Rebuilding the House of Cards

On Friday, the market seesawed around with the S&P 500 crossing over the zero line 14 times during the day. As the market searches for direction on a day when job loss data was again “better than expected” even as the unemployment rate ratcheted up to 9.4%. We have now put 3 months between ourselves and the market’s bottom in early March, with almost uninterrupted gains since that time. Remember, it was an internal memo from Citigroup’s (C) CEO Vikram Pandit suggesting that his bank would be profitable in the first quarter that started this extended rally. Other major banks followed suit telling the market that, just months after record losses in the 4th quarter 2008, the largest banks in the country would turn a profit.

With the benefit of a few months of hindsight we know that much of what the banks reported as profits, could be largely explained by clever accounting tricks. An article today on Bloomberg’s website did a great job of displaying exactly what some banks reported as profit in the first quarter.

“‘Bogus’ Profit

Citigroup’s $1.6 billion in first-quarter profit would vanish if accounting were more stringent, says Martin Weiss of Weiss Research Inc. in Jupiter, Florida. “The big banks’ profits were totally bogus,” says Weiss, whose 38-year-old firm rates financial companies. “The new accounting rules, the stress tests: They’re all part of a major effort to put lipstick on a pig.”

Further deterioration of loans will eventually force banks to recognize losses that their bookkeeping lets them ignore for now, says David Sherman, an accounting professor at Northeastern University in Boston. Janet Tavakoli, president of Tavakoli Structured Finance Inc. in Chicago, says the government stress scenarios underestimate how bad the economy may get…

Debt Valuation

Along with that change, FASB also let companies recognize losses on the value of some debt securities on their balance sheets without counting the writedowns against earnings. If banks plan to hold the debt until maturity, they can avoid hurting the bottom line.

At Citigroup, the recipient of $346 billion in fresh capital and asset guarantees from the government, about 25 percent of the quarterly net income came thanks to the debt securities rule change, the bank said.

Another $2.7 billion before taxes came from an accounting rule that lets a company record income when the value of its own debt falls. That reflects the possibility a company could buy back bonds at a discount, generating a profit. In reality, when a bank can’t fund such a transaction, the gain is an accounting quirk, Weiss says.

Citigroup also increased its loan loss reserves more slowly in the first quarter, adding $10 billion compared with $12 billion in the fourth quarter, even as more loans were going bad. Provisions for loan losses cut profits, so adding more to this reserve could have wiped out the quarterly earnings.

Wells Fargo

Without those accounting benefits, Citigroup would probably have posted a net loss of $2.5 billion in the quarter, Weiss estimates. In the five previous quarters, Citigroup lost more than $37 billion.

Wells Fargo also took advantage of the change in the mark- to-market rules. The new standards let Wells Fargo boost its capital $2.8 billion by reassessing the value of some $40 billion of bonds, the bank said in May. And the bank augmented net income by $334 million because of the effect of the rule on the value of debts held to maturity.”

The market has shown impressive resiliency of late and the bulls appear to be firmly in control. However, at Ockham, we are of the opinion that this sort of pace is not sustainable without a corresponding improvement in underlying market fundamentals. The headlines made banks look stronger than was actually the case, as the quote explains Citi would have lost another $2.5 billion had they applied more traditional earnings standards. The banks have used the opportunity provided by the first quarter earnings and the “better than expected” (there’s that term again) stress tests to raise a lot of capital very quickly. The effect of this will ultimately be positive, but buyers beware on these banks. It will be very hard to pull the same accounting shenanigans again. If the purpose was to inspire confidence in banks once again, it appears to have worked. Lets hope that the improvement in the broad economy allows for banks to resume their more traditional profitable activities, and inspire the kind of confidence that can sustain a further rally.

Rebuilding the House of Cards

About Ockham Research 645 Articles

Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

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