Nightrider

Wells Fargo delivers for now, but visibility is poor.

When times are good, banks make out like bandits.  Every time money changes hands, the banks get a cut.  Call it wealth by a thousand cuts.  But that was then, and this is now.  Even as the Fed seeks to expand the the supply of money in the U.S. by trillions of dollars, the velocity of money has slowed.  The spending power of consumers is diminished by declining incomes; some of it is trapped in upside-down home mortgages.  The investing power of cash-flush corporations is being held in reserve, thanks to regulatory uncertainty and crumbling consumer demand.  Fewer transactions all around.  Fewer cuts.

What can an honest, self-respecting bank do to grow profits in this environment?  Wells Fargo has a short-term answer:  take share from competitors.  On Friday Wells kicked off the quarterly earnings parade for the biggest banks by announcing record net income on revenues that grew 7% year-over-year.  Not bad.  The company sported a hefty $125 billion in new mortgage originations.  75 percent of that activity involved refinancings.  Industry-wide, that's a robbing-Peter-to-pay-Paul scenario.  When most of the other mega-banks report later this week, we'll find out who Peter is.  (Bank of America, anyone?)

If you look at Wells Fargo's earnings summary (PDF), you will find worrisome signs that the company may not be able to sustain the momentum.  Net Interest Margin (NIM--see page 11) has declined from 3.91% in the first half of 2012 to 3.56% in Q4.  Lower margins mean smaller cuts.  Page 14 reveals billions in "environmentally-elevated costs," a cute euphemism for liabilities stemming from bad loans.  Page 15 shows that the $125 billion in new mortgages was actually down 10% from the prior quarter.  Finally, repurchase demands from Fannie Mae and Freddie Mac (page 20) for risky loans made between 2006 and 2008 remain stuck at roughly $2 billion, even as repurchase demands pile up for newer-vintage originations.  Wells was forced to add $841 million to its repurchase reserves in the second half of 2012.  Mop-up duty continues, with no end in sight.

ZeroHedge has a useful graphic (below) capturing the company's dilemma:  deposits (a cost center) are rising faster than loans (a profit center), a sure recipe for shrinking margins.  And if the loans go bad (can't happen, no way!), then profits will shrink as well.

[click to enlarge]