JP Morgan (NYSE: JPM) and Wells Fargo (NYSE: WFC) Benefit from Hedging Mortgage-Servicing Rights

Wells Fargo & Co. (NYSE: WFC) and J.P. Morgan Chase (NYSE: JPM) both earned a significant share of their quarterly profits by hedging mortgage-servicing rights, producing gains that have allowed some of the U.S. banks to offset their weakened consumer-lending businesses.

Almost a full one-third of Wells Fargo’s pretax earnings came from its mortgage-servicing hedges. The company’s hedges outperformed write downs and the bank took the mortgage-servicing rights by $1.5 billion and J.P. Morgan Chase came out ahead by $435 million. Between JP Morgan Chase, Bank of America, Citibank and Wells Fargo, those four banks wrote down mortgage-servicing rights by $5 billion during the third quarter as mortgage rates dropped by about 0.25%.

Rochdale Securities analysts, Richard Dove, dropped his rating of Wells Fargo to sell from Neutral citing mortgage servicing rights as his primary reason. In his report, Bove said “The earnings level is unsustainable.” After Bove’s report came out, Wells Fargo & Co’s stock dropped by about 5%, with a lot of the decline coming after Bove’s report.

Many of the largest bank’s mortgage units are using gains on mark-to-market adjustments and hedging derivatives to generate earnings as mortgage lenders accrue record losses on consumers loans. Net gains from mortgage-servicing rights added $1 billion to Wells Fargo’s earnings during the 2^nd quarter and $1 billion to JP Morgan’s earnings during the 1^st quarter.

The value of the mortgage-servicing rights often depends on the expected life of the mortgage, which ends when a borrower pays off the loan, goes into default, or refinances the loan. When mortgage rates drop and more borrowers are refinancing their mortgages, mortgage-servicing rights values typically decline. Banks typically hedge against these movements using derivative investments and interest-rate swaps.

During the second quarter, Wells Fargo wrote down the value of its mortgage-servicing rights by $2.1 billion during the third quarter. The hedges that Wells Fargo used to offset the movement of those servicing rights rose by $3.6 billion, resulting in a pretax gain of $1.5 billion. During the 3^rd quarter, Wells Fargo reported pretax net income of $4.67 billion and $3.24 billion in after-tax profit.

Wells Fargo stated that its 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.”

JP Morgan Chase reported a $1.1 billion write-down of servicing rights while earning $1.53 billion on its hedges. JP Morgan’s hedges increased the bank’s earnings to $3.59 billion from just $527 million a year earlier.