The Only Thing Better Than A Zero Hedge? Wells Fargo's "Never Lose" Economic Hedge
Spot what is wrong with the chart below.
In case it was not apparent, let's highlight what exactly we are referring to:
If you see the issue here, you can stop reading as you probably know what we are getting at. If, however, you are confused by the above chart, read on.
In an article published earlier today, the ever inquisitive Jonathan Weil from Bloomberg highlights the relationship between a firm's Mortgage Servicing Rights (MSR) and the derivatives associated with these, or as Wells calls them "economic hedges":
Mortgage-servicing rights are intangible assets that
consist of rights to receive fees from third parties in exchange
for doing things like collecting and forwarding monthly payments
from homeowners. Unlike other intangibles, such as goodwill or
trademarks, companies have the option under the accounting rules
of marking them at their fair market values on a quarterly
basis, and then running the changes in value through their
Being a Level 3 asset, MSRs are purely mark-to-model. In other words, the firm owning these will use every contraption possible to extract as much GAAP value from these as legally possible, and often times, as much more as excel will allow without crashing. Yet the rub lies in the fact that MSRs have corresponding derivatives, whose impact ends up being netted out from the MSR contribution on the firm's income statement when run as a non-cash item through the P&L. At least these derivatives, which Wells classifies as an "economic hedge" tend to be of a Level 1 or Level 2 variety, meaning they are more prone to be affected by that sad concept known as reality.
Each firm has a unique name for these two presumably somewhat offseting concepts: for Wells the MSR line item is quantified as Changes in fair value to residential MSRs due to changes in valuation model inputs or assumptions, while the derivative impact is classified as Net derivative gains (losses) from economic hedges. This is precisely the data we have shown on the charts above. The blue column is the quarterly impact from MSR FV changes, while the red is the offsetting "economic hedge."
The observant ones will notice that while for all quarters prior to Q4 2009, these two items have always had opposing signs, meaning that, as expected, the hedge would offset the favorable of adverse impact of the MSR FV change, in Q4, both of these were up! A simple analogy to clarify why this should induce several frontal lobe hemorrhage is to assume that one is long a stock and hedged with a put. In Q4, Wells Fargo made a profit on the stock from its move higher, and also miraculously made a profit on the put.
Let's put these numbers in perspective: Wells Q4 pre-tax net income was $3.962 billion, or $0.08 EPS. Of this, the impact of MSR valuation changes and economic hedges was a whopping $1.882 billion or nearly 50% of pre tax net income! (see page 42 of the attached Wells Fargo presentation) Specifically, the Fair Value change to MSR in Q4 was $1.052 billion, while the net derivative GAINS from economic hedges were $830 million, in either case representing 27% and 20% of pretax income. In other words, had the economic hedge worked the way it should have and offset the gain in the MSR, there would have been a delta of at least $830 million and likely considerably more in the wrong direction, eating up a quarter of Q4 earnings both pre- and post-tax. Furthermore, since the derivative presumably has more grounding in reality due to it being higher on the totem pole in the Level 1-3 gradation, in all likelihood it is the MSR impact that would have to be negative and presumably inverted. Lastly, in a perfect world where the economic hedge does in fact hedge, the two items should have offset each other, cutting Wells pretax in half.
As an example we present a comparable data series from JP Morgan, which defines the MSR impact as Changes in MSR asset fair value due to inputs or assumptions in model, while the offset is a Derivative valuation adjustment and other. Note the latter is nowhere called an economic hedge, which for all intents and purposes is the opposite of a derivative adjustment.
Note that not only does JPM not have a favorable impact from derivatives in Q4, but the relationship over the past several years is roughly as expected, with the MSR and the derivatives always pointing in opposite directions. Lastly, while Wells Fargo has seen an increasingly more favorable cumulative benefit from these two components over the past three quarters, for JPM their combined impact has been negative over the same time period.
How does Weil interpret these data:
The last time I took a close look at this subject for a
column on Wells was in August 2007, after the company reported
quarterly earnings that got a huge boost from Level 3 gains on
its servicing rights.
Back then Wells had reported a $2 billion gain, or more
than half its pretax profits, from changes to inputs in its
servicing rights’ valuation models. However, the company said I
would be wrong to make comparisons between the size of its Level
3 gains and its overall profits.
Its argument: Doing so would ignore the effect that rising
interest rates at the time had on the values of both the
servicing rights (which went up) and the corresponding
derivatives Wells said it was using as economic hedges (which
went down). The derivatives, which generally fall into the Level
1 and Level 2 camps, had declined by about $2.2 billion.
I wrote the column anyway, expressing skepticism that these
derivatives were hedges in any real sense. It turns out I
probably wasn’t skeptical enough.
As for the specific impact of this peculiar phenomenon on Wells' Q4 earnings, here is the summary:
Wells’s spin on the latest results is that its hedges
worked. On the company’s Jan. 20 earnings call, Wells’s chief
financial officer, Howard Atkins, explained the gains by saying
“hedging results in the mortgage business were strong” and
“could remain relatively high as long as short-term rates
remain low and the hedge performs effectively.”
He added that Wells manages its mortgage business “very
holistically” and that “actual hedge results in any quarter of
course will reflect how much of the servicing asset we hedge and
the effectiveness of the particular instruments we use to
Similarly, in its earnings release, Wells said the $1.9
billion of gains largely reflected “the continuation of strong
carry income and effective hedge performance.”
What’s carry income? Actually, it doesn’t really matter,
because Wells declined to disclose how much it was. And
“effective” hedge performance? Give me a break. Remember, the
gains on the derivatives were almost as large as the gains on
the items they were supposed to be hedging.
What does all this imply? Could it be that Wells is taking extreme liberty with its Level 3 modeling of its MSR contribution? When your "economic hedge" is not hedging at all, but merely further enhancing the impact of the underlying "hedged" security, red lights have to go off.
Furthermore, for a $1.3 trillion balance sheet, MSRs represent a tiny $16 billion asset. Yet not only does this small, in the grand scheme of things, asset generate half of the company's net income, but the firm identifies MSR valuations as one of its six critical accounting policies - it lists them even above its policies on fair value for financial instruments. Why?
It should be pointed out that companies are not required to mark their MSRs to fair value, through derivatives or otherwise. One company that neither hedges nor marks its MSRs at a fair value is SunTrust. The bank carries its MSRs at the lower-of-cost-or-market, and occasionally takes an impairment charge to write them down. Notably, SunTrust's CFO, Tom Panther has said: "In my mind there is no effective hedging strategy out there that captures all those risks that would move in offsetting directions to MSR." This begs the question: are "economic hedges" merely yet another way to game accounting principles and extract just another penny out from underwater assets?
The conclusion, as Weil also points out, is that while in the current interest rate environment, assuming one buys Wells' explanations, the two items do add significant economic benefit to the bottom line, what will happen if and when economic conditions turn diametrically opposite? Will the "hedge" in that case merely accentuate the deterioration of the MSR P&L contribution?
For all we know, there could come a time when Wells’s
derivatives misbehave at the same time the market values of the
mortgage-servicing rights plunge. That would mean a double hit
to earnings, rather than a windfall. Oh, but what are the odds
of that happening, since Wells seems to have it all figured out?
It is ironic that derivatives, which major Wells shareholder Warren Buffett (who owns 313 million share of WFC) calls financial weapons of mass destruction, are precisely the one item that has provided almost half of his major financial investment's net income. However, ironic or not, Wells shareholders deserve to know what the basis is for this very peculiar oddity in the company's performance. If not, sooner or later derivatives will indeed end up as a financial weapon of mass destruction to none other then Wells Fargo itself.