One out of every three home loans in the United States is now funded by Wells Fargo & Co, whose mortgage operation sits in a business park next door to a country club on the outskirts of Iowa's capital city.

Wells Fargo scaled back its subprime lending in 2004, well before the housing crash. That move, and the bank's lack of exposure to investment banking and Europe, is why Wells Fargo was the one major U.S. bank to escape a ratings cut by Moody's Investors Service this week.

But former regulators and banking experts are beginning to worry that the fourth-largest U.S. bank may be becoming over-exposed to the housing market.

It is adding mortgages to its books when the economy is sluggish and interest rates are near record lows, and this could be the best scenario.

If the economy strengthens and rates suddenly rise, mortgages will suffer more than most other loans and the bank's income could be clobbered. Another recession would also hurt the bank, because defaults would rise.

Wells Fargo says it can manage the risk and sees no reason to stop expanding.

It is hiring thousands of loan processors, underwriters, and call center employees, and investing billions of dollars in new loans and tens of millions in the infrastructure to manage them.

"There's no ceiling," said Mike Heid, president of Wells Fargo Home Mortgage. "There's no cap on our size."

Investors have long praised Wells Fargo for sticking to traditional commercial and consumer banking while de-emphasizing riskier undertakings like credit derivatives trading.

But old-fashioned banking can be risky too. By expanding so much in the mortgage industry, Wells Fargo is building a potentially dangerous concentration in one type of loan, said Mark Williams, a former U.S. Federal Reserve bank examiner who teaches at the Boston University School of Management.

"What we know is that diversification is extremely important in banking," said Williams, who wrote a 2010 book on the downfall of Lehman Brothers Holdings called "Uncontrolled Risk."

Wells Fargo's Heid said the bank had decades of experience managing risk, and notes that it is expanding at a time when underwriting standards are strict and property values low. Its combined delinquency and foreclosure rate was 6.89 percent at the end of the first quarter, nearly half the rate at rival Bank of America Corp, according to the publication Inside Mortgage Finance.

"It's a really good book of business coming in right now," Heid said.

Aside from the risk to Wells Fargo, the mortgage growth also raises concerns that one company has become dominant in an industry that is so critical to the U.S. economy.

Edward DeMarco, acting director of the Federal Housing Finance Agency, said in a speech last month that he would like to see the mortgage market become more competitive.

At the same time, Wells Fargo is a key source of funding for many smaller banks, which issue mortgages and then sell them on to the company and other lenders in a practice known as correspondent lending.

Smaller banks say they have fewer buyers for their mortgages than before the 2008 crisis and that the market would lose a huge source of liquidity if Wells Fargo were to pull back.

"If you are a community bank and depend on Wells Fargo as a correspondent bank, you are unfortunately at their control," said Ron Haynie, executive vice president for mortgage services at the Independent Community Bankers of America.

Correspondent lending may be risky for Wells Fargo, too. It has said that loans written in-house are of better quality than those it buys from other banks, which may be why many of its rivals have backed away from correspondent lending.

Still, Wells Fargo, which got 42 percent of its mortgages last year from correspondent banks, says it chooses partners carefully and has net worth and performance requirements for them.

INDUSTRY PITFALLS

Like the rest of his executive team, Heid, a 24-year company veteran, works from a cubicle in this suburban office. He became co-president of the home mortgage division in 2004, at the same time Wells decided not to offer some of the riskier mortgages competitors were making -- including subprime loans in which borrowers provided little documentation of their income.

"There was a huge chunk of the market that we just consciously chose to not do," said Heid, who became sole head of the unit in a reorganization last year.

The bank's restraint paid off. In 2008, Wells became the top mortgage lender in the United States, a position it had ceded in 2004 to Countrywide Financial, which Bank of America now owns. By 2009, the bank had nearly a quarter of the market, double its market share in 2007, according to Inside Mortgage Finance.

And last year, Wells became the top collector of mortgage payments from borrowers, a business known as servicing.

Wells Fargo also bulked up during the financial crisis by buying North Carolina-based Wachovia Corp in 2008. The deal brought the company a portfolio of risky adjustable-rate mortgages, which it is gradually liquidating, but also gave it a more visible presence on the U.S. East Coast.

The bank is now one of the few investing in the mortgage business, while competitors are pulling back. Wells Fargo plans to add 1,000 loan officers nationally and is looking to hire hundreds of processors and underwriters, some of whom are working on a government program to refinance underwater mortgages. It is also developing new systems for underwriting.

So far, that investment is paying off. In the first quarter, Wells Fargo's mortgage income climbed 42 percent to $2.9 billion from a year earlier, about one-fourth of the bank's fee income. Analysts expect the business to boost second-quarter earnings.

Mortgages have also become a growing percentage of the bank's assets. Wells Fargo has $312 billion in residential mortgages and home-equity loans on its books, representing about 41 percent of its loans, up from 38 percent in 2006. Among large banks, mortgages make up a slightly higher percentage of total loans at Bank of America, but significantly less at Citigroup, JPMorgan Chase & Co and US Bancorp.

Wells Fargo keeps about 10 percent of the loans it makes, and packages the rest into securities guaranteed by government-controlled entities such as Fannie Mae and Freddie Mac, the bank has said. It sells the securities to investors.

That percentage is typical of the industry, but with its size, Wells is piling on more loans than others.

The worst-case scenario for Wells Fargo's mortgage business would be a rapid rise in interest rates, analysts said. That would push up its cost of funds, while it would still be earning historically low interest on long-term mortgages, making a large slab of its loans unprofitable.

In the 1980s, U.S. savings-and-loans were felled by such a rate squeeze, as well as risky investments they made, said Lawrence White, an economics professor at New York University's Stern School of Business and a former savings and loans regulator.

Wells can hedge this risk and has a much more diversified balance sheet than the savings-and-loans had, White said. But the bank and its regulators need to monitor the situation closely, he added.

"We need to keep the memory (of the savings-and-loan crisis) alive because with long-lived assets, clearly an interest-rate spike can get you in trouble the old-fashioned way," White said.

But while others pull back, Wells seems to be betting that the U.S. economy and the housing market is on an upswing, or at least will not weaken too much.

"If the market recovers, I think they will be sitting very pretty," said Anthony Sanders, a finance professor at George Mason University and former head of asset-backed and mortgage-backed securities research at Deutsche Bank. "But there is always a concern. We are not out of the woods yet."

(Reporting By Rick Rothacker, Editing by Dan Wilchins, Edward Tobin and Martin Howell)

• A Permanent Economic Emergency