The blogosphere – and analysts – are in varying states of agitation over Wells Fargo’s pre-announcement of its quarterly results on Thursday last week.
The bank said it would post $3bn in first-quarter profits when it releases Q1 results next month — more than double what analysts were expecting. And here’s the bank’s reasoning for the profit, contained in its rather sparse press release:
“Business momentum in the quarter reflected strength in our traditional banking businesses, strong capital markets activities, and exceptionally strong mortgage banking results — $100 billion in mortgage originations, with a 41 percent increase in the unclosed application pipeline to $100 billion at quarter end, an indication of strong second quarter mortgage originations,” said Chief Financial Officer Howard Atkins.
In this age of financial uncertainty, however, others naturally have different ideas. HousingWire in particular, writes that these results are based on the creative usage of one particular accounting rule. Here’s HW’s take:
The jump in earnings pertain to FAS 160, an accounting rule first announced in 2007 that became effective on January 1, 2009. The rule addresses accounting for minority interests, and mandates that the ownership interests in subsidiaries held by parties other than the parent corporation be clearly identified and presented as equity for the purpose of consolidated reports. Until now, minority interests in the U.S. have been reported either as a liability or as a mezzanine line item between liability and equity.
The effect of the new accounting rule allows certain liabilities to ‘jump over’ to the asset book as non-cash transactions via paid-in capital, thereby rolling directly into earnings and boosting reported equity. In the case of Wells Fargo, the bank found itself with up to $824m it could use this quarter as an accounting gain to earnings.
That gain comes as the result of WFC’s controlling interest in a legacy joint venture with Prudential Financial; the joint venture was acquired when Wells took over Wachovia last fall. Prudential currently holds a 23 percent non-controlling interest in the venture, as well as a put option on its interest in the venture; according to government filings, Prudential intends to exercise such an option “at a date in the future.”
Analysts are aware of this change, but say that a lack of transparency from Wells is making it difficult to see just how much of the bank’s jump in quarterly earnings is due to this ‘liability into asset’ transformation. And, of course, this one-time non-cash event happens to occur in a quarter where Wells needs a boost in earnings in order to bring up its lagging stock price, and ostensibly to set up any future capital raises.
Analysts like KBW’s Frederick Cannon, for instance. Via Bloomberg:
“Details were scarce and we believe that much of the positive news in the preliminary results had to do with merger accounting, revised accounting standards and mortgage default moratoriums, rather than underlying trends,” wrote Cannon, who downgraded the shares to “underperform” from “market perform.” “We expect earnings and capital to be under pressure due to continued economic weakness.”
And FBR”s Paul Miller, via Alacra:
WFC’s 1Q09 preannounced results exceeded our expectations, but the release was short on details. We encourage investors to demand better disclosures going forward, and it is our sincere hope that WFC will revisit its long-held practice of not holding live quarterly public conference calls. We caution investors not to get too excited about growth in the tangible common equity ratio until we know how much of the improvement was one-time in nature (and 3.1% tangible common equity is still too low). Announced earnings surprised on the upside, largely based on lower credit costs and net charge-offs, but WFC gave no details on delinquency trends or Wachovia’s credit losses. We find ourselves wondering how were net charge-offs so much lower than we expected? Have we overestimated WFC’s losses, or is the timing obscured by purchase accounting adjustments from the Wachovia merger? Based on everything we know about continued credit deterioration, we are skeptical, and we find no clarity from what little information Wells Fargo has provided.
Paul Miller, having recently appeared on CNBC to recommend shorting Wells Fargo stock, is talking his book somewhat, but it’s a valid point.
Wells’ statement was short and sweet – perhaps a little too saccharine. At the same time, quarterly results, unlike annual ones, aren’t audited, giving leeway for a little creative accountancy. But, we would caution that HousingWire’s take only accounts for a circa $824m boost to Q1 profits, leaving about $2bn of the profits unexplained. Even the best or most daring accountants would think twice before conjuring up that much. Instead, the bank is likely to be benefiting from a host of government-sponsored liquidity programmes and low interest rates, feeding into a generous net interest margin.
The question investors should be asking now is whether they think banks will be able to earn their way out of the financial crisis, or whether the asset problem remains a severe — if not crippling – industry liability. The US government, with its plethora of capital injections and easing of fair value accounting rules, certainly seems to be aiming for the former, without necessarily solving the latter.
Related links:
Balancing banks – The New Yorker
FDIC and the magical accountant: a financial fairytale – FT Alphaville
The IBs of March – FT Alphaville
The return of the IB capital call – FT Alphaville
Goldman first-quarter profits beat expectations - FT