July 22 (Bloomberg) -- Wells Fargo & Co., the biggest U.S. home lender, said bad loans jumped in the second quarter as the recession made it harder for borrowers to keep up with payments. The bank dropped 3.6 percent in New York trading.

Assets no longer collecting interest climbed 45 percent to $18.3 billion as of June 30 from the first quarter, the San Francisco-based bank said today in a statement. The increase was disclosed as Wells Fargo reported second-quarter net income soared 81 percent to a record $3.17 billion.

Wells Fargo added to credit reserves amid a 26-year high in unemployment and rising commercial real estate delinquencies. While the acquisition of Wachovia Corp. in January bolstered deposits and home lending, the bank must stanch losses from defaults in California and option adjustable-rate mortgages, ranked among the riskiest loans issued during the housing boom.

“Credit losses and non-performing assets increased very significantly,” said Ed Najarian, an analyst at institutional brokerage firm International Strategy & Investment Group in New York. “There’s cause for concern about how earnings will come through and credit quality will come through in the second half of the year.”

Wells Fargo, whose biggest shareholder is Warren Buffett’s Berkshire Hathaway Inc., fell 90 cents to $24.45 at 4 p.m. in New York Stock Exchange composite trading. The bank has declined 17 percent this year.

Profit for the quarter equaled 57 cents per diluted share, compared with $1.75 billion, or 53 cents, a year earlier, the bank said. Revenue almost doubled to $22.5 billion.

Wachovia Loans

The increase in bad assets, including a $5.3 billion rise in loans that aren’t accruing interest, was tied to Wachovia mortgages, the cost of modifications, the difficulty of liquidating holdings, and the deterioration of commercial real estate, Wells Fargo said.

Fitch Ratings lowered Wells Fargo’s credit grade after the report to AA- from AA, because of “continued pressure on asset quality.”

The cost of loans written off as uncollectible jumped 35 percent from the first quarter to $4.39 billion, including $984 million of Wachovia assets, more than double the previous period. The charge-offs widened to 2.11 percent of loans from 1.54 percent in the first quarter, exceeding the 1.85 percent estimate of Sterne Agee & Leach Inc. analyst Adam Barkstrom.

Wachovia Writedowns

Wells Fargo took writedowns on Wachovia’s riskiest loans at the time of the takeover through so-called purchase accounting. The company said today that losses increased in the portion of the Wachovia portfolio that hadn’t been viewed as impaired at the time. Wells Fargo Chief Financial Officer Howard Atkins said in an interview Wachovia’s nonaccrual loans will moderate in the coming quarters.

The bank said it generated $14.2 billion toward satisfying the Federal Reserve’s Supervisory Capital Assessment Program, surpassing the $13.7 billion requirement. The process will be completed at the end of the third quarter, Wells Fargo said. RBC Capital Markets analyst Joe Morford said he was “pleasantly surprised” by Wells Fargo’s ability to meet the requirement.

“We remain cautious on credit because of the pace of deterioration but Wells continues to generate strong revenue growth,” said Morford, who owns Wells Fargo shares and rates them “outperform,” in an interview from San Francisco.

Peer Reports

Wells Fargo is the last of the top four U.S. banks to post results. Bank of America Corp., the biggest U.S. lender, said last week that second quarter profit fell 5.5 percent on higher loan losses. JPMorgan Chase & Co., the second-largest U.S. bank, reported its first profit increase since 2007 on record investment-banking fees. Citigroup Inc. had a loss, excluding a $6.7 billion gain from selling control of the Smith Barney brokerage unit, as consumer and business loan defaults rose.

Of the four, only New York-based JPMorgan has repaid its bailout funds distributed by the Treasury last year. Wells Fargo said last month it will repay its $25 billion loan “at the earliest practical date.”

The lender probably won’t be able to pay back the funds within the next year to 18 months unless it raises more capital, wrote Sanford C. Bernstein & Co. analyst John McDonald, in a report this week.

Tangible common equity, a measure of capital available to withstand losses, rose to 5.24 percent from 3.84 percent in the prior period, while Tier 1 Capital increased to 9.8 percent from 8.3 percent, Wells Fargo said.

Building Reserves

Wells Fargo added $700 million to build credit reserves, a decline from the first quarter’s $1.3 billion increase. The company incurred a $565 million special assessment fee from the Federal Deposit Insurance Corp. along with a merger-related and restructuring expense of $244 million.

Mortgage originations in the U.S. surged 40 percent in the second quarter to $625 billion, according to estimates from Inside Mortgage Finance publisher Guy Cecala. Wells Fargo reported mortgage banking income of $3 billion in the quarter on $129 billion of originations. Wells Fargo’s Atkins said the Federal Reserve is likely to keep mortgage rates low, spurring more refinancing.

“Even if charge-offs go up, we’re still going to have good results because of earnings production,” said Atkins, in an interview after results. “Profit is very strong even with high credit costs.”

To contact the reporter on this story: Ari Levy in San Francisco at alevy5@bloomberg.net

Last Updated: July 22, 2009 16:40 EDT