Wells Fargo's Surprising Strength

While rivals slash their payouts, the bank hiked its dividend 10%. Is its strong quarter a sign of better conditions in banking?

Not all banks have been flattened by the credit crunch.

That was the resounding message from Wells Fargo's (WFC) profit report on July 16, which so impressed investors that they drove the bank's shares up 32%.

At a time when many big banks are slashing dividends to cover huge losses on mortgages and toxic debt, Wells Fargo raised its dividend 10%. "We continued to [expand] our company profitably at a time when many of our peers are losing money and shrinking," said Chief Financial Officer Howard Atkins during a conference call with analysts.

While the fifth-largest U.S. bank has taken some hits from the housing slowdown and credit crunch, Wells Fargo talked on July 16 as if the crisis was a great opportunity to be seized.

Adding Assets amid Adversity

The company's success reflects the benefits of its diversified business model, Atkins said, but also "the unprecedented opportunities the credit crisis itself has created." Wells Fargo used the crisis conditions to add attractive assets and new customers and to increase its market share, he said.

Revenue at Wells Fargo jumped 16% last quarter. Although this was offset by provisions for future credit losses, earnings of 53¢ per share beat analyst expectations by 3¢.

Financial-sector shares have dropped for weeks, with the level of fear spiking when IndyMac Bank, a mortgage specialist, failed and was taken over by the government on July 11. It was the first major bank collapse since the beginning of credit troubles a year ago.

The Wells Fargo news sparked a rebound on July 16, even for those banks and mortgage financiers known to face major problems. Shares of Fannie Mae (FME), Freddie Mac (FRE), Washington Mutual (WM), and Bank of America (BAC) all advanced by double digits.

Atypical Style

Experts warn, however, that the broader optimism might be premature. That's because Wells Fargo operated quite differently from many of its large banking rivals.

The message from Wells Fargo's increased dividend and better-than-expected profits? "Banks that stuck to traditional good lending practices, in both credit cards and mortgages, are going to do just fine," says Robert Ellis of Celent, a financial consulting firm.

Wells Fargo avoided the mistakes of its competitors. Unlike Washington Mutual and Wachovia (WB), it didn't make large bets on riskier mortgages, Ellis says. And unlike Citigroup (C) and Merrill Lynch (MER), Wells Fargo didn't lose big on trading of complex debt instruments.

Out of the Weeds

Before the start of earnings season, some analysts tended to lump all large banks together. For example, one analyst, who had an underperform rating on Wells Fargo, pointed out in mid-June that the stock was trading at a premium of 2.5 times its tangible book value, compared with shares of its large peers, which traded at 1.8 times book value.

Investor reaction to Wells Fargo's second-quarter earnings suggest it has justified this premium, at least for now. Naturally, many investors will be looking for other banks that can also capitalize on the crisis and outperform their peers.

Wells Fargo stayed "out of the weeds," says John Jay, an analyst at Aite Group. Even when the real estate market was hot, the bank stayed away from subprime loans and other risky debt. He cautions that banks need to be evaluated on a "case by case" basis to see whether they pursued a similar business model. And even Wells Fargo could face trouble, Jay warns, if bad-debt problems mount in its credit-card operation.

Navigating Downturns

Ellis is more optimistic about the banking industry, particularly smaller and regional banks, which mostly avoided risky bets the past few years. Yes, earnings will take a hit from a recession. But, he says, that's "not anything unusual for these banks." Experienced bank executives have been through downturns before "and know how to handle them," he says.

Have negative headlines about big banks overwhelmed evidence that much of the banking sector remains strong?

The second-quarter earnings season, which is still young, may answer this question. In the next few weeks, financial results from hundreds of other banks will demonstrate whether Wells Fargo's strength is the rule—or the exception.

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