For banks, profitability management is apparently an Alice’s Restaurant situation. Because the simple fact of the matter is: you can get anything you want.
Citigroup reported its first quarter profits yesterday. It’s clear they could have ordered up whatever number they chose to report.
After more than a year of crippling losses and three bailouts from Washington, Citigroup, a troubled giant of American banking, said Friday that it had done something extraordinary: it made money.
But the headline number — a net profit of $1.6 billion for the first quarter — was not quite what it seemed. …
Like several other banks that reported surprisingly strong results this week, Citigroup used some creative accounting, all of it legal, to bolster its bottom line at a pivotal moment.
Citigroup posted its first profitable quarter in 18 months, in part because of unusually strong trading results. It also made progress in reducing expenses and improving its capital position.
But the long-struggling company also employed several common accounting tactics — gimmicks, critics call them — to increase its reported earnings.
One of the maneuvers, widely used since the financial crisis erupted last spring, involves the way Citigroup accounted for a decline in the value of its own debt, a move known as a credit value adjustment. The strategy added $2.7 billion to the company’s bottom line during the quarter, a figure that dwarfed Citigroup’s reported net income. Here is how it worked:
Citigroup’s debt has lost value in the bond market because of concerns about the company’s financial health. But under accounting rules, Citigroup was allowed to book a one-time gain approximately equivalent to that decline because, in theory, it could buy back its debt cheaply in the open market. Citigroup did not actually do that, however.
“It’s junk income,” said Jack T. Ciesielski, the publisher of an accounting advisory service. “They are making more money from being a lousy credit than from extending loans to good credits.”
Edward J. Kelly, Citigroup’s financial chief, defended the practice of valuing its bonds at market prices, since it values other investments the same way. The number fluctuates from quarter to quarter. For instance, Citigroup recorded a big loss in the fourth quarter of last year, when the prices of its bonds bounced back.
Fair enough. It’s not like they suddenly switched to this method just because the value of their bonds declined. They have a continuing policy of marking the value of their bonds to market. It hurt them in the past, it’s helping them now. This is not a la carte trickery, by any means (though the NYT story focuses mainly on this so-called accounting gimmick).
Citigroup also took advantage of beneficial changes in accounting rules related to toxic securities that have not traded in months. The rules took effect last month, after lobbying from the financial services industry.
Previously, banks were required to mark down fully the value of certain “impaired assets” that they planned to hold for a long period, which hurt their quarterly results. Now, they must book only a portion of the loss immediately. (Any additional charges related to the impairment may be booked over time, or when the assets are sold.)
For Citigroup, this difference helped inflate quarterly after-tax profits by $413 million and strengthened its capital levels.
Not a la carte trickery either, but an accounting practice that defies understanding (and falsifies profit). One of FASB’s most shamefully absurd rulings. When you mark your debt liabilities to market, you right away book 100% of the profit you make when your bonds go down (even though you are not buying them back, and have no declared intention to, either). When you mark your impaired assets to market, you can sit tight and ignore a large part of of the loss you make when the assets go down.
Citigroup and other banks also benefit simply by taking a sunnier view of their prospects. Banks routinely set aside money to cover losses on loans that might run into trouble. By squirreling away less money, banks increase their profits.
That is what Citigroup did. During the fourth quarter, Citigroup added $3.7 billion to its consumer loan loss reserves, more than analysts had expected. In the first quarter, even though more loans are going bad, it set aside just $2.4 billion.
“Citi pulled out all the stops,” David Hendler, an analyst at CreditSights, wrote on Friday. …
Mr. Kelly said that Citigroup would increase its provisions if the recession deepened and that its reserves would be adequate.
“When they did the reserving, they were anticipating losses that were higher than losses turned out to be,” Mr. Kelly said. “You could argue we were just as cautious in the fourth quarter as we were aggressive in the first quarter.”
What Mr. Kelly is saying, of course, is that we wanted first quarter profits to be $1.6 billion. We could just as easily have gone with $2.3 billion or $1.1 billion. Each quarter, we look at ourself in the mirror, and we look around at the world outside, and we decide what’s the best profit figure to report. And that tells us how cautious or aggressive we are feeling that quarter.
(So it’s probably worth asking: Why did Citigroup want to report crappy profits the previous quarter?)
Of course, there’s nothing new here; this has always been true. It’s just that bank executives don’t usually express it so plainly.