I love it. I mean, I really and truly love it.
People always want to believe the best. It’s part of our human nature. It’s probably wired into our DNA as Americans.
So when Vikram Pandit wrote a memo last month stating that during January and February, Citigroup had $10.9 billion of operating profit for two months, people believed his message.
That message was clear: The banks are healthy.
And we bought it: hook, line, and sinker.
We starting putting more money into financials. We sent Citigroup up over 300 percent. We sent Bank of America up over 300 percent.
But did those banks really get 300 percent better?
Let’s take a look at my personal favorite Citigroup, the reason why we are in this bear rally.
Citigroup announced that it had posted a profit of $1.6 billion. Sounds good doesn’t it? But let’s take a look further.
That $1.6 billion was earnings before preferred payments. To be clear, earnings are usually reported after preferred payments are paid off. But it was convenient to state Citigroup earnings before preferred payments, because it feeds the message: the banks are healthy.
So how much money did Citigroup really make last quarter?
The answer is nothing. Zip, zero, zilch.
In fact, Citigroup lost almost $1 billion.
A billion dollars. Have we lost all sense of reality when losing a billion dollars is good news?
Apparently so, but let’s dig a little deeper. Maybe Citigroup has a long term sustainable business model that was responsible for its so-called “profit.”
Based upon Citigroup’s quarterly report, they adopted a recent Financial Accounting Standards Board (FASB) rule change regarding fair valuation (FAS 157) and other than temporary impairments (FAS 115).
The effects of these rules in plain English is that if Citigroup’s debt drops in value (normally a bad thing), then the company can book that drop as a gain.
The reasoning behind this is that a company could buy back its own debt at a discount, which under accepted accounting practices would be booked as a profit.
However, Citigroup didn’t buy back its debt, but under FAS 157 it can book a profit on the value of its declining debt. For the first quarter of 2009, that meant a $2.7 billion boost in revenue.
What a great business model. Let’s decrease the value of our debt and book a whole bunch of profits. Sounds like a winner.
With that type of accounting, other banks soared as well.
Bank of America took advantage of the repeal of mark-to-market rules to the tune of $2.2 billion, due to Merrill Lynch's credit spreads blowing out.
In case you are unfamiliar with widening credit spreads, they are a bad thing. But again, new accounting rules allow companies to book widening credit spreads as income, since in theory the company could purchase the debt back at a discount.
In Bank of America’s defense they did post a $4.2 billion profit last quarter, much more than the $2.2 billion that they took from widening credit spreads.
So let’s take a look at where the rest of the profit came from.
Earlier this quarter, Bank of America sold its stake in China Construction Bank, netting them $1.9 billion in pre-tax income.
Add that up to the $2.2 billion that it made off of widening credit spreads, you basically have the entire quarter’s earnings.
But if the entire quarter’s earnings came from changes in accounting and a one time sale, does that mean that Bank of America can keep this up for every quarter this year?
Unless Bank of America wants to sell a new unit every quarter, some of its other divisions are going to have to turn profitable or return fewer losses.
However, Bank of America’s net charge-offs increased to 2.85 percent, up from just 1.25 percent a year ago. Credit card losses as a percentage of receivables were at 8.62 percent, up from 5.19 percent a year ago.
I could go on but you get the picture: the banks are not healthy.
But human nature tells us something different. It tells us that we should believe Vikram Pandit and Ken Lewis when they tell us everything is okay.
Investors want to believe that the stock market is going up and that the recession is over.
Wouldn’t that be great!
However, I find it tough to believe that Obama solved the country’s financial crisis with the stroke of a check just three months in office.
If he did, God bless him.
Unfortunately, I know better. You cannot borrow your way out of debt, and spend your way to prosperity.
It won’t work for the banks and it won’t work for our country.
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