The hit to mortgages Wells Fargo & Co. reported Wednesday echoes the story of many banks this earnings season. The problem for Wells is that home loans are a bigger part of its business.

Looking beyond its record quarterly profit, investors hammered Wells' stock because revenue fell 5.2% year over year, to $20.3 billion, and mortgage revenue declined by $741 million quarter over quarter. (Year over year it was unchanged.)

Wells shares finished at $28.83, down 4.12%. Paul Miller, a managing director at FBR Capital Markets, said Wells had been the victim of overly high expectations.

"This company had a lot of tailwind from mortgage banking," he said. "It is a well-loved stock that didn't meet expectations. The next step has got to be loan growth, and they didn't get it."
While weakness in consumer and mortgage banking affected all of the large banks, Wells' greater concentration in those sectors contributed to the concerns. Wells' mortgage statistics suggest that originations could have farther to fall. Its pipeline of unclosed mortgages at the end of the quarter stood at $45 billion — compared with $73 billion at yearend.

Wells Fargo officials described the situation as an unavoidable bump in the road, and emphasized cost-cutting and other moves they said would promote growth.

"Can we weather the fact that originations are down? Yeah, we did," said Wells Fargo's chief financial officer, Tim Sloan, in an interview with American Banker. That revenues would fall after the blockbuster quarters in the second half of last year was inevitable, he said.

"We love the mortgage business," he said. "But when you're a long-term player, you have to appreciate you'll have cyclicality based on the economy and on interest rates."

Mortgages accounted for 53% of Wells' profits in the first quarter. In 2010, Wells made one in every four mortgages nationwide, originating $386 billion of loans.

Executives said they were planning a new push on efficiency. Dubbed "Project Compass," the effort would be a "bottom-up" review of how Wells could cut back-office costs. But the undertaking should not be seen as evidence that Wells is shifting its attention to cost controls instead of growth, Chairman and Chief Executive John Stumpf told analysts on a conference call.

"We want to be able to grow revenues faster, and we think by simplifying some of the things that we do that don't affect customers actually can help our team spend more time with customers and enhance our revenue growth and become more relevant to our customers," he said.
Miller was skeptical, however, that the intended slimming was being undertaken with growth in mind.

"The cost structure in the entire banking world is too high, and it needs to come down," he said, citing the lack of loan growth. "I applaud Wells Fargo for getting in front of that. A lot of other guys are saying, 'We're hiring so we're ready for the turnaround.'"

One constant for Wells has been the increase of its heralded retail cross-sell ratio, which rose to 5.8 products per household from 5.6 over the quarter. Though Wells' high-touch approach to branch staffing has been adopted by other banks seeking similar results, one analyst on the company's call asked for quantification of the benefit.

"When do you see that hitting the top line, do you think?" asked Morgan Stanley's Betsy Graseck.

"It takes a while for that to run through," Stumpf responded. "Typically when you add products … the profitability grows geometrically."

Wells made special note of how it has handled its $797 billion in core deposits, which grew 5% year over year and have an average cost of just 0.3%. The company has refrained from investing excess cash into securities at their current low yields. As one analyst estimated on the call, Wells is still passing up hundreds of millions of dollars in quarterly income by keeping its powder dry.
"I would not disagree with your math," Sloan responded.

With its mortgage production slackening and consumer banking still weak, the $3.8 billion profit that Wells reported Wednesday was more a reminder of how well the company withstood the crisis than a sign of accelerating growth.

Driving much of the gain was a $1 billion reserve release. Then there is the integration of Wachovia, which has already produced more than $5 billion in non-accretable yield along with new business in checking, wholesale banking and asset management. Wells also avoided some of the mortgage-related charges hanging over its rivals: It had previously written down its servicing portfolio enough to largely cover the impact of complying with federal demands for banks to improve their mortgage practices, and it faces proportionately fewer loan repurchase demands than some of its rivals.

Partly counteracting the drop in revenue were diminished non-interest expenses, down by $606 million.

If mortgages amounted to a disappointment for the quarter, Wells argued that they're likely to be far less problematic for the company than for its rivals. For large mortgage servicers, Stumpf said, much of the remaining threat is from private securitizations. Since only 7% of Wells' servicing portfolio is delinquent and it has far less exposure to subprime mortgage deals with extensive rep and warranty guarantees, repurchases pose a relatively smaller risk to Wells than its competitors.

Other consumer areas showed the effects of government limits on fees. Wells increased the estimate of its cost from the Durbin amendment's cap on debit interchange fees, from $250 million to $325 million, mostly because rapid growth in checking accounts linked to debit cards means the impact will fall on a broader base.

"We believe lawmakers should take the necessary time to understand the direct and indirect consequences of the proposed reduction in debit interchange on consumers, merchants and banks," said Stumpf. "Government price controls that wouldn't even enable banks to cover the cost of providing the service make no sense, particularly for consumers."

While consumer lending has been sluggish in what Stumpf deemed an "uneven recovery," corporate lending showed growth. Overall, the company's $754 billion loan portfolio was flat.

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