Watch Banks Pull Rabbits Out of Hats, Ably Assisted by Their Auditors

Do you own stock in a large money center bank? Work for one? Count on one to lend you money for a small business? Expect them to stimulate the economy via commercial loans and lending again for residential or commercial real estate?

You’ve been deluded by the illusion of their self-serving public relations – rah-rah intended to help you forget financial reform that barely is and no safety net for anyone but the elite.

The global money center banks are masters at managing financial reporting. Regulators repeatedly feign surprise at balance sheet sleight of hand, prestidigitation at the expert level intended to buy time until the banks can grow out of the black hole that bubble lending put them in. They announce their quarterly results, with all the details – they don’t even try to hide them anymore – and they’re ignored or the con is traded on for short term profits.

The New York Times, July 16, 2010

“Citigroup’s net income declined 37 percent, to $2.7 billion, and Bank of America’s net income fell 3 percent, to $3.1 billion, from a year earlier. Both banks padded those results with a big release of funds that had been set aside to cover future loan losses, with executives citing improvements in the economy.”

Business Week reports that BAC flip flopped on the value of assets acquired with Merrill Lynch and magic happened:

“Citigroup also got $599 million of mark-ups on loans and securities in a “special asset pool” of trading positions left over from before the credit crisis. Citigroup booked a $447 million gain from writing down the value of its own debt, under an accounting rule that allows companies to profit when their creditworthiness declines. The rules reflect the possibility that a company could buy back its own liabilities at a discount, which under traditional accounting methods would result in a profit.

About $1.2 billion of Bank of America’s revenue came from writing down the value of obligations assumed from its purchase of Merrill Lynch & Co., according to the bank’s CFO, Charles Noski.”

Interestingly enough, the opposite move also netted them a gain last year. How exactly did this year’s write down equal a gain, too?

April 2009: Sydney Finkelstein, the Steven Roth professor of management at the Tuck School of Business at Dartmouth College, also pointed out that Bank of America booked a $2.2 billion gain by increasing the value of Merrill Lynch’s assets it acquired last quarter to prices that were higher than Merrill kept them.

“Although perfectly legal, this move is also perfectly delusional, because some day soon these assets will be written down to their fair value, and it won’t be pretty,” he said.

John Talbott, meanwhile, explains today why Treasury Secretary Tim Geithner doesn’t want watchdog Elizabeth Warren as the head of the new post-reform consumer protection agency – she’ll prevent banks from making money off the little guy while lending and trading remain unreliable profit drivers.

“Hank Paulson, the Treasury Secretary at the time, had announced that the $700 billion TARP funds would be used to buy toxic assets like bad mortgage loans from the commercial banks. But this never happened and now the amount of bad bank loans has increased in the trillions. Immediately after receiving authorization of the funding for TARP from Congress, Paulson reversed direction and decided to make direct equity investments in the banks rather than using the TARP funds to acquire their bad loans.

So where are the trillions of dollars of bad loans that the banks had on their books? They are still there. The Federal Reserve took possession temporarily of some of them as collateral for lending to the banks in an attempt to clean up the banks for their supposed” stress tests”. But as of now, the trillions of dollars of underwater mortgages, CDO’s and worthless credit default swaps are still on the banks books. Geithner is going to the familiar “bank in crisis” playbook and hoping that the banks can earn their way out of their solvency problems over time so the banks are continuing to slowly write off their problem loans but at a rate that will take years, if not decades, to clean up the problem.”

Paul Krugman predicted this roller coaster ride with bank earnings back in October, in particular with regard to Bank of America and Citigroup. What he missed is that when trading profits are down too, the banks – with the assistance of their auditors’ advice –  must be ever more clever and creative to avoid having to write off those bad assets all at once or without cover.

…while the wheeler-dealer side of the financial industry, a k a trading operations, is highly profitable again, the part of banking that really matters — lending, which fuels investment and job creation — is not. Key banks remain financially weak, and their weakness is hurting the economy as a whole.

You may recall that earlier this year there was a big debate about how to get the banks lending again. Some analysts, myself included, argued that at least some major banks needed a large injection of capital from taxpayers, and that the only way to do this was to temporarily nationalize the most troubled banks. The debate faded out, however, after Citigroup and Bank of America, the banking system’s weakest links, announced surprise profits. All was well, we were told, now that the banks were profitable again.

But a funny thing happened on the way back to a sound banking system: last week both Citi and BofA announced losses in the third quarter. What happened?

Part of the answer is that those earlier profits were in part a figment of the accountants’ imaginations.”

I’ve told you more than once that Citigroup is still a mess. Anyone who isn’t a senior insider is nuts to buy their stock or count on them for a job or business. Listen to me talk about AIG, Bank of America and Citigroup, “an accident waiting to happen,” at the 8:15 mark on this video for Stocktwits TV recorded June 3, 2010.

I also told you that Citigroup’s auditor, KPMG, was their enabler. In April I warned readers about repurchase risk and KPMG.

“The latest announcements of potentially material losses due to forced repurchases of mortgages from Fannie Mae (Deloitte) and Freddie Mac (PwC) were made by JP Morgan and Bank of America – both audited by PwC.

The biggest losers are likely to be Bank of America Corp., J.P. Morgan Chase & Co. and other mortgage lenders when the housing bubble burst…

Bank of America repurchased nearly $4.5 billion of loans during the first nine months of 2009, according to data compiled by Barclays. That was triple the $1.5 billion repurchased in all of 2008. Some of the bad mortgages were made by Countrywide Financial Corp., which was acquired by the Charlotte, N.C., bank in 2008. A bank spokeswoman declined to comment.

At J.P. Morgan, total buyback demands surged to $5.3 billion in 2009 from $4 billion in 2008, according to Barclays. The New York company, which bought the failed banking operations of Washington Mutual Inc.(Deloitte) in 2008, reported higher reserves for loan repurchases in the fourth quarter… J.P. Morgan and Bank of America don’t disclose how many loans they repurchased from Fannie and Freddie.

Maybe y’all should kick the tires a little more on Citibank’s big comeback.  Citi is the only big money center bank left that is audited by KPMG. Recent testimony before the Financial Crisis Inquiry Commission says their underwriting standards fell apart between 2005-2007.”

Countrywide, now owned by Bank of America, was a KPMG client.

Gretchen Morgenson at the New York Times tells us again on June 16th that Fannie Mae and Freddie Mac are stepping up their efforts to get the banks to provide documentation for the loans they sold them or else they’ll call the bluff and force repurchase.

“The agency announced last Monday that it had issued 64 subpoenas to a throng of unidentified financial services institutions, seeking documents related to mortgage securities that Fannie and Freddie bought from Wall Street during the boom years.

The subpoenas are designed to tell the agency what many of us want to know: How did Wall Street package and sell private-label mortgage securities to investors, even though the nature and quality of some of the loans crammed inside those tidy little packages were, at best, suspect? Once that question has been answered, Fannie and Freddie can force the institutions that sold the securities to repurchase the improper loans, allowing taxpayers to recover some of the losses they’ve swallowed on Fannie’s and Freddie’s federal bailout.”

How are the banks getting away with this back and forth, write-up and write-down, pin the tail on the donkey style valuation that seems to serve only their limited need to buy time?

The auditors, specifically KPMG (Citigroup, Countrywide prior to B of A’s purchase, Wells Fargo and Wachovia) and PricewaterhouseCoopers (Bank of America and JP Morgan), are sitting on their hands, twiddling their thumbs and collecting payola while banks are doing as they wish.

The accounting standards currently allow it.

In some cases the auditors even allow the same assets to be valued differently at two of their clients. (Is there more of that going on?  Hey SEC, inquiring minds want to know.)

The data proves it.

“Accounting for Banks’ Value Gaps,” Michael Rapoport, The Wall Street Journal, December 29, 2009

“Investors count on consistency when it comes to bank accounting? As many banks struggle with piles of bad loans, some auditors appear stricter than others when assessing their true value…Banks carry most loans on balance sheet at their original cost. But they must also disclose the loans’ fair value, or current market value, in footnotes. At most banks, despite the carnage of recent years, fair value is only slightly below cost. Some banks, however, show much steeper declines.

…The average gap among Ernst and Deloitte clients in the 25-bank group was about 6%; among clients of PricewaterhouseCoopers and KPMG it was about 2%.

….The Financial Accounting Standards Board is considering changes in banks’ accounting for loans and may require them to carry loans on the balance sheet at fair value instead of cost. If that happened, the fair-value declines could reduce shareholder equity and regulatory capital—in some cases, to levels regulators would find troublesome…Who audits a bank’s books may have importance beyond whose name goes on the letter blessing the financial statements once a year.”

KPMG’s regulator, the PCAOB, has told us over and over that KPMG will fudge on behalf of their clients when it comes to auditing estimates of loan loss reserves. That claim was the smoking gun in the New Century litigation.  New Century is reportedly settled, so the truth will be buried, but the PCAOB told anyone that would listen about several other cases.

The PCAOB’s inspection of KPMG dated June 2009 for 2008:

Issuer D: Deficiencies in the Firm’s audit procedures regarding the allowance for loan losses (ALL) at selected business units included:

The degree of reliance the Firm placed on controls at certain of the business units was inappropriate in light of the control testing performed…the Firm failed to test certain of the issuer’s assumptions, including those developed by the issuer’s specialist, and/or data used in estimating the ALL, including loan loss rates, environmental factors, enterprise valuations, liquidation analyses, debt service coverage and loan-to-value ratios, weighting factors, and the homogeneity of loan pools.

Issuer E: During the fourth quarter of the year, the Firm lowered its assessment of the acceptable threshold for errors in certain accounts by two-thirds due to the market disruption that had occurred during the second half of the year.  Other than inquiry of management, the Firm did not test certain significant information and assumptions the issuer had used in assessing whether the impairment in a portion of its portfolio of available-for-sale mortgage-backed securities was other than temporary, even though securities representing approximately 90 percent of this portion of the portfolio had been in an unrealized loss position for more than 12 months, and the unrealized losses were nearly twice the Firm’s revised acceptable threshold for errors.  In addition, the Firm did not evaluate whether the issuer’s analysis considered the negative developments affecting the mortgage market and mortgage- backed securities.

Issuer F: The issuer had experienced significant deterioration in its loan portfolio during the year under audit.  For example, the issuer had an increase of over 80 percent in non-performing mortgage loans.  The issuer’s allowance for losses on mortgage loans (“ALL”) included a “non-current component” related to loans more than 90 days past due.  The issuer calculated the non current component of its ALL by applying certain percentages to different aging categories of loans in that component.

As part of its procedures to audit the ALL, the engagement team used a Firm

Credit Risk Specialist (“FCRS”) to review the issuer’s ALL methodology, and the FCRS observed that the issuer needed to develop additional quantitative support for its ALL methodology, including for loss experiences on delinquent mortgage loans, and to further analyze the validity of historical percentages in light of new economic circumstances.  Despite these concerns, the Firm accepted the percentages the issuer had used to calculate the non-current component of the ALL without determining whether they were supportable and appropriate. “

Similar deficiencies were noted in KPMG’s 2007 inspection published in 2008.

Both AIG and Goldman Sachs executives have been questioned recently by the Financial Crisis Inquiry Commission. The Commission seeks to “examine the causes, domestic and global, of the current financial and economic crisis in the United States.” We’ve also seen Lehman executives called to account by Congressional inquisitors.

But we’ve yet to see the auditors – Pricewaterhouse Coopers (auditor of AIG, Goldman Sachs, and Freddie Mac), Ernst & Young (auditor of Lehman and UBS) or KPMG (auditor of Citigroup, previously of Countrywide, Wells Fargo and Wachovia and earlier of Fannie Mae) – called to testify to explain their role in blessing fraudulent bank balance sheet accounting.

Isn’t it about time?

Additional Reading:

Robert E. (Bob) Jensen, Trinity University Accounting Professor (Emeritus), recommends this video with Lynn Turner and Frank Partnoy on bank balance sheet accounting.  It’s presented by the Roosevelt Institute.  Their book, Make Markets Be Markets, is highly recommended.