How Much of Banks' Earnings
Are Real?
Thomas Tan
May 5, 2009
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:
- 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.
- 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.
- 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.
- 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.
- 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
a 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."
- Switching to calendar year
reporting. The best award for accounting abuse, however, goes
to Goldman Sachs. But switching to a 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.
- Using credit default swap
(CDS) to book earnings. In one of my old articles 'Why
Wall St. Needed CDS?' here,
[pdf] 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 of 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 a 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 at all.
May 4, 2009
Thomas Tan, CFA, MBA
email: thomast2@optonline.net
www.investorwalk.com
 Disclaimer: The contents of this
article represent the opinion and analysis of Thomas Tan, who
cannot accept responsibility for any trading losses you may incur
as a result of your reliance on this opinion and analysis and
will not be held liable for the consequence of reliance upon any
opinion or statement contained herein or any omission. Individuals
should consult with their broker and personal financial advisors
before engaging in any trading activities. Do your own due diligence
regarding personal investment decisions.
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