The positive earnings announcement by Wells Fargo on Wednesday was marred by a sell recommendation from Dick Bove and a lot of chatter about credit writedowns and mortgage servicing rights (MSRs). I wanted to add a few words about the report, MSRs, and bank stocks more generally.
First of all, this has been a very good quarter for bank earnings. Many of the big names globally have surprised to the upside. this includes Goldman Sachs, Morgan Stanley, JPMorgan Chase, Wells Fargo, US Bancorp, SEB in Sweden, Credit Suisse in Switzerland and on down the line. As one would expect, most banks are profiting from record low interest rates.
The question for the big banks is whether the huge writedowns they are still taking and the run-up in their stock prices since march limits any upside in valuation. For smaller banks, we should expect weaker results as they are more leveraged to the sectors of the economy like commercial real estate and construction loans which are still suffering. Goldman and Morgan Stanley should do relatively better as they are really broker-dealers and both investment banking and sales & trading are doing well right now. On the whole, I have said I think upside is limited for the sector, but downside is vast. Hence I am bearish on bank stocks.
Let’s look at Wells Fargo (WFC) as an example of what is happening.
Wells reports record profits
Wells reported net income of $32 billion, a robust operating pre-tax profit of $10.8 billion, and record net income of $3.2 billion. Sounds wonderful. What’s not to like? That was bank analysts Dick Bove’s initial impression as well. Live on-air at CNBC, he said Wells Fargo “is proving itself to be a standout.”
But, once Bove got a peek under the hood and started to crunch the numbers at Wells, he was significantly less impressed – so much so that he issued a sell rating literally nine hours later. And he took a lot of flak for this about-face.
The Wall Street Journal’s Market Beat reports:
Prominent banking analyst Dick Bove, who caused a stir Wednesday with seemingly contradictory remarks on Wells Fargo, has decided he’ll no longer provide immediate earnings commentary on air.
“I’m not going to do it anymore. I’m going to have to see the numbers before I go on air,” Bove told Dow Jones Newswires Thursday. “It creates an untenable situation.”
Appearing on CNBC immediately after the San Francisco bank’s 8:00 a.m. EDT Wednesday earnings release, the Rochdale Securities analyst included Wells among “standout” banks when asked to name a few. Bove, who appears regularly on business news programs, said the earnings news suggested Wells had its loan losses “under control.” The comments left many with the impression that Bove
favored the bank.
Later in the day, Bove made waves when he downgraded Wells to “sell” from “neutral.” In an interview Wednesday with Dow Jones Newswires immediately after the downgrade, Bove called the bank’s earnings “pretty poor,” and said mortgage hedging and unsustainable tax cuts inflated earnings.
The downgrade sent Wells shares sharply lower, and weighed on the broader stock market. The Dow Jones Industrial Average finished the session lower after spending most of the day in positive territory.
So, what caused Bove to go from calling Wells a standout to telling us to sell? FT Alphaville’s Tracy Alloway has the goods:
Wells Fargo reported earnings of $0.56 per share for the third quarter. This was well above my estimate of $0.41 per share and in line with second quarter results. The earnings forecast for 2009 has been increased to $2.08 per share from $1.94 per share. The estimates for 2010 and 2011 remain unchanged at $1.93 per share and $2.67 per share, respectively. The target price on the stock is being maintained at $25 per share. The rating is reduced to Sell.
- While the quarterly number was higher than the expected, the increase seems to be due to two factors. The servicing fees on mortgages (MSR) jumped by $1.1 billion or $0.15 per share, and the tax rate fell by 2.2% adding another $0.02 per share to earnings.
- The volatility in the mortgage servicing fee is impossible to explain. In the past five quarters this fee has moved around as follows: $525 million, negative $40 million, $843 million, $753 million, and $1.9 billion. Mortgage rates in these five quarters have been as follows: 6.31%, 5.87%, 5.06%, 5.03%, and 5.15%. These rates would argue for a constant decline in the value of mortgage servicing until the third quarter this year.
- This is not what is depicted in the Wells Fargo numbers. The reason is that Wells hedges its servicing portfolio. These hedges are very large. For example in the second quarter, the bank lost $1.3 billion on its MSR hedges. In the third quarter, it made $3.6 billion on these hedges. The swing from quarter to quarter was $4.9 billion. The earnings per share impact was $0.68 per share. This is more money than the bank earned, overall, including the hedge profit, in the third quarter.
- Despite the fact that this is the most compelling earnings event in each quarter, the bank never spends much more than 5 seconds discussing it. It is an unsustainable profit but MSR hedges keep coming through for the company when it needs to bolster earnings.
- The remaining businesses of the bank were very mixed in the quarter. Most disturbing is that loan losses seem to be accelerating on the negative side.
At issue is mortgage servicing rights (MSRs) not to mention loan losses. Let’s concentrate on the MSRs. Wells Fargo has all of its financial statements dating back to 2001 on its website. I found an explanation of its reporting of MSRs from the Q3 2003 10Q useful (I have highlighted the key points).
The Company originates, funds and services mortgage loans. These activities subject the Company to a number of risks, including credit, liquidity and interest rate risks. The Company manages credit and liquidity risk by selling or securitizing most of the loans it originates. Changes in interest rates, however, may have a potentially large impact on mortgage banking income in any calendar quarter and over time. The Company manages both the risk to net income over time from all sources as well as the risk to an immediate reduction in the fair value of its mortgage servicing rights. The Company relies on mortgage loans held on its balance sheet and derivative instruments to maintain these risks within Corporate ALCO parameters.
At September 30, 2003, the Company had mortgage servicing rights (MSRs) of $5.8 billion, net of a valuation allowance of $1.8 billion. The Company’s MSRs were valued at 1.03% of mortgage loans serviced for others at September 30, 2003, up from .92% at December 31, 2002 and .89% at September 30, 2002. The increase in MSRs was predominantly due to the growth in the servicing portfolio resulting from originations and purchases.
The value of the MSRs is influenced by prepayment speed assumptions affecting the duration of the mortgage loans to which the MSRs relate. Changes in long-term interest rates affect these prepayment speed assumptions. For example, a decrease in long-term rates would accelerate prepayment speed assumptions as borrowers refinance their existing mortgage loans and decrease the value of the MSRs. In contrast, prepayment speed assumptions would tend to slow in a rising interest rate environment and increase the value of the MSRs.
The Company mitigates mortgage banking interest rate risk in two ways. First, a significant portion of the MSRs are hedged against a change in interest rates with derivative contracts. The principal source of risk in this hedging process is the risk that changes in the value of the hedging contracts may not match changes in the value of the hedged portion of the MSRs for any given change in long-term interest rates.
Second, a portion of the potential reduction in the value of the MSRs for a given decline in interest rates is offset by estimated increases in origination and servicing fees over time from new mortgage activity or refinancing associated with that decline in interest rates. In a scenario of much lower long-term interest rates, the decline in the value of the MSRs and its impact on net income would be immediate whereas the additional fee income accrues over time.
Under GAAP, impairment of the MSRs, due to a decrease in long-term rates or other reasons, is reflected as a charge to earnings through an increase to the valuation allowance.
In scenarios of sustained increases in long-term interest rates, origination fees may eventually decline as refinancing activity slows. In such higher interest rate scenarios the duration of the servicing portfolio may extend. In such circumstances, periodic amortization of servicing costs may be reduced, and some or all of the valuation allowance may be released.
What Wells Fargo is saying is that a decrease in interest rates as we have seen recently should lower net income immediately as the loss in revenue flows through the income statement. Yet, this is not happening according to the latest earnings report. the question is why? Dick Bove’s answer is the temporary gains from the hedging contracts have more than offset the more permanent loss in MSR income, that is for now. I certainly think Wells will be making boatloads of money on refinancing fees. But, this fee income “accrues over time.” What will happen with these massive hedges is unclear. What is clear is that the MSR value will have to be written down and that will be a drag to income. So, on the whole, if you strip out the hedges, the earnings level at Wells is misleadingly high.
The troubling thing about this is that these hedges are marked to market and because there are no actively-traded contracts for comparison, there are no reliable marks to mark-to-market. Let’s call these marks mark-to-make believe then. And Wells is not the only one benefitting from this. Wells, BofA, JPMorgan and Citi, the four largest mortgage servicers, all are benefitting from this.
The four banks wrote up the value of their MSRs by about $11 billion in the second quarter, according to regulatory filings. Mortgage rates climbed by 0.35 percentage point in that period, according to Freddie Mac.
The four banks control 56 percent of the market for the contracts, according to Inside Mortgage Finance, a Bethesda, Maryland-based newsletter that has covered the industry since 1984. Servicers collect payments from borrowers and pass them on to mortgage lenders or investors, less fees. They also keep records, manage escrow accounts and contact delinquent debtors.
Under U.S. accounting rules in place since 1995, banks should report the value of mortgage-servicing rights on a fair- market basis, or roughly what they would fetch in a sale. A bank must record a loss whenever it sells MSRs for a price below where they’re marked on the books.
Because there’s no active trading in the contracts, there are no reliable prices to gauge whether banks are valuing the rights accurately, analysts said.
Bank of America held the largest amount of MSRs as of Sept. 30, with $17.5 billion. JPMorgan had $13.6 billion, while Wells Fargo owned $14.5 billion and Citigroup $6.2 billion.
Let’s see where this leads for the next quarters. Right now it looks a lot like big bank earnings are inflated artificially by hedges. How well regional banks fare on loan losses should give us a better picture of the underlying fundamentals in the sector.
Wells Fargo 2003 Q3 10-Q (pdf) – Wells Fargo website