Shamipulation

by Larry Levin

Continuing with the theme of yesterday's epistle, I decided to look for more details on the Wells Fargo earnings scheme. I found the following article from Bloomberg that I believe you will find interesting. Moreover, you can expect Shitibank and the others to follow in the steps of WFC and GS. What is happening is a both a sham and criminal manipulation of the figures: shamipulation.

Wells Fargo's Profit Looks Too Good to Be True: Jonathan Weil

April 16 (Bloomberg) -- Wells Fargo & Co. stunned the world last week by proclaiming it had just finished its most profitable quarter ever. This will go down as the moment when lots of investors decided it was safe again to place blind faith in a big bank's earnings.

What sent Wells shares soaring on April 9 was a three-page press release in which the San Francisco-based bank said it expected to report first-quarter net income of about $3 billion. Wells disclosed few details of what was in that figure. And by pushing the stock up 32 percent that day to $19.61, investors sent a clear message: They didn't care.

Dig below the surface of Wells's numbers, though, and there are reasons to be wary. Here are four gimmicks to look out for when the company releases its first-quarter results on April 22:

Gimmick No. 1: Cookie-jar reserves.

Wells's earnings may have gotten a boost from an accounting maneuver, since banned, that it used last year as part of its $12.5 billion purchase of Wachovia Corp. Specifically, Wells carried over a $7.5 billion loan-loss allowance from Wachovia's balance sheet onto its own books -- the effect of which I'll explain in a moment.

First, a quick tutorial: Loan-loss allowances are the reserves lenders set up on their balance sheets in anticipation of future credit losses. The expenses that lenders record to boost their loan-loss allowances are called provisions. As loans are written off, lenders record charge-offs, reducing their allowance.

Free to Dip

Once it took control of the reserve from Wachovia, Wells was free to start dipping into it to absorb new credit losses on all sorts of loans, including loans Wells had originated itself. (Think of a child raiding a cookie jar.)

The upshot is that Wells could get by with reduced provisions until the $7.5 billion is used up, boosting net income.

Another quirk: The reserve was related to $352.2 billion of Wachovia loans for which Wells was not forecasting any future credit losses, according to Wells's annual report.

Small Losses

All this may help explain Wells's surprisingly small loan losses. For the first quarter, Wells said net charge-offs were $3.3 billion, compared with $6.1 billion at Wells and Wachovia combined for the fourth quarter. Provisions were $4.6 billion, bringing Wells's allowance to $23 billion, as of March 31.

Wells, which completed its purchase of Wachovia on Dec. 31, wouldn't have been allowed to carry over the allowance had it completed the acquisition a day later. On Jan. 1, new rules by the Financial Accounting Standards Board took effect prohibiting such transfers. A Wells spokeswoman, Janis Smith, declined to comment.

Gimmick No. 2: Cooked capital.

The most closely watched measure of a bank's capital these days is a bare-bones metric called tangible common equity. While the term doesn't have a standardized definition under generally accepted accounting principles, it typically means a company's shareholder equity, excluding preferred stock and intangible assets, such as goodwill leftover from past acquisitions.

Measured this way, Wells had $13.5 billion of tangible common equity as of Dec. 31, or 1.1 percent of tangible assets. Yet in a March 6 press release, Wells said its year-end tangible common equity was $36 billion. Wells didn't say how it arrived at that figure. Nor could I figure out from the disclosures in Wells's annual report how it got a number so high.

Shouldn't Be Guessing

Investors shouldn't have to guess. Under a Securities and Exchange Commission rule called Regulation G, companies that release non-GAAP financial measures are required to disclose "a reconciliation of the disclosed non-GAAP financial measure to the most directly comparable GAAP financial measure." (The rule applies to press releases, as well as formal SEC filings.) That way, anyone can see how the numbers were calculated.

Wells didn't do this in its March 6 release. A spokeswoman, Julia Tunis Bernard, declined to tell me the math Wells used. Silly me -- I thought the SEC's rules apply to Wells Fargo, too.

Gimmick No. 3: Otherworldly assets.

Look at Wells's Dec. 31 balance sheet, and you'll see a $109.8 billion line item called "other assets." What's in that number? For that breakdown, you need to go to a footnote in Wells's financial statements. And here's where it gets comical.

The footnote says the largest component was a $44.2 billion bucket that Wells labeled as "other." Yes, that's right: The biggest portion of "other assets" was "other." And what did this include? The disclosure didn't say. Neither would Bernard.

Talk about a black box. That $44.2 billion is more than Wells's tangible common equity, even using the bank's dodgy number. And we don't have a clue what's in there.

Gimmick No. 4: Buried losses.

How quickly investors forget. One week before Wells's earnings news, the FASB caved to pressure by the banking industry and passed new rules that let companies ignore large, long-term losses on the debt securities they own when reporting net income.

Wells didn't say what its first-quarter earnings would have been without the rule change, which companies can apply to their latest quarterly results. As of Dec. 31, though, Wells had $12.2 billion of gross losses on securities held for sale that weren't included in earnings. Of those, $4.2 billion were on securities that had been worth less than their cost for more than a year.

The bottom line: Net income isn't necessarily income. And it means nothing without complete financial statements.

Investors should have learned this lesson by now.

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Hmm, this sounds eerily familiar. This is the same thing that Lehman Brothers did in March of 2008 in pre-announcing their earnings. Last year, Lehman Brothers was believed to be in trouble right after Bear Stearns collapsed so Lehman pre-announced earnings that crushed all analyst estimates and caused their stock to spike from $31 to $46 in one day. It had fallen as low as $22 the day before.

Only later would we find out that it was all a sham and had nothing to do with their underlying financial condition since they wrote off too little, claimed the non-performance of their written-off debt as profit, and then added to it by claiming profit due to the "revaluation" of a stake they owned in an Indian Power company.

Lehman Brothers was a con just like WFCs so-called earnings.

Let's see what else was in the news today?

1) Weekly jobless claims are huge at 661,000 - check.

2) Housing starts are still plummeting - check.

3) Philly Fed data are horrible, but better than expected - check.

4) 2nd largest commercial real estate firm goes BANKRUPT - check.

5) Dow closes +95 - check.



Previous Day's Trading Room Results:

Trade Date: 4/16/09

E-Mini S&P Trades*
(before fees and commissions):


1) IDVA buy @ 8:40am at 852.00 = -1.00 (1 lot)

2) Engf sell @ 9:15am at 848.25 = -.25 (1 lot)

3) OTF sell @ 10:30am at 847.75 = -1.50 (1 lot)

4) IDVA sell @ 1:00pm at 852.75 = -1.50 (1 lot)

5) Algorithm positions (0)...combined Secret's and Algo total...-4.25


Electronic (YM) Mini-Dow:

1) None today



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