Never more so, in fact, than as the wave of first-quarter bank earnings rolls in. At first,
the stock market was bedazzled by the gains being posted during what was supposed to have been the darkest days ever seen
in the history of finance. But the legerdemain that produced those numbers is no longer impressing the stock market.
As our colleague, Alan Abelson, wrote in the print edition of Up & Down Wall Street this week, it appears banks were beneficiaries of the travails of none other than American International Group (ticker: AIG.)
As AIG looked to hit up Uncle Sam for more money, it decided to close out billions of credit
default swaps on exceptionally generous terms to the counterparties. The latter would include the biggest names on Wall Street
and the City of London, who got to book outsized profits. But the market is belatedly coming to the realization that this
windfall is unlikely to be repeated, so there's less to the first-quarter results than meets the eye.
Yet even stranger is positive effect felt by the likes of Citigroup (C) and others from the flip side. Just as banks get a boost from the write-up of their assets, they get a fillip
from the write-down of their liabilities.
Such is the unintended, Alice-in-Wonderland effect of mark-to-market accounting.
Dick Bove, the dean of bank analysts, now with Rochdale Securities, explains how mark-to-market
accounting can thoroughly distort profits. To wit:
"Bank A sees the quality of its debt deteriorate. That means, under mark-to-market accounting,
that it is able to buy the liabilities back at a discount and report a big profit.
"Bank B sees the quality of its debt improve. That means it is not able to purchase its debt
at a discount because its debt has risen in price and this results in a big loss.
"In sum, the bank with weakening quality reports a profit and the bank with improving quality
reports a loss. This, of course, makes no sense."
Citi fell into the former category and benefited. Conversely, Morgan Stanley (MS) had the misfortune of seeing its credit strengthen, so it reported weaker-than-expected earnings Wednesday and
slashed its dividend to shore up its capital position.
Bove contends that everybody was all for mark-to-market accounting when it punished the banks
when it artificially depressed its assets. Now that it is artificially reducing the value of banks' liabilities, mark-to-market
accounting is being criticized for inflating banks' profits.
It's a "lose-lose" situation for banks, he concludes, and may now be eliminated, he says.
That may be an exaggeration, but Bove is unequivocally correct when he points out mark-to-market
accounting obscures the cash flowing through the banking system. That is, how much banks are earning on the loans they make
relative to how much they have to pay on the deposits they take in. Stuff a simple guy like me can grasp.
On that score, the numbers are simply awful. Capital One (COF) Wednesday fell 8.4% after conceding its loan-loss estimates for 2009 were too low. The major issuer of credit
cards reported a first-quarter loss of $112 million after adding $124 million to its loan-loss reserves.
That follows earlier news from Bank of America (BAC), which reported blow-out overall earnings but admitted to deteriorating credit fundamentals -- about as stark
an example of the upside-down bank reporting there's been this quarter.
To cite another cliché, Abraham Lincoln said, "You can fool some of the people all of the
time, and all of the people some of the time, but you cannot fool all of the people all of the time."
The surge in first quarter earnings fooled only some of the people and only for a short time.
The big banks have to confront the conundrum that their best consumer customers are embracing
the new frugality and are paying down their credit cards as fast as they can. Getting out from under 18% or higher interest
charges is absolutely the best investment American households can make, but it deprives banks with their most profitable business.
Conversely, the banks' strapped customers are defaulting in soaring numbers, resulting in
mounting losses. Even if banks charge 18% or more, they're losing more than that when borrowers lose jobs and can't repay.
So banks are reacting by cutting credit lines, further crimping consumers.
Meanwhile, Washington is leaning on banks for their consumer-unfriendly practices of jacking
up interest rates on folks when they're reeling from falling employment, incomes and house values. The government has even
more to say to the banks now that they're wards of the state.
All that's pretty simple and straightforward, unlike the three-card-monte effect of mark-to-market
accounting on banks' profits.
Given that banks have led the stock market's advance since early March, you've got to wonder
about their leadership abilities from here.
