Wells Fargo's Earnings Troubles Are Hidden In Plain Sight: Street Whispers

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NEW YORK ( TheStreet) -- Wells Fargo (WFC) investors beware: The bank's biggest issues don't involve accounting gimmicks or trillions of dollars in hidden risky bets. Instead, they are the same earnings time bomb that has everyone from regional lenders to Wall Street titans worried: Interest rates and the prospect a mortgage refinancing boom fizzles in early 2013.

Although a recent The Atlantic magazine article attempts to paint a picture of hidden mischief scattered throughout the bank's financial statements, investors should only really care about a Federal Reserve -fueled interest rate quandary that Wells Fargo faces this year and beyond . In fact, understanding Wells Fargo's earnings illustrates why the bank isn't the financial bogeyman some in the media might make it seem.

The core dilemma for Wells Fargo headed into the fourth quarter is whether fees the bank collects for underwriting and refinancing mortgages, in addition to other types of loans, will be able to offset a foreseeable decline in interest-based earnings, on the heels a third round of Federal Reserve easing unleashed in September that targeted the mortgage market.

In the wake of the Fed's intervention -- which sets a target of $40 billion a month in mortgage asset purchases -- rates offered by Freddie Mac and Fannie Mae have fallen to or near record low levels. Those low rates cast doubt on the spread between what Wells Fargo's earns on mortgages it owns and what it costs to fund the loans -- a business that often accounts for 50% of the bank's overall revenue.

On the flipside of the coin, record low rates have bolstered Wells Fargo's fee-based mortgage refinancing activity, which accounts for a big chunk of its remaining revenue and helped the bank to steady earnings growth in 2012.

The challenge for Wells Fargo, as TheStreet noted in September, is that a government-supported refinancing boom may peter out well before interest rates -- and spreads -- rise, putting the bank's impressive earnings growth at risk starting this year.

In the third quarter, a troubling interplay between interest-rate based earnings known as net interest margin, or income and fee based revenue was on full display as the San Francisco-based bank posted a greater than forecast decline in interest rate sensitive earnings, but saw revenue buffered by overall loan growth and fees earned from mortgage underwriting and refinancing.

In spite of record earnings, the quarter raised investor and analyst eyebrows, which remain headed into the fourth quarter.

On an earnings call and in subsequent investor presentations through 2012, Wells Fargo chief financial officer Tim Sloan repeatedly told investors that while the bank isn't ready to call a bottom in its net interest margin declines -- they fell a greater than expected 25-basis points in the third quarter -- he's confident the bank's lending growth and a set of fee based businesses, which includes trading and wealth management, will be able to drive growing interest income and earnings in coming quarters.