As analysts dig into bank earnings, questions emerge about how healthy the industry really is

Meltdown 101: Banks earnings under the microscope

NEW YORK — The stock market initially cheered better-than-expected earnings reports from major banks as signs that the beleaguered industry might be stabilizing. But investors got more skeptical this week after they had a closer look.

Some banks posted one-time gains on the sale of investments while others booked outsized profits from trading securities, which could disappear any time. Still others booked gains thanks to accounting rules and a rush of mortgage refinancings which could turn out to be temporary.

At the same time, most banks reported higher losses from loans that have gone bad as more borrowers become unable to make their payments.

Here are some questions and answers about bank earnings and problems looming for them on the horizon.

Q: How did banks do in the first quarter?

A: Many banks beat analysts’ expectations, including Goldman Sachs Group Inc., JPMorgan Chase & Co., Citigroup Inc. and Bank of America Corp. Wells Fargo & Co. also said it expects to report record profit when it announces details of its first-quarter results Wednesday.

Among them, only Citigroup posted a loss. The New York-based bank would have been profitable had it not been for dividend payments to preferred stockholders tied to a private stock offering in January 2008.

Q: What are some of the reasons that many banks have reported better-than-expected results?

A: Goldman benefited from a surge in bond and currency trading, taking advantage of weak markets and less competition after some investment banks failed or were sold last year.

Goldman also changed its fiscal reporting year to begin Jan. 1 instead of Dec. 1 as it shifted its regulatory status. That left December as a separate reporting period, during which Goldman lost $1 billion, a loss that wasn’t reflected in first quarter results.

Bank of America booked $1.9 billion in pretax gains from selling a portion of its stake in China Construction Bank. It also got a boost from its 2008 acquisitions of Countrywide Financial Group and Merrill Lynch.

Citigroup, which has not turned a profit since the third quarter of 2007, gained $2.7 billion thanks to a counterintuitive accounting rule that essentially lets the bank book gains because the value of its own debt declined. Since the value of that debt fell, technically the bank owed debtholders less money.

Q: Are those types of profit sustainable?

A: Analysts are skeptical.

“You can show profits by selling appreciated assets, but you can’t do it forever,” said Bart Narter, an analyst with Celent.

Friedman, Billings, Ramsey & Co. analyst Paul Miller said, “there is a lot of non-cash or one-time benefits flowing through the system.”

That’s not to say things can’t improve for the industry, but analysts caution that one quarter’s results are not enough to show a clear trend, especially when results include gains from many businesses aside from core banking operations.

Q: What are the underlying measurements that investors should be looking at to determine if banks are improving?

A: Investors should be focusing on loan losses, Miller said. He added that he is surprised that many investors ignored loss trends when sending banks’ shares higher last week. Analysts widely agree that the “quality” of assets, such as loans written off as not being repaid and cash set aside to cover current and future defaults — are the best indicators of whether a bank’s health is actually improving.

Many banks increased provisions for credit losses in the first quarter. Bank of America set aside $13.4 billion. JPMorgan, considered one of the strongest banks, took a $10 billion provision.

Miller said he has never seen loan losses pile up so fast. He said he expects that trend to continue into next year.

Q: After earnings, what is the next big event banks are facing?

A: Earnings announcements will wrap up just in time for the federal government to release results from the “stress tests” it is running on 19 of the nation’s largest banks on May 4.

Q: What are “stress tests?”

A: The government will try to determine how loans and investments held by banks might perform if the economy gets even worse. The tests will estimate the potential losses banks would incur and how much capital they would need to have in reserve.

According to a document obtained by The Associated Press on Tuesday, the stress tests will take a harsher view on loans than other kinds of troubled investments, which could favor Wall Street banks over smaller regional lenders.

Q: What are the results expected to show?

A: That’s the billion-dollar question. The test results could have huge sway on how financial stocks perform over the next few weeks. Adam Harter, an analyst at Financial Enhancement Group said the key will be how much transparency and clarity the government provides in explaining the details of the tests and how deep the government intervention will be as a result.

“There’s no doubt one or two are in deep trouble,” Harter said of the big banks being reviewed.

In remarks Tuesday, Treasury Secretary Timothy Geithner said “the vast majority of banks” have more capital than they need.

One possibility would be for the government to convert its preferred stock in banks that it bought as part of the $700 billion bank rescue program into common stock, which would cut out the hefty dividend payments banks are currently paying to the government on the preferred stock.