Wells Fargo’s Mortgage Loan Losses Could Rise as Treasury Cuts Incentives

-5.26%
Downside
37.92
Market
35.93
Trefis
BAC: Bank of America logo
BAC
Bank of America

Source: Flickr: US Dept Labor

The U.S. Treasury Department’s recent audit revealed that the nation’s largest mortgage loan servicers, namely Bank of America (NYSE:BAC), Wells Fargo (NYSE:WFC) and JPMorgan Chase (NYSE:JPM) have done a poor job of modifying distressed home loans through the government’s foreclosure prevention program. As a result, these banks will lose the financial incentives they enjoy from the government until they improve. The banks enjoy incentives valued at more than $1,000 for a permanent loan modification. ((Treasury slams big banks’ mortgage modifications, usatoday.com))

This could have serious implications for Wells Fargo, which derives close to 30% of its value from its mortgage business according to our estimate. We currently maintain a near $32 Trefis price estimate for Wells Fargo, about 20% above the stock’s market price.

Poor Show by Banks in Audit

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One of the primary factors the audits set-out to gauge was how well the banks evaluated homeowners by correctly assessing homeowner incomes. The government intends to keep tabs on this information, as the bank may have to reduce loan interest rates quite significantly in some cases after the income assessment. In such cases, the banks have an incentive to calculate income figures incorrectly to ensure that their interest income is not hit hard.

The results showed that Bank of America, JPMorgan Chase and Wells Fargo all calculated incomes incorrectly on more than 22% of the audited loans. [1]

Fewer Modifications Could mean Higher Losses for Banks

Homeowner income assessment is essential for banks to be able to modify the terms of existing loans. Loan modifications increase the chances of loans being repaid by increasing the term of the loan, reducing interest rates for the borrower or some combination of these. The federal program has led to 700,000 permanent loan modifications since its start in 2009. However the withdrawal of government incentive for permanent loan modifications could lead to higher foreclosure in the future as well as higher provisions for credit losses as banks find less of an incentive to modify troubled home loans while borrowers fail to repay loans on existing terms.

Wells Fargo’s stock is highly sensitive to the provisions for credit losses on home mortgage loans because of the huge outstanding balance on the bank’s home mortgage loan portfolio.

If provision for credit losses as a percentage of Wells Fargo’s home mortgage loans does not decline in 2011, in contrast to our current forecast, there could be a downside of just under 10% to our price estimate for Wells Fargo.

Wells Fargo has formally disputed the audit report stating that its income calculation error rate is around 4.5%. It claims that the audit’s higher number stemmed in part from modifications done at a time when applicants weren’t required to document their income. [1]

See our full analysis of Wells Fargo.

Notes:
  1. Treasury slams big banks’ mortgage modifications, usatoday.com [] []