The Newest Ruse: Banks Capitalizing on “Toxic
Assets” to Book Puffed-Up Profits
Remember the infamous leaked Vikram S. Pandit memo we wrote to you about awhile
back that suddenly saw Citigroup Inc. (NYSE: C) turn a profit on nothing more than vapors?
Stay tuned: We're about to see more of these puffed-up profits. JPMorgan Chase
& Co. (NYSE: JPM), Bank of America Corp. (NYSE: BAC) and PNC Financial Services Inc. (NYSE: PNC) will
reportedly be booking as much as $56 billion in windfall profits using similar financial chicanery in the months
Sadly, millions of investors will likely interpret this as a sign that the U.S.
financial sector is once again a viable "profit" play - when the reality is that Wall Street hasn't learned a
single darned thing from the financial crisis and is up to its old tricks once again.
This time around, the biggest U.S. banks - including JPMorgan, BofA, and PNC -
will employ an obscure accounting rule to magically transform the "toxic debt" that they obtained from such "zombie
banks" as Wachovia Corp., Countrywide Financial Corp., National City Corp., and Washington Mutual Inc. (OTC: WAMUQ)
into actual income.
Yes, you heard me correctly - income. It makes me furious. This is kind of a
corporate accounting version of "the dog ate my homework." Only this time around, the joke is on us - the taxpayers
- since we're the ones who are bailing these bozos out.
Called "accretable yield," these mega banks will book income on loans that have
"reduced credit quality" by recognizing - hang with me on this one, it's tough to believe - the value of the bonds
on their balance sheets and the cash flow those securities are expected to earn. Please understand, we're not
talking about cash that's already been earned, and not cash in the bank ... we're talking about cash flow those
banks are expected to
Talk about making a silk purse out of a sow's ear. This is
an obscene abuse of
the accounting system - whether it's legal or not. No wonder nobody ever went broke using accrual accounting. These
guys need to be forced to recognize the money they have actually earned - not the amount they
can account for using clever financial trickery.
To understand just how absurd this actually is, let's take a close look at
JPMorgan Chase - which alone reportedly stands to reap as much as $29 billion in windfall income. It started when
JPMorgan literally bought WaMu from the dumpster (technically acting as something called "the receiver") last year
for $1.9 billion, and was allowed to mark the toxic debt that came with it down to "fair value" - which was 25%
less than the $118.2 billion it was officially carried on the books for, or $88.65 billion. But now, the bank
says that those same debts may appreciate by some $29.1 billion over the life of the loans. That's before taxes and
expenses, of course.
According to Financial Accounting Standards Board (FASB) rules, buyers such as JP
Morgan Chase carry these loans on their books at fair value. Then, as borrowers repay those loans they are allowed
to book profits. Therefore, by keeping the value of the loans low, the profits on such a small base are obviously
The incentive, as I noted when I reviewed a similar tax loophole regarding BofA's
Countrywide Financial purchase back in February, is to write down the value of the loans so aggressively that they
are practically worthless. That way, when the buyer folds them into its business, the
returns are huge.
JPMorgan's spokesman, Thomas Kelly,
News that "the accretion is driven by prevailing interest
rates." That said, JPMorgan said first quarter gains from the WaMu loans resulted in $1.26 billion in interest
income and made it possible for the bank to reap additional potential income of $29.1 billion.
The other factor that's not being talked about - at least openly - is the impact
that an economic turnaround could have. You see, the eroding economy contributed to the erosion in the value of the
securities. Conversely, when U.S. economic activity picks back up, we could see an accompanying improvement in the
value of these securities being carried on the company's balance sheet.
In an April 22 interview with Bloomberg, Wells Fargo & Co. (NYSE: WFC)
Chief Executive Officer Howard I. Atkins said that "to the extent that the customers' experience is better or we
can modify the loans,
and the loans become more current, that could help recapture some of the write-down."
That will lead to massive "profits."
Assigning brand new values to
the toxic slime
In other words, if the government is successful in reducing mortgage rates and the
housing markets stabilize, the banks get to make up entirely new numbers and "bring more of [the loans] current"
which is bank speak for being able to assign whatever brand new values they can to the very same toxic slime these
same banks wrote down only months ago during the purchasing process.
Naturally - and I think you can see where I'm going with this - the more these
guys wrote down these securities as part of the acquisition process, the higher they can write them "up" in the
months ahead - and the more powerful the "profit" surge we'll see.
Not surprisingly, JPMorgan wouldn't comment when I called - nor would any of the
other big banks - so it's especially difficult to get to the bottom of exactly when this will come to a head and
how much of an outsized "manufactured" profit we could be looking at.
But we can guess as to their motivation:
- First, the banking industry remains in a state of chaos. Despite widespread
attempts to calm things down, the banks don't trust each other and the public trusts them even less. So profits
- whether illusory or not - would go a long way to reestablishing some sense of the ordinary.
- Second, to the degree that the banks remain on the federal dole and their
balance sheets a wreck, the ability to add new earnings is a lifesaver. Not only does this practice give them
the ability to smooth out earnings, but it also arguably makes their stock more attractive because of the
apparent "growth" potential that exists going forward. Never mind that the growth is nothing more than a paper
shuffling and some fancy accounting; under FASB regs, this practice is completely legal.
- Third, because newly accreted earnings will flow directly to income and the
banks have stockpiled a huge war chest of write-downs, financial institutions maintain a substantial buffer
that can be used at their discretion whenever they need to goose their earnings. One brokerage house chief
financial officer told me privately years ago that it was his goal to maintain enough of a buffer that he could
swing earnings by as much as 10% in any given quarter - depending on what the company
Now for the trillion-dollar question: What can we do about this?
Sadly, when it comes to changing the legally approved accounting nonsense
component, the answer right now is "not much."
While an investor wanting to capture this "growth" could buy shares in the banks
or in any one of a half a dozen financial exchange-traded funds (ETFs), I think a better choice is to buy LEAP
options on each of the banks. Not only are long-term options frequently mis-priced, but the risks for any investor
buying them are strictly limited to the capital used to buy them and the returns can be proportionately higher for
options buyers than for the straight-stock alternatives available at the moment.
And those profits are real enough for me - even without accretion.