Through the credit crunch, Wells Fargo has convinced investors that it is a cut above other large banks. Its shares trade at 2.5 times tangible book value versus 1.6 times for J.P. Morgan Chase. But while Wells posted better-than-expected second-quarter profits on Wednesday, it also showed a sharp deterioration in credit quality.
The question now hanging over the company: Has Wells's management been caught out by the recent poor performance of the bank's loans? One reason Wells trades at a big premium over others is the perception that its executives have a strong handle on credit risk. Now, though, there are signs that the bank may have been too optimistic about the quality of loans it got from Wachovia, the large bank it acquired last year. Moreover, many of Wells's own loans continue to perform disappointingly, with nonperformers going up in the second quarter for corporate loans, commercial real-estate credits and its $117 billion of core home-equity loans.
Voltron says: remember, home equity loans are second mortgages. If the first mortgage is worth 99 cents on the dollar, the home-equity loan is worth zero.
Granted, as the economy struggles, rising bad loans are hardly a surprise. But they become a big deal for investors if management doesn't appear to have set aside adequate loan-loss reserves.
Wells's reserves are equivalent to 2.86% of loans, well below 5% for J.P. Morgan and 3.61% at Bank of America. Wells's defenders might point out that less of its loans are going bad. Its nonperformers are equal to 1.92% of loans vs. 2.17% at J.P. Morgan and 3.12% at BofA. But Wells's nonperformers ratio could go higher.
For instance, there are signs this may happen on a $51.6 billion portfolio of option adjustable-rate mortgages Wells inherited from Wachovia. The bank said 3.21% of these loans were more than 90 days past due in the second quarter, a big leap from 1.11% in the first quarter. And these are loans that Wells didn't treat as impaired when it bought Wachovia, presumably because management thought they were stronger than those they did mark down.