In reviewing bank earnings this week, I truly get the sense with a number of institutions that they determine just how much they want or need to outperform analyst expectations and then they figure out how to “manage” the books in order to get there.

This “managed earnings” process can be played for an extended period, but ultimately the earnings – or more importantly “hidden losses” – come out in the wash.

Citigroup played this game yesterday. The NY Times reports, After Year of Losses, Citigroup Finds a Profit. I give the Times credit; they did not report that Citigroup generated a profit, but that they found it. Where did they find it? The Times offers:

Like several other banks that reported surprisingly strong results this week, Citigroup used some creative accounting, all of it legal, to bolster its bottom line at a pivotal moment.

Citi utilized creative accounting supported by the pressure applied by Congress on the FASB. Where is the pressure applied by the SEC and FINRA on behalf of investors? Isn’t it only fair that somebody speaks up for investors? Is the SEC and FINRA in bed with Congress to “play the game?” Let’s move on.

The top rated banking analyst on the street chimes in:

Meredith A. Whitney, a prominent research analyst, said in a recent report that what banks were doing amounted to a “great whitewash.” The industry’s goal — and one that some policy makers share — is to create the impression that banks are stabilizing so private investors will invest in them, minimizing the need for additional taxpayer money, she said.

One accounting tactic banks have used to generate “phantom income” is to mark the value of their debt trading in the market at “current prices.” For example, if Citigroup issued $1 billion in debt at 100 and it is now trading at 80, Citigroup could and does book an increase in “income” of $200 million dollars. No true income is generated because Citi still pays the rate on the debt when it was issued. If the banks want to value debt at current prices, then assets need equal treatment.

The Times reports,

Edward J. Kelly, Citigroup’s financial chief, defended the practice of valuing its bonds at market prices, since it values other investments the same way. The number fluctuates from quarter to quarter. For instance, Citigroup recorded a big loss in the fourth quarter of last year, when the prices of its bonds bounced back.

Kelly’s assertion is inaccurate. The relaxation of the mark-to-market allows Citi and other institutions to mark “so called” impaired assets to market at valuations the bank deems appropriate. If that is a fair process, wouldn’t it also be fair to allow those institutions which own bank debt to also deem the debt as an “impaired asset” and mark it where it deems appropriate? For example, if Citi’s bank debt is trading at 80, but I – as an owner – view that as “impaired,” perhaps I should mark it at 90 for purposes of reporting my income.

As anybody involved in the markets knows, that approach to valuing bank debt for an investor would be palpably absurd. In the same vein, allowing banks to mark their assets at valuations they deem appropriate is equally absurd.

I would propose that bank analysts must now not only review earnings but, given these “games” being played by the banks, the analysts should also grade the integrity of the earnings based upon transparency and quality.

Fool me once, shame on you. Fool me twice, shame on me.


  • elise

    LD I should have read this post first, since it answers some of my questions. Just guessing, but it seems the Stress Tests will be reported only if the results favor the banks which they can fix with creative accounting? Is there anyway to find the truth and inform the public? Forget I asked the last question. That’s probably the dumbest one I’ve ever asked.

  • The same stupid accounting tricks that brought down the likes of Enron and Worldcom. If any stockholders fall for this, they deserve to lose everything. This is just like how GS conveniently changed their fiscal year to avoid December. This is walking the fine line between fraud and an anarchist view of FASB.

    Shame on the FED for not calling them out.

  • Peggy Sue

    I have the sense that the banks and the policy makers are living in la-la land and think all these “private investors” share the same deluded space. With everything we’ve seen and read why would “anyone” invest in a continuing scam? This is exactly what made everything begin to crumble: The Big Lie. This is not the foundation for a sustained recovery, only a wobbly shim before the whole house falls down.

    Look at the language: creative accounting,the great whitewash, create the impression, phantom income, impaired assests . . .

    Ponzi scheme revisted. Or part 2. Bernie Madoff was small potatoes next to this!

    Thanks for the ongoing material, Larry.

    • oowawa

      Ponzi scheme revisted.

      Exactly, Peggy Sue. A Ponzi scheme defers the day of reckoning. As long as new suckers are brought into the scheme to make it look like everything is on a solid foundation, the “business” thrives. But the day of reckoning eventually arrives, at least in theory. It is appalling, however, to see how long Madoff was able to fend off the ultimate accounting. I’m afraid that many banks and others in high finance will also be able to defer Armageddon for a long time. After all, the government is on their side.

  • I’m a Linda too

    Absolutely. And not a surprise about Citi being this is what has gotten them here.

    And of course, Weary Barry is just handing over our tax dollars and burdening us with more debt, he’s not intending or fixing the problems with these financial and housing institutions that got us here.

    You know, this is just another version of what Amex They started of by laying off employees and hiring Contractors to make they were decreasing salaries for the books, share holders and stocks market. But they were increasing costs (under different expenses) and having less Quality work by those employees. They were playiing this game over a decade ago.

    Then they perfected it by bringing in employees from India for American workers to train. They would put them up in hotels, 4-8 to a room and get good first hand training by the American employees, while building Call centers in India, or preparing for more “Contractor” work in India to do the work.

    After they were trained and shipped back to India, it took a little more time, then the remaining American employees, or even the American Contractor jobs went to India.

    Gotta’ love their greed while burdening American’s with loss of work and money but increased tax burden.

    • I’m a Linda too

      Oh and yes, my husband was finally one of them. in 2001 was advised that his job was finally being deleted and turned over to Contractors.

      …it took more time. First was the programmers and developers….Systems Administration usually requires hands on. So they had to get a full team in place to be able to put them on sight.

      Amazing the lenghths they go to, to fudge the books, huh?

  • oowawa

    Larry, it seems that the change in the “mark to market” accounting rules have given the banks a huge illusory windfall, and their subsequent reporting of “profits” have really given the stock market at large a big boost up. Oh well. You note that:

    This “managed earnings” process can be played for an extended period, but ultimately the earnings – or more importantly “hidden losses” – come out in the wash.

    My question is: when do you think this day of reckoning will likely arrive? Do you have a general sense of when the actual concealed damage will “come out in the wash”? How long can they continue the deception? What might trigger the day of reckoning? When might “ultimately” arrive? What kibd of time frame are we looking at here?

    • elise

      I’m not LD, but I remember a story from last week about mall foreclosure. General Growth Properties is going to file Chapter 11. Their income has fallen due to chain stores going out of business. Last month, residential foreclosures increased by a record amount and now commercial property is in trouble. Another state is reporting double digit unemployment, although I don’t remember which one or whether the total number of states is now eleven or twelve. It will be hard to hide the facts for long.

  • Objective Analysis

    Until all these publicly traded companies start showing their STATEMENT OF CASH FLOWS and not manipulated Balance Sheet & Income Statement, you guys will continue to think these companies are sound.

    It is a crock of sh***. They are creating a ponzi scheme like Madoff to give more $ to the federal reserve and Soros gang of thieves.

  • It is these games being played by the banks that will bring down the house. By trying to induce investors, the banks are making fraudulant claims that really fool nobody other than the culpable few who believe in fairy tales.

    As long as Geithner and Bernanke are directing the play don’t expect anything but a “Farce”.

    Liars and thieves who are allowed to operate so blatantly will bring us down as sure as shootin’.

    Transparency? What a laugh. This collusion between Treasury and the banks is a good example of the sleight of hand Obama has been practicing all along.