Original Link: http://finance.yahoo.com/news/ALL-BUSINESS-Accounting-apf-15191774.html
By Rachel Beck
There's nothing like a little magical math to make banks' financial woes go away.
Bank stocks have surged in recent weeks, a sign that investors are betting the worst of the financial crisis is over. But in reaching this conclusion, the market has chosen to ignore some creative accounting banks are using to bolster their finances.
Lots of fuzzy math was trotted out during the just-ending earnings season to goose profits or narrow losses, and it will show up again as banks look to shore up their capital to meet requirements under the government's "stress tests." The tactics are perfectly legal, but they make the banks look healthier than they really are.
"Investors who have been pleasantly surprised by the recent results could find themselves equally bothered later on when they discover plenty of unpleasant things," said Martin Weiss, who runs the investment firm Weiss Research Inc.
After a year and a half of frightful declines, the Standard & Poor's Financials Index of 80 banks, insurers and investment firms bottomed in early March and has since more than doubled from a 17-year low, according to S&P.
Momentum behind the rally grew in April as large banks began reporting mostly better-than-expected first-quarter results. Earnings for the companies in the S&P Financial Index have come in nearly 11 percent ahead of analysts' estimates.
That could just be the start of turnaround for the banks, said Kent Engelke, chief economic strategist at Capitol Securities Management in Glen Allen, Va. He thinks there is a 25 percent probability that there will be positive economic growth by the end of the second quarter, which will benefit banks' loan portfolios.
"In order to have a healthy economy, we need a healthy banking system," said Engelke, whose investment firm owns bank stocks. "I believe the government will do anything to ensure that will happen."
But the recent strength seen in bank earnings didn't come from significant improvements in their core businesses. Instead, accounting maneuvers helped bolster bottom lines.
Some banks reduced the amount of money they set aside to cover loan losses, which some analysts say conflicts with the reality of deteriorating loan portfolios. That means if the economy doesn't recover and troubled assets continue to rise, in coming quarters banks might have to boost loss reserves again -- which could hurt future earnings.
Wells Fargo saw its non-performing assets as a percentage of total assets jump by 40 percent over the previous quarter, yet it only increased its reserves by 5 percent. So even though more of its loans are past due or face foreclosure, it isn't setting aside significantly more cash to deal with potential losses.
Earnings at several banks also benefited, counterintuitively, because the value of the banks' own debt was reduced to reflect a decline in the market value of that debt.
In accounting-speak, a "credit-value adjustment" allows the banks to book a gain. The logic is that they could buy back the debt for less cash than they received when they issued the debt, so they get to claim a benefit, which many analysts say is illusory.
Say a bank had issued debt at 100 cents on the dollar, and it now trades at 60 cents on the dollar. The bank can mark down the value of the debt on their books to 60 cents on the dollar, and take a gain on the 40-cent difference.
For Citigroup, that debt adjustment totaled $2.5 billion, which helped narrow its losses for the quarter. The New York-based bank posted a first-quarter loss of $966 million, smaller than analysts expected.
"It's not the kind of stuff you'd point to in earnings and say, "now that's sustainable income," said Jack Ciesielski, who writes the newsletter The Analyst's Accounting Observer. "You would want to exclude it from earnings in evaluating how well a company performed."
A separate accounting rule change for valuing banks' assets that are available for sale also helped boost bank earnings. Until recently, they were "marked-to-market," meaning they were adjusted to reflect current market prices. But that has become increasingly difficult during the current financial crisis since there has been no trading of the most troubled assets.
Under pressure from politicians and banks, accounting rulemakers reversed course in early April and gave corporate managers more discretion in valuing assets in cases when markets are frozen.
That helped Wells Fargo cut its unrealized losses on certain securities in half, from $9.9 billion on Dec. 31 to $4.7 billion on March 31. That helped boost profits as a result. San Francisco-based bank reported first-quarter earnings of $2.38 billion compared with a loss of about $3 billion in the final quarter of 2008.
Accounting maneuvers also will play a big role in what happens to banks that failed the government's "stress tests," which were done to gauge which financial institutions need more capital to survive a deeper recession.
When the government invested billions in U.S. banks over the last six months, it received convertible preferred shares. That gave the banks funds for day-to-day needs, but those preferred shares are counted as debt, not as part of "tangible common equity," the government's currently favored tool for assessing the strength of a bank.
If the government converts its preferred shares into common stock, those funds would count as equity capital, making the banks look stronger.
Here's the hitch in that plan: The government would have greater influence since common shareholders have voting rights. The conversion would also dilute the ownership of current stockholders.
One way around this issue would be to convert the government funds into another kind of preferred share that could also be counted as "tangible common equity."
However the bank equity dance plays out, investors don't seem to care about any of the technicalities. They are stuck on the idea of a banking turnaround. They better hope they're right.