Profit on an Accounting Mirage

More investment banks are reporting windfall profits for the second quarter. That’s helped fuel advances in US and global stocks. Having said that these decidedly positive developments don’t necessarily indicate better days have arrived for the US banking sector.

I say these profits are merely a mirage created by an obscure accounting rule that allows banks to transform ‘toxic debt’ on their balance sheets into income. Also, the benefits of less competition, and favourable interest rates. Indeed, the Financial Accounting Standards Board has made it possible for the biggest US banks to book profits on loans that have not been fully repaid.

Banks will book income on loans that have ‘reduced credit quality’ by recognizing the value of the bonds on their balance sheets and the cash flow those securities are expected to earn.

In JP Morgan’s case, the firm took on $118.2 billion in toxic debt when it acquired Washington Mutual Inc last year. As a receiver of that debt, JP Morgan was allowed to mark that debt down to ‘fair value’, but now the bank says that those same debts may appreciate by some $29 billion over the life of the loans. And as those loans are paid back, that money is booked as profit.

Of course, this distorts banks’ earnings and camouflages the deterioration in other banking segments. Consumer and business loan losses continued to rise. Retail earnings were down sharply. Home equity charge-offs jumped and banks are warning that mortgage losses will continue over the next several quarters. Credit cards losses are highly dependent on unemployment situation – now at 9.5% in June, its highest level in two decades. The banking industry as a whole is getting pounded by rising consumer loan delinquencies, rising mortgage delinquencies, rising commercial real estate losses and more.

If you look no further than the huge divergence between Goldman Sach and CIT Group, you would realize the government is creating a two-class system of banks. Goldman, which received a large shot of TARP money and other supports, has generated a record profit in 2Q thanks to big gains in commodity, interest rates and stock trading.

On the other hand, the large commercial lender CIT was left to twist in the wind. The government refused to allow it to sell backstopped debt via the Temporary Liquidity Guarantee Program. CIT almost tumbled into bankruptcy before a group of bondholders agreed to bail it out with a $3 billion infusion.

Goldman shares have surged 89% and CIT shares have plunged 78% this year. Now that is a divergence!