“There’s a chance that it might work,” Columbia’s Stiglitz says of the government’s attempt to boost confidence.

TO BE NOTED: From Bloomberg:

"Bank Profits From Accounting Rules Masking Looming Loan Losses

By Yalman Onaran

June 5 (Bloomberg) -- Big banks in the U.S. say they’re on the mend. The five largest were profitable in the first quarter, rebounding from record losses for the industry in the fourth quarter. Share prices have jumped, with the KBW Bank Index doubling since March 6.

Treasury Secretary Timothy Geithner, after “stress testing” 19 banks on their ability to withstand a worsening economy, declared in early May that Americans can be confident in the banks’ stability and resilience. Wells Fargo & Co. and Morgan Stanley were among banks raising $43 billion in new capital since then through share sales.

“With our capital and assets, stressed as they have been, we can go back to focusing all our attention on managing our business and restoring value,” Citigroup Inc. Chief Executive Officer Vikram Pandit said after Geithner’s examinations were completed.

The revival may be short-lived. Analysts who have examined the quarterly profits and government tests say that accounting rule changes and rosy assumptions are making the institutions look healthier than they are.

The government probably wants to win time for the banks, keeping them alive as they struggle to earn their way out of the mess, says economist Joseph Stiglitz of Columbia University in New York. The danger is that weak banks will remain reluctant to lend, hobbling President Barack Obama’s efforts to pull the economy out of recession.

‘Bogus’ Profit

Citigroup’s $1.6 billion in first-quarter profit would vanish if accounting were more stringent, says Martin Weiss of Weiss Research Inc. in Jupiter, Florida. “The big banks’ profits were totally bogus,” says Weiss, whose 38-year-old firm rates financial companies. “The new accounting rules, the stress tests: They’re all part of a major effort to put lipstick on a pig.”

Further deterioration of loans will eventually force banks to recognize losses that their bookkeeping lets them ignore for now, says David Sherman, an accounting professor at Northeastern University in Boston. Janet Tavakoli, president of Tavakoli Structured Finance Inc. in Chicago, says the government stress scenarios underestimate how bad the economy may get.

The accounting rule changes that matter most for the banks came on April 2, when the Financial Accounting Standards Board gave companies greater latitude in how they establish the fair value of assets. Lawmakers, including Representative Paul Kanjorski, a member of the House Financial Services Committee, had complained that existing mark-to-market standards worsened the financial crisis.

Debt Valuation

Along with that change, FASB also let companies recognize losses on the value of some debt securities on their balance sheets without counting the writedowns against earnings. If banks plan to hold the debt until maturity, they can avoid hurting the bottom line.

At Citigroup, the recipient of $346 billion in fresh capital and asset guarantees from the government, about 25 percent of the quarterly net income came thanks to the debt securities rule change, the bank said.

Another $2.7 billion before taxes came from an accounting rule that lets a company record income when the value of its own debt falls. That reflects the possibility a company could buy back bonds at a discount, generating a profit. In reality, when a bank can’t fund such a transaction, the gain is an accounting quirk, Weiss says.

Citigroup also increased its loan loss reserves more slowly in the first quarter, adding $10 billion compared with $12 billion in the fourth quarter, even as more loans were going bad. Provisions for loan losses cut profits, so adding more to this reserve could have wiped out the quarterly earnings.

Wells Fargo

Without those accounting benefits, Citigroup would probably have posted a net loss of $2.5 billion in the quarter, Weiss estimates. In the five previous quarters, Citigroup lost more than $37 billion.

Wells Fargo also took advantage of the change in the mark- to-market rules. The new standards let Wells Fargo boost its capital $2.8 billion by reassessing the value of some $40 billion of bonds, the bank said in May. And the bank augmented net income by $334 million because of the effect of the rule on the value of debts held to maturity.

Wells Fargo spokeswoman Julia Tunis Bernard declined to comment, as did Citigroup’s Jon Diat.

The higher valuations Wells Fargo put on its securities probably won’t last, as defaults increase on home mortgages, credit cards and other consumer and corporate lending, Northeastern’s Sherman says.

Fed’s Optimism

“These changes will help the banks hide their losses or push them off to the future,” says Sherman, a former Securities and Exchange Commission researcher.

The Federal Reserve, which designed the stress tests, used a 21 percent to 28 percent loss rate for subprime mortgages as a worst-case assumption. Already, almost 40 percent of such loans are 30 days or more overdue, according to Tavakoli, who is the author of three primers on structured debt. Defaults might reach 55 percent, she predicts.

At the same time, the assumptions on how much banks can earn to offset their losses are inflated, partly because of the same accounting gimmicks employed in first-quarter profit reports, Weiss says.

“There’s a chance that it might work,” Columbia’s Stiglitz says of the government’s attempt to boost confidence. “If it does, then they’ll look like the brilliant general. But all these efforts also bank on the economy recovering and housing prices not falling too much further. Those are not safe assumptions.”

Indeed, while the government and accounting rule makers try to help the banks look their best, they may make the U.S. economy worse. As long as lenders are stuck with bad loans, they can’t provide new money to consumers or corporations to fuel a potential recovery. The banks may look pretty, but they’ll be zombies until they clean up their books.

(Published in the July issue of Bloomberg Markets magazine.)

To contact the reporters on this story: Yalman Onaran in New York at yonaran@bloomberg.net."

concealing from investors that the securities were backed by deteriorating mortgages

TO BE NOTED: From Bloomberg:

"FASB Rule Will Force Banks to Move Assets Onto Books (Update1)

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By Ian Katz

May 18 (Bloomberg) -- Citigroup Inc. and JPMorgan Chase & Co. will be required starting next year to add billions of dollars of assets and liabilities to their balance sheets under rules approved by the Financial Accounting Standards Board.

The rules, effective for annual reporting periods after Nov. 15, were approved by FASB’s five-member board today during a meeting at the panel’s headquarters in Norwalk, Connecticut. The board, which writes U.S. accounting rules, is overseen by the Securities and Exchange Commission.

Lenders recorded profits before the U.S. subprime mortgage market collapsed in 2007 by selling pooled loans to off-balance- sheet trusts, which repackaged the pools into mortgage-backed securities. Banks then sold those securities to other off- balance-sheet vehicles they sponsored, concealing from investors that the securities were backed by deteriorating mortgages.

“The desire to provide additional transparency to investors was the key driver behind today’s decisions,” FASB spokesman Neal McGarity said in an e-mail.

U.S. regulators said the 19 lenders subjected to stress tests completed this month would have to bring about $900 billion of assets onto their balance sheets because of the FASB changes, according to a Federal Reserve report released April 24. The Fed based its calculation on data provided by the banks.

“This change may have a significant impact on Citigroup’s consolidated financial statements as the company may lose sales treatment for certain assets,” Citigroup said in its annual report released in February. Citigroup spokesman Jon Diat declined to comment.

JPMorgan

In March, JPMorgan estimated in its annual report that the “impact of consolidation” could be as much as $70 billion of credit card receivables, $40 billion of assets related to so- called conduits and $50 billion of other loans, including residential mortgages. Conduits are off-balance-sheet entities that purchase long-term debt and use those securities as collateral to sell short-term debt. JPMorgan spokesman Brian Marchiony declined to comment.

The rule change will hurt banks and the economy by discouraging lending, said Wayne Abernathy, executive vice president at the American Bankers Association in Washington. “It will affect fee income and the economy’s ability to rebound on the lending side,” he said in an interview before the vote.

The FASB vote today eliminates the so-called Qualifying Special Purpose Entity, a type of trust that was exempt from balance-sheet treatment.

Postponed

In July, FASB postponed by at least a year the effective date of the changes after banks and trade groups complained. The Securities Industry and Financial Markets Association and the American Securitization Forum said the measure may make companies appear to be short of capital during regulatory reviews.

Investors are wary of a company’s unknown obligations as the world’s biggest banks and brokerages reported more than $1.4 trillion in writedowns and credit losses since the start of 2007, some stemming from losses in off-balance-sheet vehicles.

To contact the reporter on this story: Ian Katz in New York at ikatz2@bloomberg.net."

aimed at reducing the losses banks have been forced to report as the values of their mortgage-backed securities have crumbled

TO BE NOTED: From the NY Times:

"Banks Are Set to Receive More Leeway on Asset Values

By FLOYD NORRIS

Under intense political pressure, the board that sets accounting rules in the United States will meet on Thursday to complete changes in accounting rules that are aimed at reducing the losses banks have been forced to report as the values of their mortgage-backed securities have crumbled.

The changes, proposed two weeks ago after a Congressional hearing in which Robert H. Herz, the chairman of the Financial Accounting Standards Board, was essentially ordered to change the rules or face Congressional action, are generally supported by banks, although some want the board to go even further.

But they have produced a strong reaction from some investors, with one investor group complaining that the changes would “effectively gut the transparent application of fair value measurement.” The group also says changes would delay the recovery of the banking system.

“Investors,” wrote Kurt N. Schacht, the managing director of the Centre for Financial Market Integrity of the CFA Institute, “will not be willing to commit capital to firms that hide the economic value of their assets and liabilities.”

It seems highly unlikely that FASB will make major changes to the proposals that it rushed out only two weeks ago, but it may be willing to consider additional steps. And it will have to face the important decision of when to make the new rule take effect.

Some banks have requested that the board issue further guidance to make it easier for them to avoid writing down the value of assets, while some investors have asked for detailed disclosures to help them assess how far the newly reported values are from current market value.

The world of accounting rulemaking is normally a staid and slow moving one, with the board offering detailed rationales for changes and giving interested parties months to comment on them. Most comment letters come from people well versed in the accounting literature, arguing points that can seem arcane even if they could have a major impact on financial reports.

The process this time has been different in almost every respect. The board allowed only 15 days for comments, and said it would act after taking just a day to review the comments.

Those comments arrived by the hundreds, including bitter reactions from investors. “Market value is market value. Stop letting the financial industry call a duck a whale,” stated an e-mail message signed by Diane Walser.

“Who will benefit?” asked Roy Bell. “Only the very ones who already broke all the rules and have brought destruction to the world as we know it.”

The file also includes letters, evidently solicited by banking organizations, from groups contending that relaxing the rules would allow banks to report higher profits and make more loans.

The Georgia Affordable Housing Coalition submitted such a comment, perhaps without carefully reading it. The opening paragraph states, “This letter sets forth the comments of [insert name of organization here] regarding these proposals.”

The proposed rule interpretations deal with two issues in asset valuation. Banks are required to show some assets at market value, and report profits or losses based on changes in that value. Other assets may be reported at original cost, but if their value deteriorates they must be written down to market value if there is an “other than temporary impairment” in value.

The banks argue that current market values are unreasonably low, reflecting distressed trading, and are producing values that are well below the amount that will eventually be realized.

One change would allow banks much more room to conclude that inactive markets are distressed, allowing them to value the assets at what they believe they would be worth in a normal market. The other change would let banks avoid reporting some of the impairment losses on their income statements.

Some financial institutions want immediate action. The Association of Corporate Credit Unions asked the board to make the change retroactive, so that 2008 annual reports could be restated. Whatever the details of the proposal adopted Thursday, it represents an abrupt turnabout for the board. Only a day before the Congressional hearing on March 12, Mr. Herz gave an interview in which he disparaged what he called “mark to management” accounting. But after the Congressional grilling, the board quickly moved to make it much easier for banks to value assets at what they should be worth, rather than what they were currently selling for.

The CFA Institute reacted bitterly to that about-face. “Continuing on the path of politicized accounting standard-setting that caters to special interests,” it wrote, would make it hard for the board “to maintain its credibility.”

In some ways, the reversal is similar to one that the board made more than a decade ago, when it backed down under Congressional pressure from a rule requiring that companies report the value of stock options as an expense. That rule was revived only after corporate scandals early in this decade.

If the board does adopt the changes, they may quickly become universal. The International Accounting Standards Board, which sets rules for many countries, itself hurriedly changed an aspect of its market-value rule under pressure from the president of France."