This morning we saw a seemingly impressive earnings report from Bank of America (NYSE:BAC). Revenue was up. Profits beat expectations. Good news, right?
Not so much. A closer look at the numbers show some fuzzy math that only a contortionist could feel comfortable with. The real bottom line is that Bank of America earnings still are in trouble, and the entire financial sector remains a very risky bet.
Here are the headline numbers: Bank of America earnings tallied a profit of $6.2 billion, or 56 cents per share. Revenues were up 6% at $28.8 billion at BofA. Wall Street was expecting EPS of 20 cents per share on revenues of $25.95 billion, so it all looks pretty good on paper.
But the latest quarter’s earnings figure included $4.5 billion in “fair value adjustments.” In short, this means a bank can decide how much its assets and liabilities are worth on its own! For instance, a few days earlier, both JPMorgan (NYSE:JPM) and Citigroup (NYSE:C) said the spread between their debt and U.S. Treasuries led to “profits.” No business actually transpired — other than a different number being used to calculate the Excel spreadsheet in accounting. Theoretically, as their debt “loses value” it is cheaper for banks to pay it off, resulting in a paper gain.
Confused? Well you should be — because an accounting trick that conjures billions out of thin air seems fishy to many investors. Interested parties can read an excellent, detailed report on the kinky accounting practices from Reuters here. Unfortunately, we have other fuzzy math to discuss in regards to BofA and have to keep moving …
Next up is the pretax gain of $3.6 billion from Bank of America’s sale of shares in China Construction Bank. Obviously, a huge one-time gain like this cannot be recreated. And as I wrote when the deal went down, the sale damages the future of BAC lending in China, a crucial emerging market considering how poor the credit market is in the U.S. and Europe right now.
Then there’s the loss of $2.2 billion related to private equity and strategic investments. Investors had a rough third quarter too, but $2.2 billion seems a bit ugly for a supposed Wall Street icon.
To top it off, all this comes after a Monday report from Bank of America Corp.’s credit card division that indicated an increase in late customer payments for September, the first such uptick in a year. Additionally, Bank of America still has one of the highest credit card default rates in the industry.
Nobody Knows How Bad Things Are at Banks
The squints on Wall Street can fight over the finer details of this quarter’s earnings at BofA. But the bottom line is that nobody knows how bad things really are. One-time charges, goofy “mark-to-market” tricks juicing numbers and lingering problems with consumer lending mean a very bleak picture for financial stocks.
Consider these other earnings reports:
JPMorgan Chase (NYSE:JPM) saw third-quarter earnings slip 3.5% thanks to higher expenses. On the revenue front, things are going nowhere fast — 2009 and 2010 full-year revenue totals were almost identical. As for 2011, JPM is looking at a slight decline in revenue.
Wells Fargo (NYSE:WFC) third-quarter earnings missed expectations as the financial stock’s loan business didn’t grow fast enough. The revenue trend for WFC also is ugly — with six straight quarterly reports that show year-over-year declines. Not inspiring.
A massive one-time accounting gain allowed Citigroup (NYSE:C) to eke out its seventh consecutive quarterly profit, but subtract paper a paper gain of $1.9 billion related to the risk of its debt and “mark-to-market” accounting shenanigans, and the $2.2 billion in profits shrinks to a very unimpressive level. Revenue is all over the place, ranging from a low of $8 billion a quarter to a high of $74 billion a quarter in the past six earnings reports. The company just can’t seem to get ahead.
True, financial stocks have a tough row to hoe right now. Persistent troubles with bad mortgages and bad debt are eating away the bottom line. Fewer qualified borrowers are out there thanks to the tough job market and black marks on credit reports because of other economic hardships Americans have had to endure.
But that’s all academic. Aside from the fact that financial stocks willfully created the subprime mortgage bubble, Wall Street isn’t much interested in excuses. Investors want to identify profits and risks — nothing more.
Do Not Bargain Hunt in Bank Stocks
Unfortunately, the financial sector continues to be a story of big risks and little opportunity.
Consider the Financial Select Sector SPDR ETF (NYSE:XLF) is off 25% so far in 2011, showing how banks have been holding back the market. If you look at the blue line on this chart, which represents the moving average, you’ll see that the downtrend is obvious and is showing no sign of abating. Even though the market has been gyrating up and down, this financial ETF has shown zero signs of life.
Banks’ core business of consumer and business lending has failed to prop up the bottom line, and that’s not just bad news for the economy — it’s also bad news for the financial sector. Slow lending growth means slow profit and revenue growth, too. And unfortunately, the weight of bad mortgages means the demand for growth and a thriving lending business is bigger now than ever before.
Of course, those weasel-like financial stocks have other ways to juice their numbers. Bank of America is looking to bridge the holes in its balance sheet by gouging consumers with a $5 debit card fee. BAC also is looking to raise cash selling off many of its assets in a bid to raise enough capital to meet new banking regulations and prop up its bottom line.
So what’s the takeaway for investors? The bottom line is that it’s impossible to tell when bank earnings will improve. And that, amid other lingering uncertainty over European debt and unemployment and consumer spending, is enough to make you think twice. Yes, there was a brief respite for BAC stock when Warren Buffett bought in with a $5 billion deal for preferred shares. And there have been occasional moments of strength across a day or two as the market hit an updraft.
But by and large, financial stocks are frontrunners in market declines and lag behind when things turn around. It’s difficult to imagine the sector has bottomed — and if recent earnings reports are any indication, it could be quite some time before there is any sign of hope in the banking industry.
Jeff Reeves is the editor of InvestorPlace.com. Write him at firstname.lastname@example.org, follow him on Twitter via @JeffReevesIP and become a fan of InvestorPlace on Facebook. As of this writing, he did not own a position in any of the aforementioned stocks.