Banks: 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. The market searched 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. Let's 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.

Original post

Comments

[RonB:]

One only needs to look at Wells Fargo's net interest margin, the doubling of its deposit base from the Wachovia acquisition, the writeoffs it has already taken, and the growth in new business to see the benefits that will be recognized over the next few years.

Don't let silly articles like this distract you from fundamental value. There is nothing wrong with Wells' accounting. The writer seems to think that only declines in market value should be booked, but not their reversals.

Wells Fargo is the largest holding in my personal and client portfolios.

Ron Beasley
rwbi.net

Jun 06 12:47 PM

[Richandre:]

You can lead a horse to water. Just another situation where many will be kicking themselves in two years for not buying WFC hand over fist today.

Jun 06 01:36 PM

[Jasper M:]

A doubling of deposit base is a doubling of exposure to bank runs, once the public comes to understand (and they will) the bank's true state of affairs. Remember, banks don't die on the asset side; they die on their liabilities, which means deposits.
That said, I have a certain respect for the corporate culture that got WFC's CEO to actually object, out loud, to TARP, in Paulson's first 'ambush' presentation of it, and almost walk out of the room. And If it survives the next 6 years or so, I will take a small position in it, just in recognition of that.

Jun 06 02:03 PM

[untrusting ...:]

Ron,

In the long-term, yes you may be right and WFC and the market probably will recover. But in the long-term we are also all dead, and most need income and gains to live in the shorter-term. let alone build capital (as opposed to destroying it).

My questions are:
1) It was obvious to many that the market was headed for a significant turn in Dec/07. Since you claim to be a knowledgable professional and charge for your services, then why is it that you and so many others did not see this? At the very least, one would think you would have at least hedged your bets, which apparently you did not. If you did not, and it appears you did not, then why not?
2) How is your investment performance over the last 1,2,5 years vs. say John Paulson and Paulson and Co.? Your website shows no investment performance at all that I could see, other than a listing of holdings and some commentary. I would bet that your investment performance over the last 1, 2, 5 years is pretty dismal. In a performance business, you are only as good as your results, and please don't give me the comparison to S&P or some other benchmark. All that matter is significant positive performance. Less negative performance means nothing. If athletes and entertainers could make the same arguements that you investment guys make, they would all be making $25/million/year forever. However they get paid for today's performance not some less bad standard. If they don't perform, they are fired very quickly.
3). If I am not mistaken, it has been shown lately that bonds and even Treasuries have in fact outperformed stocks for about the last 40-year period. So what is your justification for not even outperfroming fixed income investments?

So the overall real point is, where is WFC going in the near term (1-6 months). The point being that there is a high probability that for anyone interested in owning WFC, there may well be much cheaper entry points in the relatively near future. What's you prediction on that? That is much more important than saying that WFC is a decent LT hold (assuming one is willing to hold it for 3-10 years).



On Jun 06 12:47 PM RonB wrote:

> One only needs to look at Wells Fargo's net interest margin, the
> doubling of its deposit base from the Wachovia acquisition, the writeoffs
> it has already taken, and the growth in new business to see the benefits
> that will be recognized over the next few years.
>
> Don't let silly articles like this distract you from fundamental
> value. There is nothing wrong with Wells' accounting. The writer
> seems to think that only declines in market value should be booked,
> but not their reversals.
>
> Wells Fargo is the largest holding in my personal and client portfolios.
>
>
> Ron Beasley
> rwbi.net

Jun 06 02:42 PM

[100%:]

The elephant in the room is not accounting tricks, it is the toxic/legacy assets which appear set to be nationalized. If that turns out to be the case, the very disadvantage that this article is talking about turns into an advantage. Imagine a company purchasing another firm that is deep in the red for a pittance, with the understanding that all the red will be made to go away by uncle Timmy, the magician, and his friend Gandalf, a.k.a., Bernanke.

Eyes should be on the legacy asset purchase/divestation/w... plan, err, magic. Accounting tricks form the veil while the magic is performed. I think this nice article and many others like it confirm the veil, which we already see (though the analysis is still nice). A better article would have calculated the value of the banks assuming the magic would value the toxic assets at X cents on the dollar, as X is varied. Then everyone could think of the odds for each X and place their bets.

It is unfair, it is fleecing, yes. But be practical. A short-side argument for banks that discards the possible impact of the magic is lacking, IMO. I do not mean to endorse any of the mentioned banks at their current prices, since we have already seen some run-ups. But, IMO, one should be ready for a run-up while being wary of the downside. It could happen in the short term. Again, eyes on the magic.

Jun 06 03:44 PM

[frosty:]

This is deplorable. The banks have looted, even reposessed the homes of America, thrown their and others' workers out onto the street, taken billions in bonuses out of tax revenues, and then they also get to lie about their income and balance sheets. I apologize, following accounting prinicples can't be lying. As far as the houses go, you have to believe in the sanctity of a contract. Congress does - it's the law and justice is blind. Which means lady justice can't see the little guy at all. Tough luck homeowners, a contract is a contract. Tough luck taxpayers, we have to save our banks (and our bankers!!!) at all costs or else where would we be?

Jun 06 05:27 PM

[Richandre:]

It's fun to hate banks these days, and easy to forget that responsible banker Wells Fargo saved the taxpayers' ass by buying Wachovia. The frantic FDIC's hastily planned shotgun Citi - Wachovia marriage would have been a taxpayer disaster similar to AIG. Regardless, you can bet that those who corral Wells Fargo together with the truly irresponsible banks will refuse to acknowledge it.

Jun 06 09:50 PM

[Larry House:]

When governments intervene and markets are not allowed to work as they should--punishing the weak and rewarding the strong--the problems are pushed further into the future, and the results will be a greater disaster.

Jun 06 11:15 PM

[Griller:]

Learn to use commas.

Jun 06 11:49 PM

[onebir:]

Another positive one-off in Q1: increases in bond prices, which must have boosted profits for banks with big proprietary trading operations (eg GS). In fact that's probably unwound in Q2...

Jun 07 02:33 AM

[buoy:]

WFC...least shananigans in the bunch.

Jun 07 11:17 AM

[atavist.avatar:]

Baseless articles like these, which appear frequently in Seeking Alpha (where do they find these people), just give knowledgeable investors greater profits.

Jun 07 11:28 AM

[ebworthen:]

"Knowledgable investors" were the ones who jumped off buildings in Great Depression 1.

The TARP, TALF, PPIP and the recent rally have all been pushed to prevent a run on the banks.

The banks do not have the money. If we all went to get our money out of our accounts it would not be there because it has been leveraged away and stolen.

It's a confidence game (a con) that works as long as people believe it. The money is gone, we have been robbed, and the bill is being passed onto us and our children. They will need to raise taxes to 60% or a lot of people will have to die.

This kind of bad behavior is what brought about WWII.

If you want to smoke the hookah about the banks not being insolvent - enjoy.


On Jun 07 11:28 AM atavist.avatar wrote:

> Baseless articles like these, which appear frequently in Seeking
> Alpha (where do they find these people), just give knowledgeable
> investors greater profits.

Jun 07 04:45 PM

[PainfullyAware:]

So Much Smoke That I Can Barely See The Mirrors.

Until the "Toxic", "Legacy", "Financial Engineering" stuff gets worked out through maturity or liquidation, none of the Inter Bank Lending will return to previous "Healthy Levels". The Banks And The Populous Still Do Not Know The Exposure.

As with all this "Good News - We Are Not Going Over The Cliff AS FAST" - Yes, Wells Fargo is better positioned than the rest of the field.

Everything is in stasis concerning the banks because we now have "Value As You See Fit" Accounting and a jumble of Tax Payer Sponsored Acronyms. However, When Defaults Occur, Reality Gets The Last Laugh.

Jun 07 05:19 PM

[Poor Dude:]

I have 3 observations related to this article.

One, the vast majority of homeowners I know (all, in fact) are still making their mortgage payments on time and plan to continue to do so regardless of what "the market" thinks their home is worth. They're not planning on selling, so why should they care what anyone thinks it's worth? (Hence the logic behind valuing "held-to-maturity" loans at their discounted cash flow values in lieu of some arbitrary market pricing based on what someone thinks the underlying collateral might be worth in a forced fire sale.)

Two, even in a depressed real estate market and weak economy like we currently have, how could anyone in their right mind even throw around numbers like 15 cents on the dollar (which I've seen tossed around repeatedly as the "true" value of those MBS)? Even in the hardest hit areas where there was the most serious speculation and "bubbling" of real estate prices, values are still holding at 50 to 70 percent of the "peak" prices. To arrive at the conclusion that a bundle of mortgages is worth only 15 cents on the dollar, you'd have to be assuming not only a 100-percent default rate (meaning that every single homeowner in America stops paying and gets tossed into the streets homeless) --- AND that real estate values will fall another 80 to 90 percent from their current levels. In such a scenario, there would be no mortgage market at all, no banks at all, and no government at all. So those wanting to hurt the banks and pick up their assets on the cheap need to at least enter the real universe. In our current situation, a 100 percent default rate would put the value of MBS at 50 to 70 cents on the dollar. And we're not headed anywhere NEAR a 100-percent default rate, which means their value is easily somewhere FAR north of that 50 to 70 cents. Probably closer to 90 or 95 percent, I'd guess. And even if you're holding the lowest tranch and you eat nothing but 100 percent of the foreclosures, you should still net out that 50 to 70 cents on the dollar (or better).

And three, most of those so-called "worthless" banks that reported profits last quarter may or may not have realized those profits as a result of accounting nuances (but aren't ALL profits nothing more than an accounting phenomenom anyways?). But I'd advise anyone shorting banks these days to remember that nearly all of the heavy prior losses were the result of banks being forced to value their assets at prices rendered in an illiquid and crazy short-term market that froze up when sellers demanded 90 cents and buyers offered only 15 cents (no wonder the market froze up!). That and a complete loss of confidence in our financial markets, which has largely been restored. But here's the key to the future of our banks: beginning with the second quarter, they will now be allowed to disregard those insane prices and apply more realistic values to their assets. Accordingly, I fully expect that a large chunk of those prior "losses" will now be reversed and start showing up as additional and unanticipated profits in the coming quarters. It's probably no small wonder that Citi felt safe in not adding quite so much to their loan loss reserves in Q1. To be sure, there is more pain coming in credit card debt and possibly commercial real estate. But to the extent that those and other assets may have been over-reserved by force under the old MtM accounting rules, those unreal "losses" can now suddenly become very real "profits".

The bottom line is that I think there are some big banks out there that right now offer long term investors the buying opportunity of a lifetime (with Citi and BofA heading that list). WFC and some of the others have already recovered to close to their pre-crisis levels, so I don't think they represent quite the bargain that the more beaten down names do, but that's just mho. And judging from the success of their recent capital offerings, I am apparently not alone in my thinking.

Jun 07 09:35 PM

[Tack:]

Instead of trying to assess artificially-created and manipulated mark-to-market asset values, every potential buyer of securities in the financial sector should be focused on only two words: cash flow.

Jun 07 11:34 PM

[Poor Dude:]

Funny that you should say that, Tack. One of the executives at General Dynamics told me years ago that their company doesn't really put too much emphasis on "profit", since that's a number they can make to be anything they want it to be. When it came to measuring the success of their managers, they were focused almost exclusively on cash flow. And the more positive that number, the better they viewed the performance of their managers.


At the time, I was a little perplexed by what he was telling me. But now, I understand!

Jun 08 12:12 AM

[Poor Dude:]

And mind you, that's not to say that cash flow can't also be manipulated to a large extent if the company's management so desires. Because it can. It's just that it is less frequently manipulated because fewer people are paying attention. And that's why it's always important to read the footnotes in all those annual reports. Buried in the small print, on page 87.

Once you've read enough annual reports, you can start to pick up on patterns. To see manipulation of the numbers. The company spent the last 3 years writing off every cent of its intangibles and reporting huge losses, while generating positive cash flow in each and every year? (All the while exponentially increasing the stock option grants to their executives because their price had declined so dramatically and they had to pay out the same equivalent value in order to retain the best talent - LOL!.)

But they've now run out of things to "write off"?

The company which is hiding unreported profits in their overseas subsidiaries?

The company which has made a judgemental adjustment to reduce the value of their deferred tax assets by 90 to 95 percent, although they state that they expect to eventually realize the full value of those assets?

That's a company which is about to soar. The "always-sought-after" ten-bagger!

Jun 08 12:31 AM

[greedcanbgood:]

"accounting shananigans" Such an intelligent, well thought out research term.

Come on people! Do your own due diligence. Everyone has a "the sky is falling" pet theory that takes pieces of an extraordinarily complex mechanisim and assembles them together to fit said theory.

I'm just waiting for the article that connects all this with the end of the world in 2012.

Jun 08 10:41 AM

[Consumer Pr...:]

The U.S. Government agreed to guarantee many of the toxic assets in banks' portfolios. Will the government require that those guarantees be removed as one of the conditions pursuant to the banks' TARP repayments?

Jun 08 01:17 PM