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Wells Fargo Q1 Profits Packed with Accounting Gain

Last week, Wells Fargo & Co (WFC) pre-announced $3bn in expected profit and growth for the first quarter of 2009, along with growth in a closely-watched earnings ratio known as tangible common equity. The stock soared over 30 percent on the incomplete earnings news, with an official announcement due later this month. Some analysts have questioned the results, as both loan loss reserves and charge-offs came in unexpectedly low, helping the bank boost reported profits.

It appears, however, that as much as nearly one-third of the bank’s first quarter earnings may be nothing more than the result of an accounting treatment; without such a move, tangible common equity would be 10 bps less than the 3.1 percent the Street expects.

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.

”Have we overestimated WFC's losses, or is the timing obscured by purchase accounting adjustments from the Wachovia merger?” Paul Miller, an analyst at FBR Capital Markets asked in a letter to clients Monday morning.

Wells Fargo representatives said they will not answer specific questions centered on the accounting moves, according to another bank analyst. A spokesperson referred us only to a disclosure of the Prudential joint venture in its most recent 10-K filing with the SEC, when asked. But a large WFC institutional investor also told HousingWire that when asked about the accounting move last week, Wells confirmed that it had impacted the earnings statement.

But in the case of Wells Fargo, this positive impact may at best be transient; when Prudential exercises its put option on the legacy joint venture, that interest in the joint venture may likely return to being booked as a liability and not as an equity interest, sources said.

Analysts, including FBR’s Miller, say they are finding answers tough to come by. “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,” he said.

“I am always still amazed how the market responds to a stock because of an accounting move,” said USC School of Accounting professor and GASB board member William Holder, after reviewing the developments at Wells Fargo.

Holder reiterated that a negative vote by FASB board member Leslie Seidman on FAS 160, who published a written dissent, states that one of the reasons she voted no on the accounting rule was because she was concerned about a non-cash capital transaction now following through to earnings.

-- Paul Jackson contributed to this story.

Editor’s note: Teri Buhl is an investigative journalist covering Wall Street who has written for the New York Post Sunday Business and Trader Monthly. Contact her at teribuhl@yahoo.com.

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