Bank Alchemy: Gold Out of Garbage

Posted: Oct 20, 2011 12:01 AM

Before chemistry was viewed as a science there was alchemy. 

For centuries, the alchemists labored over their bubbling cauldrons trying to convert lead to gold.  This was no fairy tale attempt. 

Kings and emperors knew that to not only run a country, but also to expand by conquest, it took armies that had to be clothed, armed, fed, and paid. 

And that took money. 

Of course, no self-respecting soldier would accept paper, it had to be gold. 

Often, the gold was devalued by mixing it with other elements, but that proved unsuccessful as merchants soon realized the true value of the soldier’s pay. 

Thus, great empires that chose to put forth devalued currencies saw their reigns collapse.  Rome is just one example. 

Thus, alchemists were enlisted to find the magic formula for something out of nothing.  The alchemists of the past have nothing over the U.S. bankers of today. 

In fact, our folks have actually accomplished the difficult task of creating gold out of garbage (lead). 

Take the most recent earnings from Bank of America, Citibank and Morgan Stanley.  First, they reduced the size of their reserves in anticipation of lower defaults on everything from autos, credit cards, and mortgages. 

That created an accounting gain for profit reporting purposes. 

Next, and the most recent trick, is to declare the changes in debt related credit spreads as a positive for net revenue. 

This alchemy can artificially inflate net revenues dramatically while increasing earnings per share.  Putting it simply, let’s say you owe someone money and they hold the paper.  Let’s now say the paper the creditor holds is trading in the market for 40% less than originally stated. 

What if you could buy the paper back? 

You don’t, but what if you could? 

Accounting may allow you to realize the 40% as a profit, add it to your revenue line, and increase your earnings per share. 

The details, like any good alchemy, may be a little bit more complicated, but you get the gist. 

The banks are collapsing, and are creating all sorts of accounting gimmicks in order to make the appearance of viability. 

Sure, the cheerleaders on CNBC and Bloomberg root them on.   

I would say, however, that most of those people have never heard of Rumpelstiltskin, but that’s another fairy tale altogether. 

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