Fenil's Library

“Surprise, surprise!” screamed M as I opened the door, late at night. “You know V, city life is city life. Couldn’t keep away for long.” 

We hugged and she made herself comfortable on the sofa. 

“So I gather the American economy will be up and running again,” she started again. “Larry Summers, director of the White House’s National Economic Council for President Barack Obama has said, “That sense of unremitting free fall we had a month or two ago is not present today.” Ben Bernanke, the chairman of the US Federal Reserves, has dittoed that line saying, “The green shoots of economic revival are already evident.” The big banks and financial institutions are back to making good profits. And more than anything, the stock markets have seen a huge rally. US stocks have in fact gained $2.3 trillion since March 6, 2009. The S&P 500, one of the most broad-based stock market indices in the US has gained 18.7% in March and April and this has been the best two month gain since 1975. What say?” 

I wasn’t exactly dying to discuss the US economy at this hour. But courtesy demanded I respond. Besides, I was glad she was back.

“It’s an interesting take, but it’s all an illusion,” I said. “See, the economies of the G7 countries (Canada, France, Germany, Italy, Japan, United Kingdom and United States), which make up two-thirds of the world’s output, experienced a 7.5% contraction on an annualised basis, during the first three months of this year. The US GDP contracted by 6.1% on an annualised basis. This followed a 6.3% decline in GDP during the last three months of the last year, the biggest drop in 50 years. One reason for a contracting GDP is job losses. There have been 20 lakh job losses in the US in the first three months of 2009, pushing the unemployment rate to 8.5% of the total workforce. This is the highest since November 1983. If we were to talk about underemployment, which takes into account people who are working part time because they can’t find full-time jobs, this rate goes up to 15.6%. When people don’t earn, they don’t spend, and that leads to a contracting GDP.” 

“But that’s history. Unemployment is a lagging indicator. The stock market takes future into account much faster than any other economic indicator. And as I have already told you, it’s been on its way up for sometime. How do you explain that?” she asked. 

“Good point. But the stock market has been rallying primarily because of the good financial results of financial institutions and banks. But are these “real” results or accounting gimmickry at work? As an accounts teacher of mine used to say, you don’t make a profit and loss account of a company, you sculpt it —- a little chip here, a little chip there, till it attains the form you want, of course, following the law of the land. But law, as they say, is an ass, which can be whipped the way you want it to go,” I said. 

“I don’t quite get you,” she said. 

“As market watcher Thomas Tan says, “The best award for accounting abuse, however, goes to Goldman Sachs. By switching to calendar year from a fiscal year ending November, suddenly the credit losses of $780 million disappeared from both 2008 report and Q1 2009 report, nowhere to be seen in the future. Of course, this has driven the stock price way up.” Or take the case of how Citigroup has boosted its profits. As Jim Welsh, who has been writing the investment letter “The Financial Commentator”, since 1985, says, “Citigroup said it made $1.6 billion. One of the ways Citigroup achieved this gain was booking a profit of $2.7 billion on the decline in Citi’s own debt. Say what? Under accounting rules, Citi was allowed to book a one-time gain equivalent to the decline in its bonds because, in theory, it could buy back its debt cheaply and save $2.7 billion over time. Of course, Citi didn’t actually do that.”” 

“Now what does that mean?” she asked. 

“Citigroup would have raised some debt by issuing financial securities at some point. Investors would have bought these securities. Now, these securities can be bought and sold either over the counter or on some stock market. They have a certain market price, which currently is much lower than the face value of the debt originally issued. Hence, technically, Citigroup can buy back these securities at a much lower price today. Current accounting rules allow Citigroup to book the difference between the original price and the current market price of these debt securities as a profit. All this is paper profit though,” I explained.

“So?” 

“Banks have also made lower provisions for future losses, thus boosting profits further. As Welsh points out, “Even though more consumer loans went bad in the first quarter, Citi reduced its loan loss reserve from $3.4 billion in the fourth quarter to $2.1 billion in the first quarter, thereby picking up another $1.3 billion of ‘earnings’.” The Financial Accounting Standards Board also altered rule 157, which concerns mark-to-market accounting. Banks need to mark to market the value of their loans while declaring results. Let us say a bank invests $100,000 in a financial security issued by a company. Say the company isn’t in good shape and is unlikely to make good the investment. The market value of the financial security may then be $30,000. The bank now needs to adjust the difference of $70,000 as a loss. FASB altered rule 157, allowing American banks to value toxic assets “at their own discretionary judgment,” Gary Dorsch, editor of the Global Money Trends newsletter, says in his article ‘Green Shoots’ Sprouting in Global Markets in the latest issue. “The switch-back to “mark-to-make-believe” accounting is an expedient scheme that allows the banking elite to conceal their losses, and use the same obscure and discredited models to inflate their balance sheets. The recent spate of better-than-expected earnings reports by US-banking giants, Goldman Sachs, JP-Morgan, Citigroup, Bank of America, and Wells Fargo is a testament, not to the strengthening of the real economy, but rather due to accounting gimmickry,” he writes. If these one-time adjustments hadn’t been made, Citi’s $1.6 billion in first quarter profit becomes a $2.8 billion loss, estimates Welsh. Through all these moves, banks are essentially postponing their losses, which will come back to hit them in the days to come,” I said. 

“You are a scaremonger,” she said. 

“Oh. I haven’t finished yet. The unemployment rate in the US is set to top 10%. Now what does that mean? It means the default rate on all kinds of consumer credit (home loans, credit cards, auto loans, student loans, etc) will increase. So banks and the US financial system will come under more pressure.” 

“But if things are so bad, why are people talking about a revival?” she asked. 

“When things get as bad as they are now; one tends to look at the good within the bad,” I said with a wink. We’ll leave that for tomorrow. For now, why don’t you make me some coffee?”