Fuzzy Math at Citigroup and Bank of America

4 reasons to discount the “good news” about bank earnings

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Is it a new day for the nation’s troubled banks? Or just a false dawn?

Bank of America has given economic optimists reason to celebrate, reporting first quarter earnings of $4.2 billion, or $0.44 per share. That’s a big boost over analyst expectations of about $0.04 per share. It follows Citigroup’s announcement of a $1.6 billion first-quarter profit, also far ahead of analysts’ predictions.

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The two troubled giants have become bellwethers for the entire recession. Citi lost nearly $28 billion in 2008 and has received $50 billion in government aid so far. BofA earned a $4 billion profit in 2008 but lost money in the fourth quarter, and the acquisition of Countrywide Financial and Merrill Lynch is expected to weigh down the bank for months, maybe years. It’s on the hook for $45 billion in taxpayer funds, with CEO Ken Lewis being one of the most endangered corporate chiefs in the nation. The shares of each bank have fallen more than 75 percent over the last year.

A definitive turnaround at the two troubled giants would signal the end of the financial crisis and a major inflection point for the broader economy. Unfortunately, the earnings announcements have produced rampant skepticism. Here’s why:

One-time gains provided a temporary boost. Bank of America, for instance, claimed a $2.2 billion gain due to accounting adjustments related to its Merrill Lynch acquisition in January. “Although perfectly legal,” writes Syd Finkelstein of Dartmouth University’s Tuck School of Business, “this move is also perfectly delusional, because some day soon these assets will be written down to their fair value, and it won't be pretty.” BofA also notched a $1.9 billion gain from selling its stake in a Chinese bank.

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Citigroup claimed a $2.5 billion gain due to a 2007 accounting-rule change – more than its entire first-quarter profit of $1.6 billion. As with BofA, that’s a legitimate claim, but it doesn’t reflect anything about the underlying health of banking operations. And those aren’t in such good shape.

There’s still plenty of bad news ahead. Investors in the financial sector have been bracing for mounting losses at the banks – in addition to huge housing-related writedowns they’ve already incurred – as the recession intensifies and more consumers default on loans. And the earnings reports indicate that’s starting to happen. BofA, for instance, lost $1.77 billion on credit cards – one of its most important businesses – in the first quarter. Citigroup set aside billions in cash to cover bigger expected losses for the year. “In all the banks' results declared so far,” writes Zacks Investment Research analyst Neena Mishra, “we have seen sharp deterioration in credit quality, especially in the housing and credit card portfolios. We anticipate the losses to rise further through the end of [the year.]”

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Much of the banks’ profits come courtesy of the government. In addition to bailout money, most banks are benefiting from the availability of short-term loans from the Federal Reserve at interest rates as low as 0. To earn a profit on that, all they have to do is turn around and lend it out at higher rates – to borrowers able to repay. “If the federal government let me borrow money at 0% interest,” says Finkelstein, “and then lend it out at 4.5% interest, even I could make a profit.”

The “toxic assets” are still there. Recent earnings reveal little about efforts to get billions in money-losing mortgage-backed securities off the banks’ balance sheet – the problem that Treasury Secretary Tim Geithner’s public-private rescue plan is intended to solve. That won’t get rolling in earnest until early summer, and even then, some analysts think several big banks may still need to be nationalized. “Citi and Band of America are the most worrisome,” says Dirk van Dijk, director of research for Zacks, “and also Wells Fargo. We’re looking down the barrel of some serious economic pain here.”

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Anybody who doubts private-sector skeptics should listen closely to what President Obama and his financial lieutenants have been saying. While trying to sound optimistic, Obama also recently compared the underpinnings of the economy to a “pile of sand.” And Geithner – chief administrator of the bank “stress tests” – said that before the economy recovers, “there's going to be a period where it's going to feel very bad still and very uncertain.” Somebody should tell Citi and Bank of America.

Bank of America
  • Rick Newman

    Rick Newman is the author of Rebounders: How Winners Pivot From Setback to Success and the co-author of two other books. Follow him on Twitter or e-mail him at rnewman@usnews.com.

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