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.

LD

Why do these games remind me of our current banking system? The similarities are scary. Let’s access the most recent piece from John Mauldin’s site to “view the games.”

Mauldin’s guest, John Hussman, comments on these various “games” (TALF, PPIP, TARP, FDIC, FASB), in which taxpayers bear the brunt of the risk in the government’s engagement with financial institutions. Hussman writes of the PPIP:

this is a recipe for the insolvency of the FDIC and an attempt to bail out bank bondholders using funds that have not even been allocated by Congress. The whole plan is a bureaucratic abuse of the FDIC’s balance sheet, which exists to protect ordinary depositors, not bank bondholders.

In regard to the FASB’s relaxation of the mark-to-market accounting rule for financial institutions:

the irresponsibly rosy assumptions built into these models have been a large contributor to this near-insolvency, because they virtually ignored foreclosure risks.

Whether via the TALF, PPIP, or FDIC sales, the transferral of toxic assets to private investors will ultimately only have one outcome and that will be :

the public will suffer the losses that would otherwise have been properly taken by the banks’ own bondholders. You can tinker with the accounting rules all you want, and it won’t make the banks solvent. It may improve “reported” earnings for a spell, but as investors who care about the stream of future cash flows that will actually be delivered to us over time, it is clear that modifying the accounting rules doesn’t create value. It simply increases the likelihood that financial institutions will quietly go insolvent. I recognize that the accounting changes may reduce the immediate need for regulatory action, since banks will be able to pad their Tier 1 capital with false hope. But we have done nothing to abate foreclosures, and we are just about to begin a huge reset cycle for Alt-A’s and option-ARMs. As the underlying mortgages go into foreclosure, it will ultimately become impossible to argue that the toxic assets would be worth much even in an “orderly transaction.”

In a slightly different version of the game – and in attempt to attract more players, if not necessarily truly new money – the government is considering allowing the sellers of toxic assets to also be buyers. How does that version of the game work? The sellers (Citi, BofA, JP Morgan, et al):

can put up a few percent of their own money, and swap each other’s toxic assets financed by a bewildered public suddenly bearing more than 90% of the downside risk. The “investors” in this happy “public-private partnership” keep half the upside while ordinary Americans take the downside off of their hands. Some partnership.

The NYC sidewalk games of chance are best played outside so we need to make sure the weather is good. In a similar fashion, for the government’s games to work it helps if the weather, that being the economy, is improving. Well, the difference between partly cloudy and partly sunny is all in how you look at it. In a similar fashion, regarding consumer spending:

analysts have noted that year-over-year consumer spending has only declined very slightly, hailing this as evidence that economic concerns are overblown. The difficulty is that consumer spending has never declined on a year-over-year basis, except in this downturn, so that slight decline is actually the worst showing for consumer spending in the available data.

Games of chance can be fun; however, if an individual is spending money he does not have, the risks grow exponentially. To wit, Hussman summarizes:

I have no idea how long investors will remain enthusiastic about trillion dollar band-aids and eroding the integrity of our accounting rules. I do know that at the end of the day, what matters is the long-term stream of deliverable cash flows that investors can actually expect to reach their hands. It’s exactly that consideration that makes it clear that we will sink deeper into this crisis until we observe debt restructuring on a large scale. If we don’t restructure the debt, the debt will fail, because for many borrowers, the cash flows aren’t there, and it is not possible to service the debt on existing terms.

When my “old man” encouraged me to “hustle” and “take some chances,” I am not so sure this is what he had in mind.

LD

That said, for those involved in global finance, whether you like George Soros or not, you need to know what he is thinking. Why? George Soros can move markets via his own investment strategies. Additionally, there is little doubt that George is the epicenter in a massive flow of market sensitive information.

To that end, Soros gave a stinging indictment of the change in the FASB’s mark-to-market by stating in a Bloomberg interview,

the change to fair-value accounting rules will keep troubled banks in business, stalling a recovery of the U.S. economy.

“This is part of the muddling through scenario where we are going to keep zombie banks alive,” Soros, 78, said today in an interview with Bloomberg Television. “It’s going to sap the energies of the economy.”

Is this statement a self-serving offering by Soros? Who knows? Is it an attempt to further promote the U.S. as a lessened power? Perhaps. That said, there are others, myself included, who believe the relaxation of the mark-to-market, especially for outfits like Freddie Mac, Fannie Mae, and the 12 regional Federal Home Loan Banks (FHLBs) is nothing short of a charade.

Did Soros’ statement have an impact on the market? Not today. The dollar has been improving of late. However, over the longer haul, the cost of having a number of zombie-like banking institutions will be pressure on the dollar along with increased borrowing costs for the zombie institutions or Uncle Sam who will be backing them.

From a personal perspective, would you lend money to a zombie?

And now, here’s a must-watch little treat. Crank up your speakers . . .

LD