Major Banks May Report Toxic Assets As Profits

Banks that bought "toxic assets" from failed financial companies like Wachovia, WaMu, and Countrywide may be able to report huge profits on their financial statements due to an accounting loophole. This loophole allows banks to report income based on projected future earnings on these loans. Investment Director of Money Morning, Keith Fitz-Gerald explains why this window-dressing could make the major banks look much healthier than they actually are.

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 ahead.

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 earn.

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 king-sized.

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, told Bloomberg 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.”

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 “needed.”

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.

This article has been reposted from Money Morning. You can view the article on Money Morning's investment news website here.