Last month, many banks reported strong earnings. Market sentiment has changed substantially. Only a few months ago, the collapse of the whole US banking industry threatened to bring the whole global economy down. Now, suddenly, the picture looks rosier than ever and this financial crisis seems to be over. Or is it?

With very limited transparency of bank earnings, there are several so-called earnings areas investors should question whether they are sustainable, and a few other areas investors should ask whether they are even real. They are as follows:

1. The sudden increase of financing activities on residential mortgages. Thanks to the historically low mortgage rates at Q1, some home owners have been refinancing their mortgages, resulting in both spread and fees contributing to bank's earnings. This trend could spill into Q2, but unlikely further. About one out of 5 home owners in this country are under water, meaning their home value falling below their mortgages, which in turn means they are unable to refinance. I also believe real estate has another three years to fall, until 2012, at the national basis (see my previous article "The Real Estate Apocalypse" here), further discouraging any new home buying and sending more home owners under water. I expect this part of the bank earnings is temporary and short-lived.
2. Bank analyst, Michael Mayo said last month, "Mortgage-related losses are about halfway to their peak, while credit-card and consumer losses are only a third of the way to their expected highest levels. While certain mortgage problems are farther along, other areas are likely to accelerate, reflecting a rolling recession by asset class". He also estimated for the whole US banking industry, the total bad loans could be at the range of $7 - $11 trillion, or 3.5 - 5.5% of all loans, worse than the 3.4% peak at the great depression. We have written off only about 2% so far, about the 4th inning of a 9 inning game. There will still be a very long and dark night ahead. Same as real estate, I believe it won't be until 2012 that banks would be getting close to the end of the asset write-off process.
3. Banks postponing charges to earnings for their loan and credit losses. Write-off due to their loan and credit losses by banks is a very discretionary, arbitrary and dedicated process. Most importantly, it is a delayed process. When rates fall, their portfolio rise in value immediately which they reflect in their Q1 financial statement, but they delay to mark down the value of the credit losses until they can't hide them anymore. They realize if they really reflect the real and true losses, their equities, including the huge investment by US government bailout money, will show up as a negative number. In other words, all the taxpayers' money disappears from this money pit of the banking industry. Neither banks nor government wants to show that to the public. So it is totally normal to hear that the head of US Treasury and the Chairman of Fed actively engaged and fraudulently threatened Bank of America NOT to disclose losses at Merrill Lynch to their shareholders.
4. Changing the mark-to-market accounting principal. This process is now further delayed from coercive efforts by both banks and government to deviate from mark-to-market accounting principal, letting banks to assign favorable value as they want to their portfolio which will be written off in future days. Banks are deliberately running write-offs behind the actual defaults, contrary to at the beginning of the banking crisis when they at least were at little more honest about the real losses. Now during Q1, when banks raised the value of their toxic assets, they book them as earnings. For example, Bank of America last year took over Merrill Lynch and in Q1 it increased the value of Merrill's assets to prices higher than Merrill kept them, booking a $2.2 billion gain in the process. They are all paper "gains" for one accounting period for the sole purpose of painting a rosy picture.
5. Taking advantage of "creative" accounting loopholes. One loophole is to book earnings while your debt is actually losing value. A good case here is Citigroup, which last week ended a five-quarter losing streak, took advantage of an accounting rule that allows companies to record declines in the market value of their own debt as an unrealized gain. That turned a $900 million loss into a $1.6 billion gain. It is a scam of being rich by losing money, and we can't call it Ponzi scam anymore and have to find a new name for it. Another trick is to set aside lower loss reserves. Well Fargo set aside just $4.6 billion for potential loan losses. According to banking analyst Paul Miller, the real losses should be around $6.25 billion, which helped boost its earnings by as much as $824 million. Miller said that the bank was "under-reserving for expected future losses", adding that investors should "demand better disclosures".
6. Switching to calendar year reporting. The best award for accounting abuse, however, goes to Goldman Sachs. But switching to calendar year from a fiscal year ending November, suddenly the credit losses of $780 million disappeared from both 2008 report and Q1 2009 report, nowhere to be seen in the future. Of course, this has driven the stock price way up, a perfect timing to dump more shares to the public as far as they are suckers out there. This happened before when Blackstone was conducting IPO dumping shares at the peak of the equity market with many investors so hungry about putting money into private equity firms. Bankers are really smart and public is pigs waiting to be slaughtered.
7. Using credit default swap (CDS) to book earnings. In one of my old article "Why Wall St. Needed CDS?" here, I indicated how banks have used CDS to book fake earnings, now they have found another way to use CDS, even better than the accounting trick of negative basis trading. The unwinding of CDS contracts related to AIG led to huge gains for the major banks for Q1. Those profits have been shown in fixed-income trading, gains that will not be reproduced for future quarters. This is why most of the "earnings" are concentrated under trading "profits" at their financial statement, since they can't manipulate banking fees (relying on number of deals being done), which is public information. But trading activities are not required to be transparent and reported to the public. However, if you check activities of the trading desks at major banks, there was little trading volume during Q1 at all, so where were the "profits" coming from? CDS handily came over to help one more time. Most these "profits" are actually coming from AIG, or our bailout money given by government to AIG, now being funneled through and then recorded as "earnings" by major banks during the unwinding process of CDS wild bets between AIG and major banks in past years. This is really a special time for capitalism; public taxpayer's money suddenly becoming private earnings for banks. It is again time to pay more bonuses out to bankers for such great creativity.

Many people argue that banks will eventually "earn their way out" of their losses. First of all, the record lower interest rate, thus the huge spread earned by the banks today, might not be sustainable. Interest rate will go high, and spread will shrink to squeeze any such earnings left.

Even at the best case scenario for banks, the interest rate and spread stay this way forever, the current debt is still about 4 times of our GDP. If we use 3.5-5.5% losses estimated by Michael Mayo, the total losses are about 14-22% of our GDP. In order to fill this giant hole, a fund manager made a quick calculation with the best scenario of record corporate profit margin and zero consumer savings, like the good old days, and it will still take over a decade for banks to complete this so-called "earn their way out" process. In my previous article here, I indicated that the banking industry will stay flat at this level at range bound for the next 20 years, which now doesn't seem to be far-fetched after all.

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© 2009 Thomas Tan

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How Much of Banks' Earnings Are Real? by Thomas Tan

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