Understanding the Gamble of Wells Fargo (NYSE: WFC) with its Interest-Only Mortgage Strategy

Wells Fargo’s (NYSE: WFC) decision to allow customers with option-adjustable rate mortgages to change them to interest-only loans has generated some consternation as to the wisdom of the strategy.

While there are several elements to look at concerning the strategy, two basically stand out. First, there’s no doubt the major result Wells Fargo is looking for is to keep from having to foreclose on a large number of homes, as it would make a huge impact on their quarterly results for some time into the future from the consequences of the write-downs.

The second part of their strategy is the hope that house prices will rebound sometime during the six to ten year period the interest-only loans are focused on, with the hopes that the housing prices will justify offering new loans which the value of the home could support for the bank. The other aspect of this is possibility that workers’ income will rise, helping them to secure these loans during that time period.

In past times most would think both of these are pretty easy goals a bank could build a solid foundation on, but that’s no longer the case, as it could literally take decades to return to where things were at before the recession in America. Add the misguided bailouts and excessive government spending, which will result in higher taxes and inflation, and there’s absolutely no certainty we’ll see this happen in the six to ten year period Wells Fargo is looking at. In other words, this is really a big risk by them in the economic realities we currently are experiencing.

Michael Heid, co-president of Wells Fargo Home Mortgage, confirms the risk, recently saying in an interview that Wells Fargo is “banking on the fact the economy will improve and recover over time.” That is far from a certainty.

The problem from the point of view of the consumer is whether they will continue to live in or improve a home where there will be a negative equity for years. Some believe this will result in more of a renters’ attitude than one of ownership. This could end up with the homes not being improved upon because of the ongoing uncertainty whether it would add value to the home or help with the equity. A homeowner won’t make improvements if they feel they could lose the home now or any time in the future, which could still easily happen, even with the interest-only payment structure.

So while those who attempt to stay in their homes could allow their homes to stay in the condition they’re in, which basically means they’ll leave off making any major improvements, which would essentially cut back on the price of the home growing as it would with an ownership mentality and practice.

Wells Fargo has already began to implement their strategy and so are committed, but that could come back to haunt them if it backfires, as it could have been much better to take the accounting and reporting pain over a relatively short period of time, rather than put downward pressure on the bottom line for years into the future, with a very real and high percentage possibility there will be no rebound in housing prices and wage increases for a long time to come.

Another factor in the decision for Wells Fargo was they feel the losses on these loans could be fewer than expected in contrast to last years’ projections, making it less of a gamble today than it was at that time.

Even so, it seems offered the choice to default will probably be the way homeowners decide to deal with the problem, rather than spend years sitting in a property they have no guarantee they’ll be able to keep or will go up in value, and the emotional capital connected to that alone makes the interest-only loans from Wells Fargo seem a shot-in-the-dark, rather than a workable solution.