Image Source: Jeff Turner

From July to December of last year, foreclosures at Wells Fargo (NYSE:WFC) increased by nearly a billion dollars. 

That's right. Nearly $1 billion. Take a moment to reflect on that number. Breathe slowly. Now stop worrying. Just let it go. For Wells Fargo investors, the rise in foreclosures is a symptom of something very good. 

Breaking down the numbers
In the aftermath of the real estate bubble collapse, Wells and most other banks saw a steady decline in foreclosures. The economy began to heal; the bank worked out problem loans and properties.

Then, after June 30, 2013, something changed.

Other real estate owned (accounting speak for foreclosed properties, abbreviated OREO) bottomed at $3.07 billion at the end of the second quarter. At the end of the third quarter, that number increased to $3.69 billion. By the end of the year, the number was up to $3.84 billion.

For comparison, Bank of America (NYSE:BAC) reported just $1.97 billion in OREO as of December 31. Citigroup (NYSE:C) was even stronger, reporting just $307 million for the same period. That means that Wells' OREO portfolio is 12.5 times larger than Citi's. That's a huge difference!

What's driving Wells' OREO? Mostly its single family homes.

As of December 31, 2013, Wells foreclosed properties were primarily made up of single family homes and failed construction and development projects. Together, these two categories account for about 28% of the bank's OREO. Ginnie Mae properties--the Government National Mortgage Association, a wholly owned subsidiary of the U.S. Department of Housing and Urban Development--accounted for another 54%. All told, about 85% of the bank's OREO is residential property.

What does management have to say about all this?
In the company's 2013 annual report, CEO John Stumpf went out of his way to highlight Wells' efforts to reduce foreclosures. 

Stumpf said:

Just as important, we are helping people stay in their homes. Wells Fargo is a leader in preventing foreclosures — since 2009, we have completed more than 904,000 home loan modifications and provided $7.7 billion in principal forgiveness. We also have participated in nearly 1,200 home preservation events, including hosting 107 of our own workshops where we have met one-on-one with nearly 45,000 customers facing financial hardships.

Why the big focus on foreclosures? Because no matter how you slice it, foreclosures are bad. They put everyday people out of their homes. They disrupt families. They hurt the bank's bottom line. And a slew of foreclosure related scandals have put banks on the front page of newspapers--a public relations nightmare.

How then, is Stumpf allowing foreclosures to creep up? These problems are universally bad! What gives?!

The reality of being a growing bank
The reality is that some level of foreclosures are a part of the day to day business of banking. Some loans, however well underwritten, will go bad. That's why banks take collateral in the first place. Knowing this, we should recognize OREO not just in terms of raw dollars, but also as a percentage of assets.

And in terms of assets, the picture for Wells Fargo is not as bad. OREO as a percentage of assets increased from 0.23% to just 0.27% from June to December of last year. Even with the increase, this still represents an improvement from year end 2012 when the bank reported 0.29%. 

This number is still above average in a peer comparison (Bank of America reports 0.12% and Citigroup 0.02%, which is stellar), but it is perfectly acceptable in light of the asset growth on Wells' balance sheet.

Wells grew from $1.34 trillion in total assets as of June 30 to $1.42 trillion at year end. For context, according to the FFIEC, there are only 20 banks with total assets greater than $142. Wells Fargo grew by that much in just six months!! It truly is a staggering number. 

Bank of America on the other hand is shrinking, and Citigroup is barely maintaining its current level of assets. 

Any analysis of a bank should include a review of the level of OREO on the books. Its a good indication of credit culture, asset quality, and the long term stability of earnings. Reckless lenders will have more foreclosures. Reckless lenders also go out of business.

But be careful not to ignore the possible positive causes for an increase in OREO. Problem loans are a part of banking. The objective is to minimize them while still focusing on growth and profits. Wells Fargo is doing exactly that, and that's why investors should not be concerned about the bank's growing OREO.