First Brokers, Now Banks: More Fictitious Gains

Yesterday’s surprisingly bad news out of Citibank and then UBS sent us back to the  research archives looking for information about the quality of Banks earnings.

As we  noted last week, much of the Brokers’ gains were fictitious.

It turned out that a decrease in the value of the B/D’s  own debt was offset with a phantom accounting entry. These are presented in the earnings as if they are actual gains, not accounting phantasms.

But don’t think its just the big Brokers. The Banks are now getting in on the scam act:

"Now some banks may be set to similarly benefit from their own misfortune. Financial titans such as Citigroup Inc., Bank of America
Corp., and J.P. Morgan Chase & Co., which will report third-quarter
results next month, all opted earlier this year to start applying
market values to some of their own liabilities, according to the
research service the Analyst’s Accounting Observer.

This means they, too, might see a boost to profit from
declines in the value of their debts during the summer credit crunch.
"It might not be unusual at all to be seeing gains on debt issued
hitting earnings in the third quarter," the Analyst’s Accounting
Observer said.

Officials at Citigroup, J.P. Morgan and Bank of America declined to comment.

The brokers
and banks are doing nothing wrong or improper in booking such gains.
The accounting rules as they stand allow the practice. But some
investors are crying foul, saying the rules shouldn’t have been changed
to allow for such gains . . ."

So much for gains in earnings quality . . .


The Gold at Crunch’s End
How Banks May Benefit From Their Debt Values; ‘The Gains Were Real’
WSJ, September 28, 2007; Page C1

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What's been said:

Discussions found on the web:
  1. blam commented on Oct 2

    I stopped taking earnings statements at face value in the late 90’s. There is really no way to judge the current staye of a business from the reported earnings statement or balance sheet.

    I don’t know how the decline in earnings realiability has impacted the cash flow statement. Cash flow used to be somewhat reliable but off balance sheet accounting vehicles make it impossible to judge at-risk liabilities.

    Caveat emptor.

  2. Justin commented on Oct 2

    Fat chance The Excutive branch, or Congress will do anything about it during an election year. Their MO, is to keep the voter unaware of reality.

  3. UrbanDigs commented on Oct 2

    so are you suggesting more Enron/Worldcom/Tyco style of collapses in the years to come if the quality of earnings is not there?

    What is the side effect of this? You bring up great points, but Im curious to know your opinion on what the ramifications will be?

    It seems stocks are in love with the false sense of hope that comes with transparency given what we went through the past few months. What if this adjustment in earnings occurs for another few quarters and is more widespread than anybody thinks?

    Will stocks just continue to roll on because the companies, CAME OUT WITH IT?

  4. SINGER commented on Oct 2

    TD Banknorth buys CBH… that a strong CAD play???

  5. Philippe commented on Oct 2

    As an example a specialised lender going bankrupt had Golman Sacks and Credit Suisse has largest lender and Société Générale mortgage financing as the smallest with 2 billion dollars outstanding.
    160 specialised lenders have closed their activities.
    Mr Bernanke estimates on the subprime potential default is 100 Billion USD
    Pareto is hovering at 700 Billion USD

    Should the banks statement be so reassuring they would lend to each other (many are rated junks in the interbank lending)
    You may hold the “paper” for a day but the loans are usually of longer tenor.

  6. Dave commented on Oct 2

    Barry, you are making too much of this. All financial reports are taken with a grain of salt, no? When the market reverses they will have to take marks/hits against earnings, or goto jail. The permabulls will then discover the issue and talk down the hits, mirroring what you are doing now. That’s the game.

  7. SPECTRE of Deflation commented on Oct 2

    From Calculated Risk. I guess dancing with the stars ain’t what it used to be Mr. Prince. Here’s hoping he square dances right off a cliff!

    Citi: Music Stops, Prince Visits Confessional

    From MarketWatch: Big write-downs to slash Citi’s quarterly net 60% (hat tip Lyle)

    Citigroup Inc said Monday it expects … huge write-downs for unsold debt it issued to finance corporate takeovers and for big losses on the value of subprime mortgage-backed securities.

    The decline “was driven primarily by weak performance in fixed-income credit-market activities, write-downs in leveraged loan commitments, and increases in consumer-credit costs,” Chairman and Chief Executive Charles Prince said in a statement.

    Earlier Monday, Swiss banking giant UBS said it will take a hit of 4 billion Swiss francs ($3.4 billion) in the third quarter from its subprime mortgage exposure and plans sweeping management changes and job cuts at its investment-banking division.

    Citi sees a write-down of $1.4 billion pretax, net of underwriting fees, on funded and unfunded loans for clients doing leveraged buyouts.

    Citi also cut the value of its mortgage-related positions, as rival Wall Street investment banks did last month.

    It said it expects losses of $1.3 billion pretax, net of hedges, on the value of subprime mortgage-backed securities warehoused for certain securitizations, and $600 million pretax in fixed-income credit trading due to significant market volatility and the disruption of historical pricing relationships.
    I guess the music has stopped.

    “As long as the music is playing, you’ve got to get up and dance. When the music stops, in terms of liquidity, things will be complicated.”
    Chairman and Chief Executive Charles Prince, July 2007

  8. Aaron commented on Oct 2

    I wouldn’t term the GS earnings from last week as low quality. I find it very strange though that Goldman actually traded down on the day of their report and Bear closed higher, though Goldman blew out the numbers and Bear was far below estimates.

  9. Ben Bittrolff commented on Oct 2

    Hey, I have a brilliant NEW idea: Lets setup a fancy financial company and issue lots of debt. We then squander the debt by lending to unqaulified people that can’t possibly pay it back. BUT we use Level 3 and Level 2 accounting to Mark to Make Belief and Mark To Model. We can than also record the declining value of our own debt (as Bond holders flee in panic) as even more gains. Then we wait for the short bus to pull up and let the Bulltards come in bid up our shares…

    Oh wait, never mind.


  10. Justin commented on Oct 2

    Off Topic: I just saw where the Itailian “FED” is asking banks to show their “off balance sheet books.” Can anything be done to have that happen here in the United States of America, land of opertunity and transparency???

  11. Big Al commented on Oct 2

    How is the Bank of New York doing?

  12. John W. commented on Oct 2

    I enjoy “The Big Picture” immensely, being referred initially to you by MI Implode. I’m a 20 year vet of the mortgage biz so I’ve seen the ups (01-06) and downs (89, 91-94, 06 to present).

    What I believe will be a huge coming scandal is the impact of banks presenting “negative amortization” as “future income”. Washington Mutual and other banks that specialized in Option ARM loans have been counting the accumulated deferred interest on their mortgages as “future income” – if you have a $100k loan that adds $2k per year to the balance, that loan pay back is now worth $102,000. The problem is that if your loan balance is $102k and your house is worth $90k, the bank is not going to get anything other than a bad asset when it forecloses. With Option ARM rates tied to LIBOR – a rising index whenever the fed cuts rates – many of these loans will not only become un-refinanceable due to values falling but un-payable by their holders at a rate of 8 to 9 percent. That then will turn a “super-bank” with $1b in phantom profits tied to phantom assets into a $1b bailout candidate as the market flips over.

    I believe that a jolt to the housing market and our economy as a whole is on the near horizon. Not just because of this one issue, but a perfect storm of asset devaluation (real estate), currency devaluation (dollar and bond dumping) and hyper inflation beyond our Fed’s control. I hope I’m wrong. If I’m not, we’re in for a bumpy ride to say the least.

    Keep up the good work.

  13. Greg0658 commented on Oct 2

    I believe the Enron Worldcom Tyco HealthSouth etc.. boiled up in 2001 because it was the best time to fess up. Favorable Congress & WH.

    Is this timeslot (14 months to regime change) good to go another round? Blaming it on the naives borrowing to buy houses with cooked income statements? Maybe.

    Your executive cross link matrix prior post is sooooo …. your guess. Who bows out and who takes the reins. Maybe age of board? What is retirement age for super corp execs? Na – positions are way more fluid than that. It’ll go down the way the supercomputers say so, moment by moment. Good move BR on that optic trunk line.

Read this next.

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