Why Financial Sector Earnings Are a Deceptive Farce

Because of a slew of earnings reports, this has been called “the week of truth” for the financial sector. However, a deeper look at the sector shows that big bank earnings reports are at best symbolic. One could even say that the whole ritual is utterly deceptive.

Earnings season is in full swing and most financial heavy weights are due to report this week.

Yahoo!Finance writes that: “It’s a make or break week for the financial sector with five of six of the nation’s largest banks (JPMorgan, Goldman Sachs, Citigroup, Bank of America, and Morgan Stanley) scheduled to report fourth-quarter earnings results” this week.

Earnings are directly related to stock market valuations, but big bank earnings releases are nothing more than a ritualistic farce. Why?

There’s no simple answer, but the next few minutes will be well worth your time. Warning! Knowledge about banks’ (corresponding ETF: SPDR S&P Bank ETF – KBE) accounting standards will result in loss of faith in the financial sector’s worth.

From Mark-to-Market to Mark-to-Make-Believe

There was a time when banks loved the Mark-to-Market accounting model, because it allowed them to showcase truly miraculous real time profits. By 2006/07 the financial sector accounted for over 40% of S&P 500 earnings.

Things changed in 2007/08. Mark-to market was unpopular with banks because it would have shown enormous real time losses. Bankers preferred to hide their balance sheets, along with the Federal Reserve and Congress too.

Bankers lobbied the Financial Accounting Standards Board (FASB) to change the fair market accounting rule – rule 157 – but the FASB resisted. Changing fair market or Mark-to-Market was a free pass that practically required no write-downs ever.

However, via the Emergency Economy Stabilization Act of 2008, Congress gave the SEC the authority to suspend Mark-to Market accounting. FASB rule 157 was suspended on April 2, 2009.

FASB 157 – What Does it Mean?

Since April 2, 2009, banks are basically free to value their toxic assets as they please. This example illustrates how the financial engineering formula works in real life.

Bank ABC holds mortgage-backed assets originally valued at $1,000. After running some proprietary and non-verifiable models the bank determines it will eventually sell the asset for $950. The loss, termed credit loss, is only $50.

However, because of MBS bad rep, the banks portfolio is currently worth only $500. The actual current value ($500) minus the credit loss ($50) is called noncredit loss ($450).

The $450 noncredit loss is recorded on the balance sheet under “comprehensive income,” but is not run through the income statement. Those losses don’t affect earnings, and are excluded from banks’ regulatory capital calculation.

Extreme Financials

The chart below (courtesy of Yardeni Research) illustrates the effect of financials. The worst recession since the Great Depression caused five quarters of extreme earnings contraction followed by eight quarters of extreme earnings growth (yearly growth rates were capped at +100% and -100% due to extreme values).

Was the miraculous earnings recovery due to a fundamentally strengthening financial sector (corresponding ETF: Select Sector Financial SPDR – XLF) or accounting tricks?

P/E Ratio Based Valuations are Beyond Deceptive

P/E ratio analysis used to be a time-tested, go to valuation parameter. Recent changes however, have turned the P/E ratio into the most deceptive value barometer around. Here’s why.

The P/E ratio is based on profits and only reliable as long as the “P” in P/E are actual profits. In a world where Wall Street thrives on manipulation, do P/E ratios still apply?

To illustrate: Wells Fargo is trading around $33 a share with earnings per share of $3.18 and a P/E ratio of 10.40. This is cheap, isn’t it?

But how do we know that Wells Fargo’s profit is really $3.18 a share?

As of December 30, 2011, Wells Fargo had total assets of $1.313 trillion and total liabilities of $1.173 trillion. You and I don’t know what the assets and liabilities are, and I venture to say that Wells Fargo doesn’t even know.

How much are the millions of homes Wells Fargo financed before the housing bust really worth? Again, we don’t know, but we know that due to an FASB (Financial Accounting Standard Board) rule change, Wells Fargo and every other corporation in the U.S. can now overstate the value of their under water assets.

FASB Rule 157

FASB rule 157 applies to fair value (or mark-to-market) accounting. Fair value is (or used to be) defined as “the price that would be received to sell an asset or paid to transfer liability in an orderly transaction between market participants.”

In 2008 the market turned disorderly and on April 9, 2009, the FASB (strong armed by Congress) changed rule 157 to suspend the fair value rules when the market is unsteady.

Instead of reporting the current value of an asset (market-to-market), corporations are now allowed to pick a price they believe the asset will be worth in the future (mark-to-make-believe).

Cause and Effect

What effect would this have? A March 2009 Bloomberg published this assessment:

“By letting banks use internal models instead of market prices and allowing them to take into account the cash flow of securities, FASB’s change could boost bank industry earnings by 20 percent. Companies weighed down by mortgage-backed securities, such as New York-based Citigroup, could cut their losses by 50 percent to 70 percent, said Richard Dietrich, an accounting professor at Ohio State University in Columbus. ‘This could turn net losses into significant net gains,” Dietrich said.’”

Is that really what happened? Let’s see which companies drove earnings growth for the S&P 500 in 2012.

The chart and data below was compiled by Morgan Stanley’s Adam Parker. According to his research, ten stocks are driving about 88% of the entire S&P 500 earnings growth.

Six (seven if you consider GE a financial stock) of the ten companies belong to the financial sector (Bank of America, AIG, Goldman Sachs, Wells Fargo, JPMorgan Chase, Citigroup).

Without Apple and the financial sector, earnings growth for the S&P 500 would be next to zero. A bad year for Apple and a return to fair value accounting could easily double the P/E ratio.

Based on P/E ratios, does the S&P 500 still look cheap?

Simon Maierhofer shares his market analysis and points out high probability, low risk buy/sell recommendations via the Profit Radar Report. Click here for a free trial to Simon’s Profit Radar Report.