Citigroup chief financial officer Ned Kelly was trying to explain an aspect of the bank's better-than-expected first-quarter results on Friday morning when star analyst Meredith Whitney interrupted him. "Could you dumb that down for me?" she asked.
It was the question of the week. Just a few months after the near meltdown of the financial system, Citi, JPMorgan Chase and Goldman Sachs all reported billion-dollar-plus profits for the quarter ending March 31. Wells Fargo, which won't be releasing its earnings numbers until next week, preannounced on April 9 that it made about $3 billion a record for the firm. (See pictures of the dangers of printing money.)
But what does that actually mean, dumbed down? Whitney's question was specifically about Citi's $1.7 billion in investment-banking profits in Europe, and Kelly's eventual answer was basically just that business had been good. But bank financial statements are never that simple: Citi's overall investment-banking earnings were boosted by a $2.5 billion derivatives valuation adjustment "mainly due to the widening of Citi's CDS spreads." In somewhat dumbed-down but still utterly flummoxing language: credit-default swap (CDS) spreads represent the cost of insuring against Citi's default. That cost went up in the quarter as investors fretted about Citi's solvency, so Citi was able to book $2.5 billion in gains. Got that? Without that boost, Citi's $1.6 billion in quarterly profit would have been more than wiped out. As it was, holders of Citi's common stock still had to take a $966 million loss because of accounting adjustments related to the planned conversion of preferred shares owned by the U.S. government and other investors into common stock. Again, got that?
The upshot is that, while the quarter was Citi's best since mid-2007, it's awfully hard to say what it signifies. The chances that the bank might eventually be able to earn its way out of its troubles without more taxpayer help seem to have increased. But it will take many more quarters before anybody can say that with confidence.
The same goes for the country's big banks as a group. This week's positive results, which had been anticipated by a monthlong rally in bank stocks, are certainly better than last year's multibillion-dollar losses. But bank earnings are extremely sensitive to assumptions about the future, and whether the banks are actually on the road to recovery will depend to a great extent on how the economy performs in the coming months. That said, there are a few dumbed-down lessons that can be taken from the earnings news thus far:
The demise of competitors is good for profit margins. For the past 40 years, the rise of a shadow banking system of securitization, investment banks, hedge funds and private-equity firms has taken business from conventional banks. Now much of that shadow banking system is gone, and the surviving banks battered as they may be are gaining market share in everything from mortgage lending to investment banking. As Wells Fargo shareholder and Goldman Sachs bondholder Warren Buffett put it on CNBC in early March, "This is a great time to be in banking, you know, if you just get past the past."
While mortgage losses show faint signs of moderating, banks still have a lot of credit-card ugliness to work through. At JPMorgan Chase, card services was by far the worst-performing division, with a loss of $547 million. When Whitney asked CEO Jamie Dimon if the business would return to profitability this year, his answer was a succinct "No." At Citi, "credit-card losses seem to be breaking their historical correlation with unemployment," CFO Kelly said. That is, credit-card losses normally rise with the unemployment rate. Now they're rising faster.
It's nice to forget December. Investment banks traditionally end their fiscal year in November, commercial banks in December. Since Goldman Sachs and Morgan Stanley shifted to commercial-bank status late last year, they decided to shift their fiscal years starting this year. In doing so, they orphaned the month of December 2008. For Goldman, it was revealed this week, that meant saying goodbye to $780 million in losses that will never show up on the bottom line of an earnings report.