ANALYSIS:The latitude given firms as to when to recognise losses has given rise to eyebrow-raising results, writes PROINSIAS O'MAHONY
WELLS FARGO, Goldman Sachs, JP Morgan, Citigroup, Bank of America, Morgan Stanley – most of the big guns of the American banking industry have reported earnings over the last fortnight. With the exception of loss-making Morgan Stanley, all have beaten earnings estimates, thereby helping the US bank index more than double from its March nadir.
However, despite superficially pleasing results, accusations of accounting sleight of hand and deterioration in underlying trends mean that analysts remain cautious. This uncertainty was manifested by Bank of America’s reporting of first quarter earnings on Monday. “Bank of America profits roar in first quarter,” one early headline read. “Global markets slide on banking fears,” headlines screamed just hours later, with the bank plunging by 24 per cent and leading the overall banking sector to a one-day fall of 15 per cent.
Despite reporting a better-than-expected profit of $4.25 billion and a doubling in revenue, investors were shaken by the bank’s admission that “credit is bad” and “going to get worse”.
On the other side of the equation, profits were swelled by a number of one-off gains, including $1.9 billion reaped by the sale of part of its stake in China Construction Bank.
The bank’s accounting shenanigans, meanwhile, drew particular ire from Sydney Finkelstein, a professor of management at Dartmouth College. Bank of America last year took over Merrill Lynch and this quarter increased the value of Merrill’s assets to prices higher than Merrill kept them, booking a $2.2 billion gain in the process. “Although perfectly legal, this move is also perfectly delusional, because some day soon these assets will be written down to their fair value, and it won’t be pretty,” Finkelstein said.
Controversial accounting stunts are not the sole preserve of Bank of America. Bank earnings in general look a little “funny”, as Nobel economist Paul Krugman put it. 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 unrealised gain. That turned a $900 million loss into a $1.6 billion gain – a mechanism likened by one analyst to claiming you are richer because the value of your home has dropped.
A fall in the price of JP Morgan’s bonds meant that it too was able to announce stellar profits. Accusations of creative accounting also dog Goldman. Last week saw it blow past expectations in reporting a $1.8 billion quarterly profit. The fact that the firm was recently required to switch to reporting results from a fiscal to a calendar year meant that its fiscal year ended in November while its calendar year first quarter began in January. That made December a so-called orphan month.
As it happened, Goldman booked a pre-tax loss of $1.3 billion in December. Michael Williams of research firm Gradient Analytics noted that firms have a large degree of latitude in deciding when to recognise gains and losses, adding that it seemed “rather remarkable that they ended up with such a large amount of losses in December itself”.
A Goldman spokesman pointed out that “we didn’t make the rules”. Still, by burying the December figures in a table on page 10 of a news release, it certainly didn’t seek to draw attention to the losses.
As for Wells Fargo, accounting changes allegedly helped boost its earnings by as much as $824 million. The fact that it set aside just $4.6 billion for potential loan losses also raised eyebrows. Banking analyst Paul Miller had expected it to set aside $6.25 billion. Miller said that the bank was “under-reserving for expected future losses”, adding that investors should “demand better disclosures”. Sceptics argue that bank earnings may be increasing but fundamentals are deteriorating and that banks still seem unwilling to be transparent.
The unwinding of bets related to AIG reportedly led to windfall gains for the major banks in the first quarter. Profits have been led by huge gains in fixed-income trading, gains that will not be easy to reproduce. Record low mortgage interest rates have led to a refinancing boom although analysts caution that this, too, is unsustainable. Meanwhile, indebted American consumers mean that underlying trends are worsening, as Bank of America’s results indicate. JP Morgan has total consumer loan exposure of $482 billion, slightly above Wells Fargo’s $475 billion.
Banks argue that the scepticism is overdone and that the bounce in share prices reflects a genuine improvement in their fortunes. US treasury secretary Tim Geithner said as much this week, telling Congress that the results of soon-to-be-announced stress tests would show most of America’s top banks are well-capitalised. However, Nouriel Roubini’s description of them as “fudge tests” is shared by many, given that certain economic indicators are already worse than had been projected in the tests. In short, analyst suspicion is unlikely to disappear any time soon. Having been assured of the soundness of company fundamentals on countless occasions over the last 18 months, many simply don’t trust the banks anymore.
