October 21, 2009 12:03 PM EDT by Elizabeth MacDonald
Banks like Goldman Sachs and JP Morgan Chase hit the cover off the ball when they reported their earnings.
But the overall picture is a bit bleaker at two major banks -- Morgan Stanley and Wells Fargo, which issued seemingly solid third quarter profit reports today that beat analysts' estimates and has all of Wall Street crooking the trumpets.
Hold on though, for just a second. Join me in taking a look behind the glowing reports coming out of these two battered banks, and you may hold off on the hats and horns.
Wells Fargo joins Bank of America and Citigroup in having not yet returned government bailout funds, $25 billion at Wells, though all say they plan to pay back taxpayers pronto. Wells Fargo, though, is still struggling with growing defaults in its loans it picked up from Wachovia, which means it may have to wait a bit on that one.
And yes, Morgan Stanley has been faring a bit better of late, but its numbers should come nowhere near the level of outperformance enjoyed by Goldman Sachs.
And yes both Morgan and Goldman are still bank holding companies, meaning they get to borrow cheaply in the capital markets and at the Federal Reserve's discount window in order to reap windfall profits off of things like flash trading, which Goldman has perfected (Goldman is gaining in power as its trading desks are going like gangbusters; if a meteorite hit the US, there would be three things left standing"”Goldman Sachs, cockroaches, and Cher).
And accounting maneuvers, now increasingly in vogue in the financial sector, protected the bottom lines at both Wells Fargo and Morgan Stanley.
Accounting Move Protects Bottom Line
Specifically, the accounting move has to do with sheltering more rotten assets in a line item called comprehensive income.
This line item is increasingly being treated like a halfway house for the sick loans, securities, derivatives, hedges and other assets still careening around in a hospital gown on Wall Street and in the banking sector.
Merrill Lynch pioneered the accounting run-around last year to protect its battered bottom line, but it could only go so far with the move before it was bought by Bank of America with $20 bn in taxpayer money.
The accounting move boosted third quarter pretax profit 6% at Wells Fargo; some analysts say it helped the bank improve its first half bottom line by 14%.
And without the move, Morgan Stanley would have spilled $129 mn more in red ink than the $157 mn loss it reported in the first half. That means its reported loss would have been $286 mn for the first six months.
Wells' Fire Engine Red Flags
Dig deeper into Wells Fargo's third quarter report, and here's what you'll find. It's got a massive consumer loan portfolio that it picked up when it bought Wachovia a year ago.
Wachovia had been brought low by its disastrous decision to buy the damaged Golden West Financial, which popularized the now excoriated "?pick-a-payment' loan program, which essentially let borrowers defer interest payments and add them to the loan's principal.
Many of these loans carry low initial rates that are just now starting to reset higher, backfiring on Wells as the recession continues.
Pick-A-Payment Losses
Ok, now this is where it gets to be a funhouse hall of mirrors. Amidst the pie charts and graphics and footnotes, you'll see this in Wells Fargo's report: $107.3 bn in pick-a-payment loan principal still due and owing at the bank.
Now, a new accounting rule that just took effect this past summer says banks must book the value of those loans as of the time they're reported to shareholders. It's part of the "?fair market' rules you may have heard about.
So now Wells says these loans are really only worth, watch this: $87 bn, according to its footnotes. It calls this the carrying value of these loans.
That $20 bn could potentially come out in the wash as a future writedown"”and $20 bn is nearly half of Wells' $53 bn in Tier 1 capital, Tier 1 being the capital cushion bank regulators says all banks must have to support their businesses.
But where did that $20 bn swing downward come from? Dig deeper into Wells' disclosures, you'll see that of those $107.3 bn in pick-a-payment loans, Wells says $57 bn are what's called "?impaired,' meaning, they're either not paying any interest, they're in default, or they are flat out delinquent.
Out of that pile of rotten apples, Wells says it thinks just $37.9 bn are worth anything at all, according to its footnotes.
What do you want to bet that it's not actually $37.9 bn, but the full $57 bn are worth zip, given that home foreclosures are soaring, wages are falling, as unemployment continues to rise?
Wells' Souring Commercial Real Estate Loans
It gets, well, worse at Wells. The bank says it also has $135 bn commercial real estate loans, much of which it picked up from Wachovia--$43 bn of this sum is at risk, according to its footnote disclosures. About a third of Wells Fargo's commercial real estate loan book is tied to properties in California or Florida, two states slammed hard by the downturn in real estate.
Dick Bove's Concerns
Top bank analyst Richard Bove at Rochdale Research cut his rating on Wells Fargo to sell from hold late in the trading day on Wednesday, which market watchers believed helped send the Dow into a reversal.
Bove cited qualms about Wells Fargo's mortgage servicing rights [MSRs], which are basically the funds Wells Fargo earns from servicing mortgages, including loans that have been securitized, point being, Wells will make money if rates stay high and the loans are 100% fully paid up, when loan defaults and delinquencies are rising.
Bove notes that "the volatility in the mortgage servicing fee is impossible to explain. In the past five quarters this fee has moved around as follows: $525 mn, negative $40 mn, $843 mn, $753 mn, and $1.9 bn."
He adds that mortgage rates in these five quarters, however, 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," but "this is not what is depicted in the Wells Fargo numbers," Bove notes.
Bove also cites Wells' large paper gains from its hedges on its servicing portfolio, which have both boosted Wells' profits and added chop to its results.
"For example in the second quarter, the bank lost $1.3 bn on its MSR hedges. In the third quarter, it made $3.6 bn on these hedges. The swing from quarter to quarter was $4.9 bn. 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," Bove notes.
And, he says, "despite the fact that this is the most compelling earnings event in each quarter, the bank never spends much more than five seconds discussing it," even though this paper gain "is an unsustainable profit, but MSR hedges keep coming through for the company when it needs to bolster earnings."
Wells' Off-Balance Sheet Uglies
There's more. Wells also has $174.4 bn in off balance sheet assets, with some $109 bn that could come back onto its balance sheet if a new accounting rule takes effect next year.
And Wells executives are staring morosely at a mountain of rotting paper, $55 bn in other toxic assets, called level 3 assets, according to its footnotes. Supporting all of this is its $53 bn in Tier 1 capital, as well as $98.1 bn in net worth on a hard asset, or tangible, basis.
Cookie Jar Reserves Swamp Interest Income
Meanwhile, Wells' loan loss reserves have grown to $24.5 bn, double its $11.7 bn in net interest income for the third quarter. Net interest income is the lifeblood of any bank, it's the money that comes in the door from loans, mortgages, credit cards, you name it.
When cookie jar reserves swamp interest income, watch out, that's a fire-engine red flag. Wells' credit reserve ratios are also well below what JPMorgan Chase and BofA now report.
The President on Wall Street
So, amidst the tricky profit reports, you may be entertained by headlines that the President visited Wall Street bankers Tuesday night to get more political donations to the Democratic party at a time when the US government has granted extraordinary, unorthodox bailout funds to Wall Street.
A politician on Wall Street asking for money? Does the Osmond Family have teeth?
Believing there is roundtripping of bailout funds as political donations might be a bit too cynical, but hey, Goldman and Morgan can borrow much more cheaply than banks on Main Street due to the government's commercial paper, FDIC debt guarantees, and Fed discount window. You didn't see Bank of Main Street officials Tuesday night at the party in New York, did you?
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We tried to save our standard mortgage through Wells Fargo and "re do it" under the Obama Di$a$terama mortgage saver plan. It was so complicated and WF was so unresponsive, there was nothing we could do. We intentionally went into default, negotiated a short sell, were extorted by the PMI insurance company into agreeing to pay half their claim, and finally got it done. One more toxic asset off their books, but WF took a $50k hit on the deal.
Liz, thanks for continuing to advance public awareness of the tilted playing ground in favor of the mega banks. While regulators protect these big banks from dissolving, they happily close or threaten to close the doors of hundreds of smaller community banks who could really begin to bring us out of this mess the big banks caused. Unfortunately, I don't see anyone else delving into the shifty financial reports these behemoths release.
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