What Could Slow the Wells Earnings Train

Wells Fargo (WFC) is on such a roll that its fourth-quarter profit — a record $5.1 billion — exceeded the previous year's earnings at every U.S. bank other than JPMorgan Chase (JPM) and Citigroup (NYSE: C).

Question is, can that momentum continue throughout 2013? The refinancing boom that has driven earnings in recent quarters will end eventually, and investors are starting to question how Wells intends to replace that income.

In a conference call with Wells' executives Friday, analysts also asked questions about how regulatory changes and an uptick in expenses in the fourth quarter might affect future profits, and they raised concerns about transparency of the bank's balance sheet.

Wells' Chief Financial Officer Timothy Sloan acknowledged that the company faces potential threats, but he expressed optimism that it will continue to show steady growth.

"There's all kinds of headwinds," Sloan said in an interview after Wells reported its quarterly results, before adding: "They're the same headwinds we've been facing over the last one two or three years, and we've continued to grow earnings."

As with all banks, Well's biggest challenge is the pace of the economic recovery. Outside of mortgage refinancing, loan demand remains relatively weak and banks' margins continue to narrow as a result. But Wells also faces challenges unique to the largest banks, and here are four that could affect profits and its stock price in 2013 and beyond.

Maintaining Mortgage Dominance
Wells now originates roughly one-third of all U.S. mortgages. The company has benefited from not only a wave of refinances across the country, but also the timing of that opportunity — since other banks, including Bank of America (BAC), have scaled back their mortgage lending.

On Friday's call with analysts, Wells Fargo chief executive officer John Stumpf suggested that the refinancing boom still has some steam. He noted that the average interest rate on mortgages that Wells services is more than one percentage point higher than today's mortgage rates.

One potential threat to the high margins that Wells Fargo has been generating from its mortgage business is a bill in Congress that aims to increase competition for refinances among different servicers. A recent report from Compass Point Research & Trading LLC identified Wells Fargo as one of the firms that could be negatively affected by the measure.

But Sloan said that if the measure becomes law, he expects Wells Fargo would make up any lost revenue in additional volume. Overall, he said, "I think it'd be a slight positive."

Regulatory Costs
New mortgage rules from the Consumer Financial Protection Bureau, which are expected to shape eligibility criteria for future borrowers, should have an outsized impact on Wells Fargo, given its huge role in the mortgage market.

Stumpf was complimentary of the rules during Friday's conference call, though he acknowledged that the company has yet to review the proposal in detail. "I think this is a step in the right direction," he said.

One concern that others in the industry have raised is whether the new rules will restrict the availability of jumbo mortgages — large-balance loans that carry higher interest rates and could run afoul of the rule's restrictions on high-cost loans. Stumpf, who recently said that his bank wants to grow its footprint in the jumbo market, said Friday that Wells has yet to evaluate the new rule's impact on high-balance mortgages.

"We love that business. We've been at it for a long time. In many cases these are our best customers," he said. "I'd be surprised if whatever happened there had a big negative impact on the jumbo market."

Another area where regulatory scrutiny could affect Wells in 2013 involves its Direct Deposit Advance product, which consumer advocates criticize as a bank payday loan. Five Senate Democrats urged regulators on Tuesday to crack down on the product.

In comparison to some of its big-bank competitors, Wells will feel less of an impact from the Volcker Rule, which bars banks from engaging in proprietary trading and investing in private equity. The Volcker Rule is expected to be finalized in 2013.

Sloan told analysts that he expects the company's investment in Norwest Equity Partners, a $5 billion private equity arm, will be allowed under the Volcker Rule. But he did acknowledge there will be some impact.

"Our best guess of the impact we're going to see from the Volcker Rule is that it would eliminate or end our opportunity to invest in a private equity fund or a real estate fund as a limited partner," Sloan said.

Controlling Expenses
Wells Fargo has been seeking to reduce its expenses, but the firm's efficiency ratio took a step backwards in the fourth quarter, rising from 57.1% in the previous quarter to 58.8%.

Company officials attributed that increase to two one-time expenses, and they noted that its efficiency ratio is still nearly two percentage points below its level a year ago.

But with investors still keenly interested in the company's commitment to cost-cutting, Wells management said Friday they are looking to control costs without going so far as to undercut growth.

Sloan assured analysts that the company can move quickly to cut its mortgage origination expenses if lending begins to slow.

"Our mortgage folks have seen cycles before," Sloan said. "I would say there's about a 60- to 90-day lag, so a one-quarter lag, but we can move pretty quickly."

Wells is experimenting with smaller branches, but is not looking to reduce its 6,300-branch footprint, according to Stumpf.

"We're not in the camp that you can shrink your way to greatness," he said. "So stores still remain an incredibly important part of the ecosystem of delivery. That might change over time."

Balance-Sheet Transparency
Wells engages in fewer complex trading activities than some of its big-bank peers, so its executives probably did not appreciate being singled out in a recent Atlantic Monthly article that focused on hard-to-understand aspects of its balance sheet.

(Wells had $3.8 trillion in notional exposure to derivatives as of Sept. 30, compared with $71.8 trillion at JPMorgan Chase.)

The article's authors argue that even well-informed market professionals can't understand the risks on the balance sheets of the nation's largest banks, and this opacity has hurt the banks' stock prices.

On Friday's conference call, analyst Nancy Bush of NAB Research asked Stumpf to respond to the article, and he said that Wells is more transparent now than it's been throughout his decades at the bank.

"In fact, this team is available to any one of you," Stumpf said. "Call us. We're not hearing any of these things from any of our investors."

"I've never seen us be more transparent. So if there's other things we can do, I'm all ears," he added.