The Accounting Wizardry Behind Banks’ Strong Earnings

Wells Fargo reported a personal-best $5.6 billion in fourth-quarter earnings today, overtaking JPMorgan Chase as the most profitable U.S. bank. JPMorgan reported $5.3 billion in fourth-quarter income and $17.9 billion for all of 2013, not too shabby for a year in which the bank spent $23 billion on legal settlements.

Upon further review, however, these profits don’t look quite as robust. More than 31 percent of JPMorgan’s 2013 earnings, or $5.6 billion, and about 10 percent of Wells Fargo’s, $2.2 billion, weren’t really earned last year. That money came instead from the banks’ so-called loan-loss reserves, an accounting accrual that’s kind of like a rainy-day fund.

Lenders set aside that cash during and shortly after the financial crisis to cover future losses in case the U.S. economy got worse and consumers couldn’t pay their credit card bills, mortgages, and other loans. But collections on most consumer loans have never been better—banks tightened lending standards, plus people went back to work—so the banks are using that money to bump up earnings.

Meanwhile, revenue growth has been on a steady decline, which means those nice-looking earnings are a result of tapping those reserves and cost-cutting, says Josh Rosner, an industry analyst with research firm Graham Fisher in New York. “At some point you run out of reserves to release, and you can’t cut more costs without cutting loans,” he says.

Among the four largest U.S. banks, Bank of America, which will report earnings tomorrow, has received the biggest boost from releasing reserves: The move helped it turn $11.8 billion in losses since 2010 into $11.4 billion in profit. Citigroup, which reported $40.4 billion in net income over that time, would have booked about half that amount without the accounting benefit.

This cuts the other way, too. Bank of America would have reported almost $55 billion in profit in 2009 if it weren’t for the $48.6 billion it put back into reserves that year. Spokesmen for Bank of America, JPMorgan, and Wells Fargo declined to comment. Profits at all the other banks were also hit as they built up their reserves during the crisis.

This is all perfectly normal—JPMorgan Chief Executive Officer Jamie Dimon even said in an earnings call today that he believes accounting standards compel banks to release their reserves when their loans are performing well. At the same time, analysts say rampant use of the reserves has made profit reports virtually meaningless. Not all investors may feel the same way. JPMorgan rose 25 percent in the last 12 months. Citigroup is up 27.5 percent over that time, while Wells Fargo gained 31.3 percent and Bank of America surged 44.6 percent.

“Bank earnings are a joke,” says Paul Miller, a bank analyst at FBR Capital Markets in Arlington, Va. “They are very poor quality, but investors are just embracing them.”

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