3 Challenges Facing This Big Bank

I know it seems crazy to question the management of one of the most well-respected banks in the country. For some investors, just the fact that Warren Buffett has such a high opinion of Wells Fargo is enough to buy the stock without question. That being said, the bank has some distinct challenges, and investors shouldn't ignore them any longer.

This is nothing new
Many people are well aware that Wells Fargo has for years invested heavily in its consumer loan business. In the bank's most recent quarter, nearly 55% of the bank's total portfolio was in consumer loans.

While it's true that both Bank of America and JPMorgan Chase have less than 50% of their portfolio in consumer loans, Citigroup actually carries nearly 60% in consumer lending balances. With a high percentage of consumer lending, both Wells Fargo and Citigroup are betting on the retail customer. This works fine as long as interest rates work in the bank's favor and borrowers pay on time.

This is the first challenge facing Wells Fargo, the bank is investing heavily in loans that are tied mainly to fixed rates. This is the big difference between consumer and business loans. Business loans are usually tied to an index that varies over time. This gives banks that are heavy commercial lenders some interest rate protection. Wells Fargo's heavy investment in consumer loans isn't news, but the interest rate risk it poses is something investors may not be fully appreciating.

This risk is real and upcoming
The second challenge facing Wells Fargo is huge interest rate risk, and long term, this is more complicated than many investors realize. In the last year, Wells Fargo's net interest margin has dropped from nearly 4% in June 2012 to under 3.5% in June 2013. However, if you think further down the line, this might be just the start of the pain for the company.

While the Federal Reserve is continuing its bond purchases and keeping mortgage rates low, at some point, this will change. When the Fed stops buying bonds, mortgage rates will rise. With over $320 billion in first and second mortgages, and most locked in at rates under 4.3% Wells Fargo faces a real problem if rates rise. 

As most bond investors know, if you hold an asset at 4.3%, and new investors can get a rate that is higher, your bond's value goes down. With 40% of Wells Fargo's loans tied up in largely fixed-rate loans, the bank would have trouble unloading these assets if mortgage rates rise. Given that Wells Fargo has challenges with credit quality in these assets as we'll see in a minute, the threat of higher interest rates is something for investors to consider when valuing this stock.

Though the bank has tremendous funding to cover future higher rate loans, more than 40% of Wells Fargo's deposits are money market and savings accounts. These accounts are generally interest-rate sensitive, and there is no guarantee these deposits will stick around if competitors engage in a battle to take these balances with promotional interest rates.

In addition, Wells Fargo's total funding sources are only costing the company about 0.3%. If short-term rates rise, the bank's cost of funding will rise as well. More than 57% of the bank's funding sources come from interest-bearing deposits. As rates move up, Wells Fargo could see its funding costs increase while its loan yields stay the same.

This is a problem right now
While Wells Fargo might have to worry about higher interest rates in the future, the bank's nonperforming asset percentage is a problem right now. This is a third challenge facing the company. While many investors believe this is a high-performing bank, when it comes to nonperformers, Wells Fargo isn't performing well at all.

At a high level, the bank's nonperforming asset percentage is 2.6% as of June 2012. Of several of its large bank peers, Bank of America's rate of nonperformers comes in at 2.3%, while both JPMorgan Chase and Citigroup come in at less than 1.6%.

When you get down to why Wells Fargo has a higher percentage of nonperformers, it ironically has a lot to do with the bank's commercial lending. The bank's consumer nonperformers represent almost 63% of overall problem assets. By comparison, Bank of America, Citigroup, and JPMorgan Chase carry more than 70% of its nonperforming assets from consumer loans.

Based on these numbers, you might expect Wells Fargo's nonperforming asset percentage to be lower. However, with more than $4 billion in problem commercial assets, Wells Fargo is dealing with more than twice the commercial nonperforming issues relative to its peers. Bank of America and Citigroup carry just over $2 billion in commercial problem assets, and JPMorgan Chase carries just over $1 billion.

Today and tomorrow
Whether it's challenges today with commercial loans, or potential issues with higher interest rates and locked-in consumer loans, Wells Fargo has challenges coming from both sides. Though the bank pays a 3% yield and is a favorite of Warren Buffett, there are questions here that need answers.

Long-term investors need to look at this bank from all angles and decide if they believe it can weather the potential storms on the horizon. Some of the bank's choices can't easily be undone, and the future of this well-respected institution may not be as bright as many expect.

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The article 3 Challenges Facing This Big Bank originally appeared on Fool.com.

Chad Henage has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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