgages. The current pace of growth has given Wells Fargo almost a Goldilocks scenario, but a move in either direction could upset that delicate balance.

2. Regulatory uncertainty isn't going away anytime soon.
Huge changes in the regulatory framework have forced Wells Fargo, Bank of America, and JPMorgan Chase to adapt, as their status among the largest bank holding companies have put them in the crosshairs of regulators looking to impose tougher standards on the banking industry generally. Wells Fargo identifies several regulatory efforts as potentially problematic, including the ongoing implementation of Dodd-Frank Act reforms, Basel capital and liquidity standards, and Federal Reserve supplemental capital rules and guidelines.

In particular, a proposal to boost supplementary leverage ratio requirements to 5% to 6% by 2018 is projected to force the eight banks it would affect, including Wells Fargo, JPMorgan Chase, and Bank of America, to hold an extra $68 billion in capital. Those provisions aren't guaranteed to become final rules, but the regulatory environment nevertheless points to greater scrutiny in the future for Wells Fargo and its peers.

3. Potential changes in the mortgage market present new risks.
Wells Fargo notes its mortgage business is a key part of its overall success, and to a large extent, it relies on government-sponsored enterprises Fannie Mae (NASDAQOTCBB: FNMA  ) and Freddie Mac (NASDAQOTCBB: FMCC  ) to repurchase most of the loans it extends to customers. As the largest mortgage originator and servicer in the U.S., Wells Fargo is particularly sensitive to changes in the mortgage market, and government efforts to wind down Fannie Mae and Freddie Mac could potentially transform the industry in a way that would require a swift and strong response from the bank.

Like JPMorgan Chase and Bank of America, Wells Fargo could have to repurchase bad mortgage loans from the various entities to which it sells those mortgages. Moreover, Wells Fargo notes the risk of losing servicing revenue, which becomes increasingly important as more borrowers hold onto their mortgages for a longer period of time rather than quickly refinancing them. Wells Fargo hopes the multibillion-dollar settlements that the industry has reached to settle allegations of improper mortgage practices will prove to be the end of a difficult time for the industry, but it doesn't guarantee further problems won't turn up.

When Wells Fargo issues its quarterly report, keep these three risks in mind. By putting Wells Fargo's results in this context, you can get a better sense of what its future prospects might look like.

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