Wells Fargo, JPMorgan Benefit From Servicing Hedging

Wells Fargo & Co. earned almost a third of its pretax quarterly profit by hedging mortgage- servicing rights, producing gains similar to those that have helped some of the biggest U.S. banks offset weaker consumer- lending businesses.

Wells Fargo’s hedges outperformed writedowns it took on the so-called MSRs by $1.5 billion and JPMorgan Chase & Co. came out ahead by $435 million. The two banks, as well as Bank of America Corp. and Citigroup Inc., wrote down MSRs by at least $5 billion in the third quarter as mortgage rates fell by about 0.26 percentage point.

“The earnings level is unsustainable,” Rochdale Securities analyst Richard Bove said yesterday, and cited mortgage servicing as he cut his rating on Wells Fargo to “sell” from “neutral.” Shares of San Francisco-based Wells Fargo dropped 5 percent in New York trading to $28.90, with most of the decline coming after Bove’s report.

Banks’ mortgage units are using gains on mark-to-market adjustments and hedging derivatives to drive earnings as lenders record losses on consumer loans during the worst recession since World War II. Net gains on MSRs and hedges also added $1 billion to Wells Fargo’s earnings in the second quarter and to JPMorgan’s in the first.

The value of the rights depends largely on the expected life of the mortgage, which ends when a borrower pays off the loan, refinances or defaults. When rates drop and more borrowers refinance, MSR values decline. Banks typically hedge the movements using interest-rate swaps and other derivatives.

Writedowns

Wells Fargo wrote down the value of its MSRs by $2.1 billion in the quarter, the result, it said, of model inputs and assumptions. The hedges it used to offset the movement of the servicing rights rose by $3.6 billion, resulting in a pretax gain of $1.5 billion. Wells Fargo reported pretax net income of $4.67 billion and a record $3.24 billion third-quarter after- tax profit.

The net gain was “largely due to hedge-carry income reflecting the current low short-term interest rate environment, which is expected to continue into the fourth quarter,” Wells Fargo said in a statement announcing its earnings.

JPMorgan reported a $1.1 billion writedown of servicing rights, while it earned $1.53 billion on hedges. That helped the New York-based bank’s earnings rise to $3.59 billion from $527 million a year earlier.

‘Inundated’ With Swings

“You are inundated with these swings with the accounting provisions,” Anthony Polini, an analyst at Raymond James Financial Inc., said in an interview. “From a quality of earnings standpoint, you would rather see the growth in net interest income but this is how we bridge the gap. That’s why they are called hedges.”

Bank of America, which posted a $1 billion quarterly loss, wrote down MSRs by $1.83 billion. The Charlotte, North Carolina- based bank didn’t disclose the performance of its hedges. A $1.2 billion decline in mortgage-banking income was driven in part by “weaker MSR hedge performance,” the company said.

The carrying value of Citigroup’s rights fell by $542 million in the quarter. The bank, based in New York, didn’t report how much of the decline stemmed from changes in its valuation models or from the impact of customer payments. Citigroup, which reported a $101 million profit, also didn’t disclose its hedge performance.

56 Percent of Market

The four banks wrote up the value of their MSRs by about $11 billion in the second quarter, according to regulatory filings. Mortgage rates climbed by 0.35 percentage point in that period, according to Freddie Mac.

The four banks control 56 percent of the market for the contracts, according to Inside Mortgage Finance, a Bethesda, Maryland-based newsletter that has covered the industry since 1984. Servicers collect payments from borrowers and pass them on to mortgage lenders or investors, less fees. They also keep records, manage escrow accounts and contact delinquent debtors.

Under U.S. accounting rules in place since 1995, banks should report the value of mortgage-servicing rights on a fair- market basis, or roughly what they would fetch in a sale. A bank must record a loss whenever it sells MSRs for a price below where they’re marked on the books.

Because there’s no active trading in the contracts, there are no reliable prices to gauge whether banks are valuing the rights accurately, analysts said.

Bank of America held the largest amount of MSRs as of Sept. 30, with $17.5 billion. JPMorgan had $13.6 billion, while Wells Fargo owned $14.5 billion and Citigroup $6.2 billion.

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