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Jonathan Weil: Wells Fargo gorges on mark-to-make-believe gains

Section: Daily Dispatches

By Jonathan Weil
Bloomberg News Service
Wednesday, August 22, 2007

There's the kind of earnings investors can take to the bank. And then there's the kind the bank can show to investors.

Word to Wells Fargo & Co. investors: Beware the second kind.

Last quarter Wells Fargo reported record net income of $2.28 billion, up 9 percent from a year earlier. Read the footnotes to its latest quarterly report, though, and you will see a new term in accounting lingo called "Level 3" gains. Without these, the financial-services company's earnings would have declined.

So what are Level 3 gains?

Pretty much whatever companies want them to be.

You can thank the Financial Accounting Standards Board for this. The board last September approved a new, three-level hierarchy for measuring "fair values" of assets and liabilities, under a pronouncement called FASB Statement No. 157, which Wells Fargo adopted in January.

Level 1 means the values come from quoted prices in active markets. The balance-sheet changes then pass through the income statement each quarter as gains or losses. Call this mark-to- market.

Level 2 values are measured using "observable inputs," such as recent transaction prices for similar items, where market quotes aren't available. Call this mark-to-model.

Then there's Level 3. Under Statement 157, this means fair value is measured using "unobservable inputs." While companies can't actually see the changes in the fair values of their assets and liabilities, they're allowed to book them through earnings anyway, based on their own subjective assumptions. Call this mark-to-make-believe.

"If you see a big chunk of earnings coming from revaluations involving Level 3 inputs, your antennae should go up," says Jack Ciesielski, publisher of the Analyst's Accounting Observer research service in Baltimore. "It's akin to voodoo."

For San Francisco-based Wells Fargo, whose stock is up 5 percent this year at $37.37, last quarter was a veritable mark- to-make-believe feast.

About $1.21 billion, or 35 percent, of its $3.44 billion in pretax income came from Level 3 net gains on the $18.73 billion portfolio of residential mortgage-servicing rights that Wells Fargo marks at fair value. These assets, known as MSRs, consist of rights to collect fees from third parties in exchange for keeping mortgages current, by doing things like collecting and forwarding monthly payments.

Wells Fargo's July 17 earnings release didn't mention Level 3 items. This isn't how the second-largest U.S. home lender wants investors to parse its earnings either.

Instead it stresses a metric called "market-related valuation changes to MSRs, net of hedge results," which was minus $225 million last quarter. Spun this way, it looks like changes in the servicing rights' values actually hurt earnings.

To get that figure, the company first broke the $1.21 billion of net gains on MSRs into two parts.

Part 1 was $2.01 billion of gains "due to changes in valuation model inputs or assumptions." Part 2 was $808 million of fair-value declines from changes related to the servicing rights' expected cash flows over time. (All figures are rounded.)

Next, Wells Fargo took the first part -- the $2.01 billion in gains -- and netted it against $2.24 billion in fair-value losses on certain 'free-standing derivatives.' The company says it uses these derivatives as 'economic hedges' against changes in MSR values, although they don't qualify for hedge accounting under the accounting board's rules.

Here's the rub: The footnotes show the vast majority of the $2.24 billion in derivative losses were Level 1 or Level 2, while the $2.01 billion in MSR gains were all Level 3.

In other words, it's a safe bet that the losses were real while the gains had all the substance of a prayer. Indeed, Wells Fargo said in its Aug. 6 quarterly report that "the valuation of MSRs can be highly subjective and involve complex judgments by management about matters that are inherently unpredictable."

Moreover, to get to minus $225 million for "market-related valuation changes to MSRs, net of hedge results," Wells Fargo excluded the other $808 million in MSR losses, meaning these fair-value changes weren't hedged at all.

In an e-mail, Wells Fargo spokeswoman Janis Smith Appleton said "it would be inaccurate to characterize one component of our servicing revenue for the quarter in relation to our total results." She said that's "because it would ignore the effect" rising interest rates had "on both the increase in fair value of our residential MSRs as well as the corresponding net derivative losses associated with the economic hedges of our MSRs."

Inaccurate? No. The real stretch is calling these derivatives hedges.

Nobody forced Wells Fargo to start running quarterly fair- value changes for MSRs through its income statement. The accounting standard that let it do so, called Statement 156, gave it a choice.

SunTrust Banks Inc., by comparison, elected not to. Why? "In my mind there is no effective hedging strategy out there that captures all those risks that would move in offsetting directions to MSR," says Tom Panther, SunTrust's chief accounting officer. So SunTrust waits until the servicing rights are sold before recognizing any pent-up gains.

MSR values normally rise when interest rates do, because fewer customers refinance and prepay their mortgages. At some point if rates rise too high, though, delinquencies on adjustable-rate mortgages could soar, as customers' rates reset, pushing MSR values down.

With mortgage markets now crashing, SunTrust looks like it made the more prudent choice. Yet in the lunch buffet of generally accepted accounting principles, both companies' approaches are permitted.

Someday Wells Fargo investors may regret this.


Jonathan Weil is a columnist for Bloomberg News Service.

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