Bad mortgages get worse at Wells Fargo stretching out schedule for paying back $25 billion bailout

07/22/2009 11:32 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Fear of the future trumps current earnings, as far as investors are concerned, when it comes to Wells Fargo (WFC).

On July 22, before the opening bell, the company reported second quarter earnings of 57 cents a share--far above the 34 cents a share Wall Street had projected, and revenue of $22.5 billion, again above Wall Street expections of $20.5 billion. As the company said in its conference call, "Wells Fargo earned another record profit this quarter: $3.17 bln. While many banks are struggling to earn consistent operating profits, we've had back-to-back quarterly record profits"

And once the stock market opened for trading, the stock sunk like a stone. By 11 a.m. ET shares had dropped by 6%.

Why? Because investors looked past current earnings and revenue to the bank's huge portfolio of some of the riskiest types of mortgage loans in some of the nation's worst real estate markets, and didn't see much that they liked.

Here's the problem: thanks to its acquisition of deeply troubled mortgage lending leader Wachovia, Wells Fargo is the proud owner of $130 billion in residential mortgages. And since Wachovia was an extremely aggressive lender, many of those mortgages are option adjustable-rate mortgages, a class that has racked up high default rates during the real estate meltdown. Many of those mortgages are concentrated in the Florida and California markets, which don't look like they've bottomed yet.

So investors are afraid, deeply afraid, of what might still be headed their way if they own Wells Fargo. In a worst case, but not by any means impossible, scenario these mortgages would go into default to a degree that Wells Fargo would have to raise more capital. That would dilute the value of current shareowners holdings. And it certainly wouldn't be good news from a bank that still owes the U.S. government $25 billion it received as part of the banking system bailout.

This quarter's news on the condition of that loan portfolio wasn't very reassuring. The bank announced that the cost of loans written off as uncollectable jumped 35% in the second quarter to $4.4 billion from the level in the first quarter. Charge-offs grew to 2.11% of loans from 1.54% in the first quarter.

But it's the continued deterioration of the Wachovia portfolio that creates the most worry about the future of this stock. At the time of the Wachovia acquisition, Wells Fargo took writedowns on what it then thought were the riskiest loans in that portfolio. This quarter, however, the bank said that losses increased on the part of the portfolio that at the time of the acquisition had looked most stable.

That shouldn't be too surprising since unemployment in California stood at 11.6% in June, better than two percentage points worse that the national average. Six of the state's cities are among the 10 cities in the United States with the highest foreclosure rates, according to RealtyTrac of Irvine, California.

Not surprising perhaps but none the less disappointing to investors who had hoped to hear the company say it would pay back its bailout billions sooner rather than later.

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