The Only Thing Better Than A Zero Hedge? Wells Fargo's "Never Lose" Economic Hedge

Tyler Durden's picture

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
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.

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Altan311's picture

BIZARRO WORLD, oh wait, we're just talking about accounting.


Hot Tip:

- an accountants favorite trick is to pretend to forget how to count money.

Hephasteus's picture

An accountants favorite trick is to clearly present the data so that it tells a cohesive story. Even if that cohesive story is a complete and utter lie. Because people are too lazy to check.

Daedal's picture

This story supports my conclusion that a perfect hedge only exists in a Japanese garden.

Problem Is's picture

Or the perfect hedge only exists in Ward Cleaver's front yard...

Bear's picture

Well since they are broke anyway it's all moot.

max2205's picture

Maybe it was an out of the money put. Really we all know historically the guberment has quitely told "banks" it ok to lie on financial reports. Raising the red flag on this is fine but how long can ZH beat it's head against the wall it is what it is. BTW this week the $SPX traded under the 4 wk ema and the 4 wk ema crossed down through the 10 wk ema. Time to sell all spike rallies till this situation changes. That's all we need to know ( for index traders)

fuu's picture

Too many pies.

Gubbmint Cheese's picture

Warren knows all this right? He's still comfortable with WFC..



Daedal's picture

And, after they do suffer from 'unexpected' market events, they'll undoubtedly blame lack of foresight on an African American Swan.

Anonymous's picture

This is a classic mental phallacy. Any time there are 50 moving parts, any "part" we want to focus on "accounts for all" of some small net part like "profits".

Example -- cutting out peanuts accouted for ALL OF UnitedAir's PROFIT!! So what? They probably barely made a profit. It doesnt say much.

Poor logic.

Anyone notice that MSFT had $19B in sales? Best Q ever. AMZN sales up 42% YoY. Also, best Q ever. Hmm... I thought people werent buying anything? I thought the USD (or Dolear?) was worthless and only Gold mattered.

Anonymous's picture

Both those corps have a very healthy non-US market, again to use you're earlier fallacy - just because msft sales are up does not mean all of that is attributable to US sales - or USD denominated sales.

Also MSFT released a new flagship product in that quarter, but haven't really looked at the numbers to see what Win7 sales were as a portion of total.

Lastly one of the reasons MSFT and AMZN saw increases is that the USD is worthless (as in worth-less), meaning books and other imported products are now a lot cheaper to a AUD, EURO, etc buyer.

So in short you attempt to declare a fallacy was being committed and then proceed to make quite a few yourself...curious. Buy gold.

Unscarred's picture

Tyler, I stopped reading because I couldn't stop laughing!

Anonymous's picture

this dexter person is an idiot. morgan stanley is all over both of those posts. even the commenters refer to MS and the morgan stanley report. its not like that's not obvious. who is this teri drool character and who is paying her to blow bullshit out of proportion?"

deadhead's picture

i just went back to the original post.  the chart clearly shows the MS credit.

Cistercian's picture

 Nothing says you are doing a good job quite like persecution.

  ZH rocks.


moneymutt's picture

I guess this is a WallStreet m.o....Goldman claimed the Goldman666 blogger site was pretending to be them?! and now MS goes after a ZH.

Cistercian's picture

 In the Goldman666 site example I can see their point.

 Does Goldman serve Evil?Of course.I sometimes wonder how the upper executive staff at Goldman would react if confronted with an exorcist.I suspect it would not be pretty.



Careless Whisper's picture

Let those idiots sue. I can think of a half dozen causes of action ZH would have to counter-sue. I think we could start a legal defense fund if ZH would promise to get a few MorganStanley execs under oath and to publish a few highlights from the depositions. 

Problem Is's picture

"I sometimes wonder how the upper executive staff at Goldman would react if confronted with an exorcist.I suspect it would not be pretty."

The next time Blank-dick-fein testifies before Congress, some one should dress up as a priest, throw holy water on him and chant the exorcism rites...

I would pay cash money to see that...

Hephasteus's picture

Let me edit that for Morgan Stanley.



Strike through font isn't working on the comment editor.

deadhead's picture

I still get confused over all the different names of these banks that used to be investment banks or brokerage houses or hedge funds or primary gofers for the Fed.  Anyways, would this Morgan Stanley that is referred to be the same one that is being sued by the Federal Home Loan Bank??

Would this be the same Morgan Stanley that just walked away from, like, 5 or 6 big office buildings and gave back the keys to the lenders???

Is this the same Morgan Stanley that I read has started to repackage some of them thar financial derivative thingees to resell them to investors?

Is this the same Morgan Stanley that was reported by Vanity Fair to have been offered up to Jamie Dimon by Henry Paulson for free back in the Lehman days???

I get so confused. Jon Stewart had a piece on just last nite and showed some guy named Stanley Morgan, doncha know?

Lloyd, you crafty little devil, are you trying to divert some of the spotlight on to your old buddy John?  Shot across the bow to the new guy?  Mightn't it be real nice to have another squid out there?

Truth be told, it sure would be colorful to see one of those multi billion dollar wall street firms, dearly beloved by the American citizenry, still on the gov't mammaries for backstops, TLGP, whatever, spending its time and money going after a blog....can you imagine all the ink that will be devoted to this?  can you imagine some of the stories that could come out of this? perhaps there are some folks out there who can start providing some background info to get things going just a bit?  howzabout sending any goodies to tips at zerohedge dot com ?? 

velobabe's picture
uh morgan stanley is busy tonight. or i am late to the party.   Breaking News: Morgan Stanley looking into legal action against ZeroHedge January 28, 2010 at 6:09 pm by At the beginning of the week, financial research firm and industry online publication The Davian Letter posted a story that compared a Morgan Stanley research note written by Jim Caron to a story published by Tyler Durden at Zero Hedge.
deadhead's picture

you're late. andy posted it above, which got the discussion going.

andy is originally from west virginia and visits there often.

velobabe's picture

good, this is the kind of late i want to be.

Hephasteus's picture

Oh my god that is the WEAKEST arguement I'VE EVER SEEN. You would have to have medically verifiable brain injury to reach the conclusion thier arguement wants you to reach.

Who's been shoving metal spikes through morgan stanley's employees heads.


Anonymous's picture


The onion peels back another layer, the crowd smells smoke, but there is still money to be made at the casino tables.

For how long? We all know WF and the other TBTFs are
pulling off the crime of the century. The question is
simply when do those that make it out alive, quietly
grab their chips, cash in, and disappear before the
fire is obvious to all gamblers -even the drunken
SS/Medicare/401k sheeple hitting the nickel slots.

Listen not to what politicians and their bankster
henchman say. Pay attention to what they do, and
how it effects your ability to earn, keep, and
own private assets with out the bank and taxman
holding a gun at your head.

Private property is slipping swiftly from the
reach of America's well armed middle class...

Things That Scare Me

Fluorescent lights engage
Blackbirds frying on a wire
Same birds that followed me to school When I was young

Were they trying to tell me something?
Were they telling me to run?

The hammer clicks in place
The world's gonna pay
Right down in the face of God and his saints

Claim your soul's not for sale?
I'm a dying breed who still believes
Haunted by American dreams

Haunted by American dreams


Anonymous's picture

Does a black bird qualify as a black swan?

Anonymous's picture


That tune is for you Deadhead. Anyone who knows,
knows Uncle Jerry could pick a mean banjo...


deadhead's picture

Blackbird singing in the dead of night......

thanks Anon....

AndItsGone's picture

+finity for bringing the divine Miss Case into the conversation.

Anonymous's picture

Funny. Suddenly I get this incredible urge to buy exactly one share of MS and attend a shareholder meeting. Or is it an urge to file a FOIA for what MS has been discounting at the Fed window? They both sound fascinating.

lizzy36's picture

Oh Andy...

Seriously, A 10th tier blogger attempts to strive for relevance should have been the title of the story. 




faustian bargain's picture

so...exposé on this Buhl chick and whoever the Davidian letter guy is, coming up soon I expect.


Unscarred's picture

Spent some time seeing who else picked this story up.  Looks like it's getting some traction.  But hey, "You wanna make an omelet, you gotta break some eggs," right?  I'll offer 2-to-1 that this whole thing goes away in no time.

Plus, why worry about showing your ass to everyone over the Internet when you look like Brad Pitt?

moneymutt's picture

So, to my small mind, it appears the WF is using capital that acts as reserves for insured deposits to take speculative hedge fund risks, profits from which are currently accounting for more than half of its earnings?

Sheila....ummm, Ms. Bair....that's our money these WF MFers are buying poker chips with...can you please tell them to step out of the casino while they are up and immediately drive them to treatment center.

Not only could this end badly for WF investors, this ranks up their with derivatives mess that could take down whole financial system, brilliant.

Clycntct's picture

Any body think there will be any large sacrificial lambs?

If wfc is it then it's bet time and thanks for the early Chrisma$$ present but if the house continues the float uaahhh?-$$$$$

deadhead's picture

it'll never happen while buffett is still on this side of the grass.

moneymutt's picture

Andy - interesting development, I love this line:

"...However, many old media journalists and traders see the folk behind Zero Hedge as nothing more than opinionated, biased-thinking Wall Streeters who are trying to influence the street for their own financial benefit."

Something about a pot and kettle comes to mind.

Cistercian's picture

 That was the lowest blow.They must have been thinking of cramer.

deadhead's picture

This was a beautiful piece.  .

Long live the menagericalism (it's a word, trust me, like Fedgate) of the FASB FAS 157 modifications.

You must be so proud Warren of your little "cash cow" that is just such an earnings machine.

What the hell, why doesn't WFC just mark up all those home equities to 100 cents on the dollar....

Cursive's picture

Similar to the Kubler-Ross Stages of Grief, we have Cursive's Corporate Stages of Valuation Fraud:

1.) Mark-to-Market

2.) Mark-to-Model

3.) Mark-to-Fantasy

4.) Insert plug number

5.) Claim national security exemption from full disclosure

moneymutt's picture

very funny...isn't the final stage acceptance? Guess we're not there yet.

Cistercian's picture

 Actually the final stage involves boarding a private jet and flying to a country without an extradition treaty.

Anonymous's picture

Great summary of Weil's thoughts, explanation, and additional data support.

They're all insolvent...

D.M. Ryan's picture

And Warren Buffett still owns it...

I'm lost for words.

Problem Is's picture

At a loss for words for Buffett?

Fake Facade... Flim-Flam Man... Bullshit Deluxe... Senile Extraordinaire...

All come to mind...

Anonymous's picture

Great post ... their mark-to-myth models are everyone's downfall though, unfortunately: Of Mortgage Brokers, ARMs, Attrition and Marathons

Lothar the Rottweiler's picture

Just paid off my very minor auto loan to Wachovia/WF.  I should be getting the title here in 7 or 10 days. :)