Having Trust Issues

by Inya Ivkovic, MA

Nineteen big banks in the U.S. have gone through the Fed- administered financial health tests, some emerging with a passing grade, some with a qualified response, but now all claim to be on the mend. Five of the largest banks returned to profit during the first quarter of this year, after posting record losses just a quarter before. Banks’ fiscal performance was also reflected in their market performance. To illustrate, the KBW Bank Index more than doubled from the first week of March to the first week of May. It seemed that Treasury Secretary Timothy Geithner’s confidence in the 19 banks to withstand worsening economic conditions has been vindicated. But is it really so?

The rebound in the banking sector might be short-lived for a number of reasons. For starters, industry analysts decided not to take the Fed’s stress test at face value, instead putting the banking industry under further scrutiny. So they dug into the banks’ recent quarterly profits and the stress tests and what they found was that the banks’ group photo may have turned out much better because of recent accounting rule changes and because the stress test scenarios were not as dire as Geithner presented them.

The likely reason why the government didn’t design the stress test to reflect truly the direst of dire economic conditions was to give the banks time to earn their way out of the crisis. But if the banks are still weak, despite passing the stress test, they will remain reluctant to lend, and that is some monkey wrench to be thrown into President Obama’s efforts to steer the country out of the Great Recession.

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For example, for the recent quarter, Citigroup reported net earnings of $1.6 billion. However, if more conservative accounting rules had been applied, most of that profit would simply vanish. On Bloomberg.com, Martin Weiss of Weiss Research Group went so far as to say that, “The big banks’ profits were totally bogus. The new accounting rules, the stress test: They’re all part of a major effort to put lipstick on a pig.”

So, what is the worst-case scenario? Simply put, if loans held on banks’ books continue to deteriorate, eventually no amount of easing the accounting rules will prevent having to recognize them on banks’ books as losses. For now, banks are allowed to ignore those losses and, coupled with stress test scenarios effectively underestimating how bad things could actually go with the economy, it sure sounds like a recipe for disaster.

In case you are wondering what’s going on with accounting rules, on April 2 this year, the Financial Accounting Standards Board gave companies more maneuvering space when calculating the fair value of their assets. The reason these have changed was because of the applied pressure from the government to relax the old mark-to-market rules, which many considered as only perpetuating the financial crisis.

In addition to fair value calculations, other rules have changed as well, such as recognizing losses on some debt securities on the balance sheet without actually having to count them as write-downs on the income statement, thus not adversely impacting the earnings. The plan is to hold out until those debt securities mature and just get them off the books without them ever really hurting the bottom line.

And while all of these beautification efforts by the government and their accountants are resulting in the banks looking pretty in the group photo, the overall economy is getting uglier and uglier. The way out of this depressing recession is to deleverage, to get rid of toxic assets once and for all, and to free lenders finally to start providing consumers and businesses with new, healthy money. Only with clean books can the true recovery begin.