Bank Profits Mask Peril Still Lurking

By Binyamin Appelbaum
Washington Post Staff Writer

Citigroup announced a surprisingly strong first-quarter profit yesterday, the latest bank to report a sharp improvement from the disastrous final months of 2008.

The earnings bloom, however, is probably a false spring, according to bank executives and financial analysts. Banks rise and fall with the economy. As prosperity recedes, more people and companies are defaulting on loans. The nation and its banks still face grave challenges, they said.

"We don't see the light at the end of the tunnel," Edward "Ned" Kelly, Citigroup's chief financial officer, said in an interview, referring to the state of the economy. His company, the most troubled of the large banks, reported that defaults increased during the first quarter on nearly every kind of consumer loan.

J.P. Morgan Chase also announced strong earnings this week. The company's chief executive, Jamie Dimon, also did not see in those results evidence of recovery.

Asked about loan losses in a call with analysts, he said: "Eventually they will peak, but they've been going up consistently. We've shown you here that they're going to go up even more. They're going to continue going up in all the home lending areas, mortgage and home equity and credit cards."

Large banks have profited despite their problems because of accounting maneuvers and earnings from investment banking.

The banking industry's bleak tone contrasts with recent expressions of cautious optimism by President Obama and Federal Reserve Chairman Ben S. Bernanke. The president said last week that he saw "glimmers of hope across the economy," such as signs that spending on homes and consumer goods might stop falling.

Bank executives are more downbeat, according to some analysts, because banks are suffering more during this recession than other sectors as a whole. This is unusual. It is a well-established industry rule of thumb, for example, that the proportion of credit card loans in default roughly equals that of Americans without jobs. But the collapse of the housing bubble has destroyed vast amounts of wealth, pushing people to default on other kinds of loans, including credit cards.

The nation's unemployment rate stands at 8.5 percent, but Citigroup, for example, reported a 10.2 percent loss rate on domestic credit card loans in the first quarter.

The struggles of financial firms also reflect the limited success of the government's massive efforts to help banks, including the Treasury Department's investment of almost $200 billion in more than 500 banks and the Federal Reserve's extension of more than $1 trillion in emergency loans through various programs.

The government programs were intended to help banks increase lending, at least above the levels without government aid. But the volume of loans made by the largest banks -- which received most of the federal aid -- has continued to decline, in part because losses continue to rise on the loans banks do make. Also economic woes have diminished demand for loans, particularly among businesses.

Despite these problems, Citigroup said yesterday it earned $1.6 billion in the first quarter, compared with a loss of $5.11 billion in the first quarter last year. The company paid out all its profits and then some to preferred shareholders, leaving a net quarterly loss of 18 cents per share. The overall profit still surprised financial analysts, who expected the company to lose money.

The largest banks have reported huge profits from the trading of financial instruments such as corporate bonds. Citigroup, for example, made $2.8 billion in investment banking and lost $1.2 billion in consumer banking.

In part, the companies relied on accounting rules.

Citigroup recorded revenue of $2.5 billion from a decline in the value of its own bonds. A 2007 change in accounting rules allowed the company to gain from its investors' loss because the company conceivably could buy back the debt at the lower value, paying less than it originally expected.

Earlier this year, accounting rule-makers also loosened the rules that determine when a company must recognize a decline in an asset's value as a permanent loss. Citigroup said that change added about another $600 million to its bottom line.

Goldman Sachs last reported earnings through the end of November. This week it reported a profit for the first three months of 2009, then separately reported a large loss during the orphaned month of December. The company switched its reporting periods as a consequence of its decision to become a bank.

Wells Fargo took the unusual step of announcing a large first-quarter profit two weeks before it plans to publish an earnings report, leaving investors and financial analysts uncertain how the company achieved the results.

Financial analysts say every major bank would have sustained large losses, and some might have collapsed, if the government had not made emergency investments in them last fall. The government has invested $45 billion in Citigroup and guaranteed to limit the losses on a portfolio of more than $300 billion in troubled loans. J.P. Morgan and Wells Fargo each received $25 billion in capital. Goldman Sachs accepted $10 billion.

Analysts also caution that the combination of unusual investment banking profits and accounting benefits make it unlikely that banks can sustain profits at this level.

"I think we knew all along that the first quarter might not be indicative," said Nancy Bush, a financial analyst with NAB Research. She noted that investment banks benefited from demand for services that built up during the fall, when the capital markets largely were shuttered. Competition on Wall Street also was diminished by the collapse of Bear Stearns and the bankruptcy of Lehman Brothers, leaving more pie for the surviving firms.

Bush said she expected increasingly clear differences among banks, with the strongest showing greater profitability while the weakest hobbled along with government help.


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