UPDATE 4-Wells Fargo credit losses dampen record profit

* Nonperforming assets soar 45 pct from first quarter

* Profit sets record, helped by Wachovia

* Shares fall 3.3 percent (Recasts opening paragraphs; adds comments, Fitch downgrade)

By Jonathan Stempel

NEW YORK, July 22 (Reuters) - Wells Fargo & Co (WFC.N) disappointed investors as a surge in bad loans overshadowed record quarterly profit, driving its shares lower.

The credit deterioration fanned concern that Wells Fargo, which took $25 billion of federal bailout money, will need even more capital to cover loan losses.

Nonperforming assets, where borrowers are not making payments, soared 45 percent to $18.34 billion in the second quarter from the prior three-month period. This included a 69 percent jump from commercial and commercial real estate loans.

Many of the bad loans came from Wachovia Corp, which nearly collapsed from option adjustable-rate mortgages before Wells Fargo acquired it at the end of last year. The merger caused Wells Fargo to double in size and created the fourth-largest U.S. bank.

"They continue to underprovision relative to their charge-offs," said Paul Miller, an analyst at FBR Capital Markets in Arlington, Virginia. "Credit costs continue to increase at an alarming rate."

Second-quarter profit applicable to Wells Fargo shareholders rose 47 percent to $2.58 billion, or 57 cents per share, from $1.75 billion, or 53 cents, a year earlier.

Before payment of dividends, profit rose 81 percent to $3.17 billion, the San Francisco-based bank said. Revenue nearly doubled to $22.51 billion.

Analysts on average expected profit of 34 cents per share on revenue of $20.63 billion, according to Reuters Estimates. Results reflected per-share charges of 8 cents to replenish a federal deposit insurance fund and 3 cents for merger costs.

Net charge-offs increased 35 percent from the first quarter to $4.39 billion, but Wells Fargo said it added only $700 million to reserves, giving it $23.53 billion.

Fitch Ratings cut the bank's credit rating, citing the loan losses as well as capital levels that "moderately lag" peers.

In afternoon trading, Wells Fargo shares were down 83 cents, or 3.3 percent, to $24.52. The KBW Bank Index .BKX was up 1.9 percent. Wells Fargo's largest shareholder is Warren Buffett's Berkshire Hathaway Inc (BRKa.N) (BRKb.N).

CFO CALLS COMMERCIAL REAL ESTATE "SOFT"

Regulators have not permitted Wells Fargo to repay its $25 billion of bailout money, though the bank said it built a $13.7 billion buffer required under a federal "stress test."

Wells Fargo said its reserves should cover 12 months of consumer loan losses and 24 months of commercial and commercial real estate loan losses. Wells Fargo took a $37.2 billion writedown on riskier Wachovia loans when it bought that bank, and said those loans are performing in line with forecasts.

"The loan portfolios are performing OK," Chief Financial Office Howard Atkins said in an interview.

He said "commercial real estate generally is soft right now" and will likely remain that way until the economy "really begins to improve, adding that "there are signs here and there" that the economy has bottomed.

Chief Credit Officer Mike Loughlin said the bank expects credit losses to increase despite "some moderation" in the rate of growth in some consumer portfolios.

Other banks to report rising credit losses include KeyCorp (KEY.N), SunTrust Banks Inc (STI.N) and U.S. Bancorp (USB.N) on Wednesday, and Bank of America Corp (BAC.N), Citigroup Inc (C.N) and JPMorgan Chase & Co (JPM.N) over the past week.

BIGGEST MORTGAGE LENDER

Wells Fargo remained the nation's largest mortgage lender, making $129 billion of home loans, up 28 percent from the first quarter, and getting $194 billion of home loan applications. It ended June with $90 billion of mortgages yet to be closed.

The home loan volume compared with the $114.3 billion reported by Bank of America, which bought Countrywide Financial Corp last July.

Profit in wealth management, including the former Wachovia Securities, rose 40 percent from the first quarter to $363 million, as client assets approached $1 trillion.

Atkins said Wells Fargo would like to repay the government bailout money when "appropriate," so long as capital is sufficient.

The bank slashed its dividend 85 percent in March and still expects $7 billion of annual cost cuts, including $5 billion tied to Wachovia. (Reporting by Jonathan Stempel; Additional reporting by Sweta Singh; editing by John Wallace and Tim Dobbyn)