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Bank Earnings Reveal This Emperor Has No Clothes

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When the tide goes out, we see who's been swimming naked.

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At around 10:00 a.m. on March 5, 2009, Todd offered the following on the Buzz & Banter:

"I just bought some General Electric (GE) calls. Not because the CFO painted the tape -- it's a vehicle, pure and simple, and a defined risk one at that.

I simply sense that, given the historical significance of this American icon, we'll several defenses (much like we did in Citigroup (C), and should mark-to-market rules be 'relaxed', this could be a $12 stock in a blink."

Well, $12.52, actually, at least as of last night's close.

And in hindsight, it all appears so simple: Change accounting, and you change history.

Postpone the recognition of losses, and maybe there won't be losses to take. Or at least that's the hope.

I share all of this as a preamble to my thoughts on second-quarter bank earnings -- because somehow "unprecedented" doesn't seem to do them justice.

By suspending mark-to-market accounting, (which, by March 5, it was clear Congress would demand), the accounting industry set in motion one of the strongest, if not the strongest, bull markets in risk. Equities soared, fixed income spreads collapsed, and sentiment changed, setting the stage for the exceptionally well-received stress-test results in early May. Subsequently, bank after bank successfully issued enormous amounts of new common equity. The accountants bailed out Wall Street, who in turn bailed out Washington.

A trifecta -- or perhaps a quad- or penta-fecta of staggering proportions.

That trading firms reported enormous profits shouldn't have come as any surprise. How could they not? For underwriters, the "tsunami" of stock and bond issuance into eager hands generated extraordinary revenues. And beyond the basic suspension of loss recognition, the rapidly improving markets turned securities losses into gains and capital shortfalls into surpluses.

That's the good news. And in scouring both trading banks and more traditional regional banks, all took advantage of the improving markets to book whatever gains were available. And, not surprisingly, many offered in their second-quarter results that booking one-time gains was far superior to issuing dilutive common stock to bolster their regulator-mandated Tier 1 common equity ratios.

And book them, they did: Regions Financial (RF), for example, booked a $61 million pre-tax gain on early extinguishment of debt; sold its remaining interest in Visa (V) shares, recognizing an $80 million dollar pre-tax gain, and sold $1.4 billion of US government securities at a $108 million pre-tax gain.

And more than one-third of JPMorgan's (JPM) total second-quarter profits came from "corporate," where the firm reported "higher levels of trading and investment income in the investment securities portfolio and a gain of $150 million (after tax) from the sale of MasterCard (MA) shares."

Gains whipped pain.

But while banks were busy taking whatever securities-related profits they could from their balance sheets, their core banking businesses were decidedly mixed. On the good-news front (unless, of course, you're a saver), banks lowered deposit rates and raised transaction fees left and right.

At the same time, loan portfolios showed continued credit deterioration across the board. Worse, loan loss reserves appear to have been sized for an immediate recovery, rather than positioned for any kind of continuing economic malaise.

As I have written before, I don't believe that accounting changes the ultimate outcome -- just the timing. In the second quarter, as the tide back came in, banks accentuated the positive and postponed the negative.

Should a sustainable recovery occur, no one will likely ever know the difference. But realize: That's the bet. And from where I stand, the bank "gain cupboard" is now officially bare.

Warren Buffett is reported to have said that, when the tide goes out, you can see who's been swimming naked. I, for one, would beware the tides of March.
Position in SH, JPM and SPY options
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