Why Bank Profits Aren't Good News

If you take the headlines at face value, it has been a good month for banks. Wells Fargo announced $3 billion in first-quarter profits, Goldman Sachs racked up $1.8 billion, JPMorgan Chase had $2.1 billion, Bank of America $4.25 billion and even beleaguered Citigroup tallied $1.6 billion in profits. Treasury Secretary Tim Geithner validated the good news by declaring that the "vast majority" of the nation's banks are now well capitalized and solvent. Markets rallied. The worst of the financial crisis, it seemed, had passed.

Smart investors know better. At the core, this financial crisis has been driven by uncertainty—about who's holding what, how much it's worth and when it might blow up. A careful look at last week's profit news reveals that there's still plenty of uncertainty lurking on the balance sheets of America's top banks.

First, the most glaring examples: even as Bank of America was chalking up its profits, it was also warning that it faced growing credit losses, due to a decline in credit quality across all of its businesses (the bank's provisions for credit losses rose to $13.4 billion in the first quarter from $8.5 billion in the last quarter of 2008). "Make no doubt about it," said BOA chairman Kenneth Lewis, "credit is bad, and we believe it will get worse before it eventually stabilizes and improves."

At least he admits it. Goldman's chair Lloyd Blankfein certainly didn't go to any pains to explain that a chunk of his bank's good news came not from savvy trading, but from an accounting shift. Goldman switched from being a securities firm to a bank holding company last autumn, which changed its fiscal year, allowing it to leave much of December—a month with plenty of write-downs—largely off the books. And that's only the bad news that we can see.

As a high-level source in credit research (who didn't want to be quoted by name speaking about Goldman) pointed out to me, the bank carries around $585 billion worth of what are known as "level 2" assets—securities that may not have a clear market price but can be accounted for in the company's books by comparing them to a similar asset.

That leaves a lot of wiggle room when it comes to recording the value of such assets, which can include loans, securities, etc. If even a small fraction of them are actually worth less than Goldman assumes, it could account for a few billion worth of the company's first-quarter revenue. A spokesman for Goldman would not confirm or deny the $585 billion figure, or whether any level-2 assets had been marked up, but did say, "Goldman Sachs did not announce any material write-ups for the first quarter."

There are plenty of smart people who believe that the improved profits of not just Goldman, but also most of the big banks in question are in large part the result of relaxed accounting rules. Banks have been lobbying hard for the Federal Accounting Standards Board to lift the "mark-to-market" rule that requires them to account for the value of their assets based on current market prices. Banks didn't seem to mind this rule when prices were up—and made their results look better—but now they say the rule is unfair, because troubled assets are so hard to sell these days. Early in April, the board relented, easing the rule and allowing banks to write some of those assets back up.

Bottom line: there's less clarity than ever about what the remaining junk on bank balance sheets is worth. And it won't become clear whether those strong first-quarter earnings represent a turning point in the crisis or just more fudging of the numbers, "until it doesn't matter anymore," says Sean Egan, head of Egan-Jones, one of the country's largest independent credit-rating agencies. Government money will ultimately help banks out of the crisis, whatever the cost to taxpayers; forensics on the accounting will have to be done by the historians.

Meanwhile, Ken Lewis isn't the only one expecting more write-downs. The IMF now expects that total losses in the global financial sector will reach $4.1 trillion (with $2.7 trillion of that coming from the U.S.). Banks are expected to carry two thirds of those losses, with insurance companies, pension funds, hedge funds and others taking the rest.

Another recent report by McKinsey takes a similarly bleak view, noting that U.S. banks still hold more than $2 trillion in toxic assets. Perhaps the most disturbing thing noted by the McKinsey authors is that most of the write-downs that have been taken by banks to date have been on securities and loans that are clearly marked to market. McKinsey notes, however, that about 60 percent of the credit on the balance sheets of U.S. banks are for items that aren't marked to market, but to those ever-nebulous financial models that got us into all the trouble to begin with. That murky area is where most of the future losses are likely to occur.

This is not to say that there haven't been some real green shoots in the real economy. But make no mistake—the banking sector isn't yet out of crisis. Financial executives should be wary of paying back their bailout money until they are much more certain that they aren't going to need it.