The Newest Ruse: Banks Capitalizing on “Toxic Assets” to Book Puffed-Up Profits
By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report
Remember the infamous leaked Vikram S. Pandit memo we wrote to you about awhile back that suddenly saw Citigroup Inc. (NYSE: C) turn a profit on nothing more than vapors?
Stay tuned: We’re about to see more of these puffed-up profits. JPMorgan Chase & Co. (NYSE: JPM), Bank of America Corp. (NYSE: BAC) and PNC Financial Services Inc. (NYSE: PNC) will reportedly be booking as much as $56 billion in windfall profits using similar financial chicanery in the months ahead.
Sadly, millions of investors will likely interpret this as a sign that the U.S. financial sector is once again a viable “profit” play – when the reality is that Wall Street hasn’t learned a single darned thing from the financial crisis and is up to its old tricks once again.
This time around, the biggest U.S. banks – including JPMorgan, BofA, and PNC – will employ an obscure accounting rule to magically transform the “toxic debt” that they obtained from such “zombie banks” as Wachovia Corp., Countrywide Financial Corp., National City Corp., and Washington Mutual Inc. (OTC: WAMUQ) into actual income.
Yes, you heard me correctly – income. It makes me furious. This is kind of a corporate accounting version of “the dog ate my homework.” Only this time around, the joke is on us – the taxpayers – since we’re the ones who are bailing these bozos out.
Called “accretable yield,” these mega banks will book income on loans that have “reduced credit quality” by recognizing – hang with me on this one, it’s tough to believe – the value of the bonds on their balance sheets and the cash flow those securities are expected to earn. Please understand, we’re not talking about cash that’s already been earned, and not cash in the bank … we’re talking about cash flow those banks are expected to earn.
Talk about making a silk purse out of a sow’s ear. This is an obscene abuse of the accounting system – whether it’s legal or not. No wonder nobody ever went broke using accrual accounting. These guys need to be forced to recognize the money they have actually earned – not the amount they can account for using clever financial trickery.
To understand just how absurd this actually is, let’s take a close look at JPMorgan Chase – which alone reportedly stands to reap as much as $29 billion in windfall income. It started when JPMorgan literally bought WaMu from the dumpster (technically acting as something called “the receiver”) last year for $1.9 billion, and was allowed to mark the toxic debt that came with it down to “fair value” – which was 25% less than the $118.2 billion it was officially carried on the books for, or $88.65 billion. But now, the bank says that those same debts may appreciate by some $29.1 billion over the life of the loans. That’s before taxes and expenses, of course.
According to Financial Accounting Standards Board (FASB) rules, buyers such as JP Morgan Chase carry these loans on their books at fair value. Then, as borrowers repay those loans they are allowed to book profits. Therefore, by keeping the value of the loans low, the profits on such a small base are obviously king-sized.
The incentive, as I noted when I reviewed a similar tax loophole regarding BofA’s Countrywide Financial purchase back in February, is to write down the value of the loans so aggressively that they are practically worthless. That way, when the buyer folds them into its business, the returns are huge.
JPMorgan’s spokesman, Thomas Kelly, told Bloomberg News that “the accretion is driven by prevailing interest rates.” That said, JPMorgan said first quarter gains from the WaMu loans resulted in $1.26 billion in interest income and made it possible for the bank to reap additional potential income of $29.1 billion.
The other factor that’s not being talked about – at least openly – is the impact that an economic turnaround could have. You see, the eroding economy contributed to the erosion in the value of the securities. Conversely, when U.S. economic activity picks back up, we could see an accompanying improvement in the value of these securities being carried on the company’s balance sheet.
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In an April 22 interview with Bloomberg, Wells Fargo & Co. (NYSE: WFC) Chief Executive Officer Howard I. Atkins said that “to the extent that the customers’ experience is better or we can modify the loans, and the loans become more current, that could help recapture some of the write-down.”
That will lead to massive “profits.”
In other words, if the government is successful in reducing mortgage rates and the housing markets stabilize, the banks get to make up entirely new numbers and “bring more of [the loans] current” which is bank speak for being able to assign whatever brand new values they can to the very same toxic slime these same banks wrote down only months ago during the purchasing process.
Naturally – and I think you can see where I’m going with this – the more these guys wrote down these securities as part of the acquisition process, the higher they can write them “up” in the months ahead – and the more powerful the “profit” surge we’ll see.
Not surprisingly, JPMorgan wouldn’t comment when I called – nor would any of the other big banks – so it’s especially difficult to get to the bottom of exactly when this will come to a head and how much of an outsized “manufactured” profit we could be looking at.
But we can guess as to their motivation:
- First, the banking industry remains in a state of chaos. Despite widespread attempts to calm things down, the banks don’t trust each other and the public trusts them even less. So profits – whether illusory or not – would go a long way to reestablishing some sense of the ordinary.
- Second, to the degree that the banks remain on the federal dole and their balance sheets a wreck, the ability to add new earnings is a lifesaver. Not only does this practice give them the ability to smooth out earnings, but it also arguably makes their stock more attractive because of the apparent “growth” potential that exists going forward. Never mind that the growth is nothing more than a paper shuffling and some fancy accounting; under FASB regs, this practice is completely legal.
- Third, because newly accreted earnings will flow directly to income and the banks have stockpiled a huge war chest of write-downs, financial institutions maintain a substantial buffer that can be used at their discretion whenever they need to goose their earnings. One brokerage house chief financial officer told me privately years ago that it was his goal to maintain enough of a buffer that he could swing earnings by as much as 10% in any given quarter – depending on what the company “needed.”
Now for the trillion-dollar question: What can we do about this?
Sadly, when it comes to changing the legally approved accounting nonsense component, the answer right now is “not much.”
While an investor wanting to capture this “growth” could buy shares in the banks or in any one of a half a dozen financial exchange-traded funds (ETFs), I think a better choice is to buy LEAP options on each of the banks. Not only are long-term options frequently mis-priced, but the risks for any investor buying them are strictly limited to the capital used to buy them and the returns can be proportionately higher for options buyers than for the straight-stock alternatives available at the moment.
And those profits are real enough for me – even without accretion.
[Editor's Note: Thirteen trades. All profitable. Since launching his Geiger Index trading service late last year, Money Morning Investment Director Keith Fitz-Gerald is a perfect 13 for 13, meaning he's closed every single one of his trades at a profit. And he did this in the face of one of the most-volatile periods since the Great Depression. Fitz-Gerald says the ongoing financial crisis has changed the investing game forever, and has created a completely new set of rules that investors must understand to survive and profit in this new era. Check out our latest insights on these new rules, this new market environment, and this new service, the Geiger Index.]
News and Related Story Links:
- Money Morning Market Commentary:
Citigroup Stock Drama: Capitalist Conspiracy or Pursuit of Profits? - Money Morning News Analysis:
Citi Reports Profit, But Some Analysts Advise Further Caution on Big Banks. - Money Morning Special Investment Report:
Money Morning’s Bank Stress Test Says These Three Banks Are the Strongest. - InvestorWords.com:
Income. - Bloomberg News:
JPMorgan’s WaMu Windfall Turns Bad Loans Into Income. - Wikipedia:
Comparison of Cash Accounting and Accrual Accounting. - Money Morning News:
JPMorgan Chase Biggest U.S. Bank With Its Purchase of Failed WaMu. - Telegraph.com:
Q&A about Toxic Debt. - Money Morning Market Analysis:
Shareholders 1, Subprimes 0: Ailing Countrywide Gets “Countryfried” for Expensive Ski Junket. - Investopedia:
Write-Downs. - WikInvest:
LEAP Option.
Comment by Barbara R on 2 June 2009:
One thing we could do would be to require all companies to use an accounting system that only allows for actual money earned, taken in and spent. If the accounting system allowed by law would NOT allow anticipated profits, income, etc., but only what is ACTUALLY there, then we might get back to how business worked when people actually behaved honestly and accepted responsibility for their actions. Novel approach, huh?
Comment by lYNN sTEVENSON on 2 June 2009:
WAhy dpesn’t pir congressmen see throughh this?hink all Federal mony shpould be pilled back from the banks and they should be held to True accounting.
Pingback by Accretable Yield – Tuesday’s Term Of The Week on 2 June 2009:
[...] give you an even clearer idea, here’s Money Morning’s Keith Fitz-Gerald on the [...]
Comment by Joseph Hollow on 3 June 2009:
RE: “Newest Bank Ruse”
If you are going to write fiery acusatory articles on financial issues, and you don’t want to sound like Greta:
You really ought to learn the difference between the “Asset & Liability” side of the financial statement vs the “Income & Expense” side. While you’re at it try to understand why “mark to market” was often a misleading process and was killing financial companies. It was a bookkeeping standard that meant well but needed to be modified.
FYI “Profits” aren’t realized until the asset is sold (or liquidated) and the value is then moved from A & L to the Profit (or Loss) side. Re-valuing a loan (or a loan backed security) held as an asset on a corporate balance sheet (some were historically “current” and unjustafiably marked down via mark-to-market) does not appear as a profit or a loss.
Furthermore, please stop refering to the so-called “Bank Bailout” as if the bank officers or shareholders are in a position to benefit. The government recieves quarterly interest payments on preferred stock issued to secure the temporary monetary infusions, to which you refer, some of which were unsolicited and unwanted. Will community organizers of “The Left” let the banks repay said “bailout” immediately as they seem to want to do? BTW, the current dividend yield is in excess of 5.5%, which is far in excess of any ROI available in the market place.
How does this look compared to GM? What will the taxpayer get for their Billions going to ACORN type organizations.
Also, FYI: Banks don’t create money and they don’t set interest rates outside of a competitive environment that is ultimately government regulated. Banks charge fees for service and lend money on a spread based, once-upon-a-time on risk. Blaming banks for government mismanagement of the economy is a hoary left-wing cannard. [Edited by Money Morning Admin to fit Money Morning language guidelines. June 4, 4:05 pm]
Comment by Steve on 3 June 2009:
Joseph Hollow, your critique of this article is spot-on. The fact that this article is by it’s own admittance is based on conjecture (”Stay tuned: We’re about to see more of these puffed-up profits.”) makes it even more ludicrous.
“Not surprisingly, JPMorgan wouldn’t comment when I called – nor would any of the other big banks.” No, that’s not surprising at all. Why would they humor you?
Comment by Jonathan Goldstein on 4 June 2009:
It would appear that neither you (Steve) nor Mr. Hollow actually understand what you read. Both JP Morgan’s spokesperson and Well’s CEO commented on the record that this was precisely what they intended to do. There’s no conjecture about it. As for the notion that bank officers didn’t benefit, get serious. Many laughed all the way to their tax payer funded walking papers after having driven shareholders straight into the ground. Maybe you worked for a bank and are trying to clear your conscience….
Comment by Barbara R on 4 June 2009:
Jonathan Goldstein – I don’t think many here are saying that bank officers didn’t benefit outrageously from this system. THE PROBLEM IS THAT THE MEDIA IS LETTING THE GOVERNMENT AND ITS OFFICIALS CALL THE SHOTS ON WHERE TO PLACE THE BLAME AND NOT FOCUSING ON THE GOVERNMENT’S ROLE IN THIS FIASCO. THE POLITICIANS WERE IN BED WITH THOSE BANK EXECUTIVES AND HAVE NOT BEEN HELD ACCOUNTABLE BY ANYBODY! The politicians talk about fixing the system but to do that it would start with Washington. Outlawing lobbying and somehow keeping campaign donations to a ridiculously low level so that no group or individual has outside influence would help. I see no difference between the following: an individual working for a company taking bids on a contract and that individual keeps money from a company bidding on the contract but the contract goes to another company – it is still taking a bribe (undue influence). How does that differ from a politician taking campaign money and/or lobbying money from a company in considering how to vote a certain way. Even if they don’t vote on a particular bill to favor the company, at some point that money influences their behaviour. There is plenty of it to go around for both parties. Republicans in getting rid of Glass Steagall and the uptick rule were influenced by Wall Street and Banks; Democrats in failing to regulate Fannie Mae and Freddie Mac, putting them into conservatorship and not receivership with OUR TAXPAYER MONEY and never mentioning Franklin Raines when talking about clawbacks. Both are guilty. There should be a law passed that states no taxes will be raised until the executives of any company (CEO, CFO, COO) receiving taxpayer help pay back all bonuses received in 2007 and 2008 AND all politicians receiving campaign donations and lobbying money in 2007 and 2008 from those companies must pay it back as well. They should all have liens against their houses and bank accounts until they do so. Where is the media in all this? Why aren’t they doing their job? The focus has been on bank executives but NOT on Fannie Mae and Freddie Mac executives nor on the politicians. It is hypocrisy of the first order when Dodd, Franks and Obama demand bank executives pay back their bonus money and executives who came late (2009) to these banks to clean up the situation are being told to have their salaries capped but Dodd, Franks and Obama are not being asked to return their lobbying largesse and campaign donations from Fannie Mae who we bailed out with taxpayer money. These men were the #1, 7 and 3 recipients of Fannie Mae lobbying money and Franklin Raines was Obama’s #1 campaign donor. I have a real issue with the WHOLE focus being on bank executives and NONE on politicians who failed in their job to regulate and deal with this situation and who tried to make our financial system a welfare state giving money to people who didn’t qualify and couldn’t pay back loans so they could buy a house. A house is a privilege not a right. An individual can always rent. I think Republicans like Eric Cantor who got money from AIG should be required to return it as well under the same circumstances outlined above. I am sick and tired of the politicians who had a big hand in this crisis determing the conversation and the media NOT DOING ITS JOB by saying so.
Comment by Jonathan Goldstein on 4 June 2009:
To Barbara – Yup…and well said. I find it interesting that neither party (and both clearly had a hand in being asleep at the switch here through several generations of politicians) has done any kind of self examination. They’ve been asleep at the switch for all of this and have taken countless dollars that would be a conflict of interest under even the most generous of circumstances. It sure would be funny to see the citizen sitting up on the dias and grilling the politicos on CSPAN…can you imagine???!!! Now that would be entertainment.
Pingback by JPMorgan, Goldman Sachs Profit Surge is an Accounting Mirage, Not a Sustainable Sector Trend on 17 July 2009:
[...] To the contrary, many analysts – including Money Morning Investment Director Keith Fitz-Gerald – say these profits are merely a mirage created by an obscure accounting rule that allows banks to transform “toxic debt” on their balance …. [...]