Earnings Fiasco at Citigroup and JP Morgan: What's In The Piggy Banks?

(MoneyWatch)  Just when you thought it wasn't possible, bank accounting has gotten a whole lot weirder. While Goldman Sachs changed its reporting calendar to shrug off a $1.5 billion loss in December, JP Morgan Chase reported a fall in the price of its bonds as a profit. Meanwhile, here on BNET Finance, David Phillips points out that Citigroup managed to post $1.6 billion in net income by betting against its own creditworthiness.

The news must be hard to stomach over at Morgan Stanley, which reported a $177 million loss thanks to an improvement in its credit standing. Paul Krugman sums it up:

So Citigroup is profitable because investors think it's failing, while Morgan Stanley is losing money because investors think it will survive. I am not making this up.

The zany accounting practices come just weeks after an accounting-standards board gave the green light for banks to use "significant" judgment in valuing assets to reduce writedowns on certain investments, including mortgage-backed securities.

Time's Justin Fox chimes in:

Basically, this is the side of mark-to-market accounting that nobody talks about. FAS 157 (the accounting term for mark to market accounting) applies to both assets and liabilities.

Here's how it worked in this case. When investors think Citigroup is teetering on the edge of collapse and likely to default on its bonds, the market price of that debt plummets. Then, two things happen:

• Since the lower price means that Citi could theoretically buy back the bonds and retire the debt more cheaply, the bank can -- and, of course, did -- record those "savings" as a reduction in its liabilities, and then book that "decrease" in debt as a profit. Citi booked a $30 million profit from that jig.
• The likelihood of bond default also pushes up the price of credit-default swaps on Citibank debt. Those CDS contracts are essentially insurance that pays off if Citi defaults, so they rise in value as that prospect grows more likely. Citi reported a staggering $2.5 billion profit from improved derivative positions (see p. 7 of the release) -- as the bank itself put it, "mainly due to the widening of Citi's CDS spreads." While Citi doesn't come right out and say that it bet against itself by amassing insurance against its own default, it's hard to see how else you'd explain it.

Of course, those profits will turn to a loss the moment things start to improve for the bank, so it's not as though Citi has done much more than sweep its problems under the rug for a bit. The bigger problem is that earnings like these make valuing banks an increasingly difficult task. And if no one knows what banks are worth, it's much harder to determine whether they're solvent or not.

One thing is for certain: these earnings reports are sure going to make the Treasury's "stress tests" interesting reading when they come out early next month.

More on recent bank earnings at BNET Finance:

• Citigroup Receives an "A" in Fuzzy Math
• Goldman, Citibank and Others Rely on Earnings Tricks -- But Not Revised Mark-to-Market Rules