That the financial industry was and remains in trouble is not revelatory to those who pay attention to fair value measurements. Take Citigroup for instance. This firm, once a giant among banks, now gasps for its existence.
Citi’s reported net income was $(27,684) for 2008 (all accounting numbers in millions of dollars). While this is a smelly number, the odor grows worse when one adjusts it for various items that bypass the income statement.
Ever since the FASB invented the comprehensive income statement in a political move to get business enterprises to do some accounting for items they didn’t want to disclose, I have advocated that investors use comprehensive income instead of net income. Comprehensive income includes relevant items that have had a real economic impact on the business entity; therefore, investors will find these items informative.
For fiscal 2008, Citi shows unrealized losses on its available-for-sale securities of $(10,118). It also shows a loss on the foreign currency translation adjustment of $(6,972), a loss on its cash flow hedges of $(2,026), and a loss for additional pension liability adjustment of $(1,419). This makes Citi’s comprehensive income $(48,219).
But the bad news doesn’t end there. The pension footnote (footnote 9) shows the expected rate of return is 7.75%. While this is what is required per FAS 87, it is nonsense. Did anybody know the 2008 rate of return in (say) 2005? The FASB should get rid of such fantasyland assumptions and require business enterprises to employ the actual rate of return. If Citi had done so on its pension assets, it would have had an actual return of (5.42)%, so we shall adjust downward the 2008 income by another $1,370.
The most interesting item is Citi’s move with respect to its investments. It reports debt securities in its 2007 held-to-maturity portfolio of only $1. By year end 2008, however, this amount mushroomed to $64,459. Clearly, Citi is shielding these debt instruments from fair value accounting and the reporting of additional losses. Footnote 16 indicates that these losses for 2008 amounted to $(4,082).
Another item concerns the firm’s deferred income tax assets. For 2008, Citi discloses $52,079 in deferred income tax assets and a valuation allowance of zero. Given that Citi paid no federal income taxes in 2007 or 2008 and likely will pay no federal income taxes in the near future, if ever, how can the company justify a valuation allowance of zero? Whatever amount it should be would further reduce the profits of the firm. Since we don’t know how to estimate this valuation allowance correctly, we shall continue to hold its balance at zero, even though this is clearly wrong.
Putting these considerations together, Citigroup has an adjusted income in 2008 of $(53,671). This is still an estimate but clearly it is more nearly accurate than the reported number. And it reveals that Citi lost twice as much as it reported.
Recently, we have been hearing how Citi has turned things around and that the first quarter in 2009 returns Citi to the black column with a profit of $1,593. Don’t believe a word of it!
Items in comprehensive income shows a modest gain in the available-for-sale portfolio of $20, gains on cash flow hedges of $1,483, and a gain because of the pension liability adjustment of $66. Unfortunately, these gains are wiped out by a loss in the foreign currency translation adjustment of $(2,974). Comprehensive remains ugly at $(225).
We don’t have any disclosure in the quarterly report about actual versus expected returns on pension assets, so we cannot adjust them to show the truth.
But, the strategy to move debt securities from available-to-sale to held-to-maturity paid off significantly. First quarter results show a staggering loss on these securities of $(7,772).
So far, the adjusted earnings for Citigroup for the first quarter of 2009 is $(7,584). Don’t tell me that Citi has improved its operations.
Further, these numbers have been improved by an eccentricity in FAS 157. For some silly reason, the board allows entities to show a gain on their liabilities if the firm’s own credit risk has increased. This takes a perfectly good notion of fair value of liabilities to an absurd result. Failing companies might be able to make liabilities disappear by claiming a sufficiently high increase in their own credit ratings! Utter rubbish—and the FASB should amend its statement.
Citi disclosed in a conference call that the first quarter results include a gain of $2,700 because of this increase in its own nonperformance risk. This gain is total nonsense, so I would adjust quarterly income further, giving Citi adjusted earnings of $(10,284).
Citigroup suffered a cardiac arrest in 2008, and it remains in critical condition. Any other conclusion is propaganda or self deception.
And forget the stress tests; they are so flawed that Lehman Brothers might pass them. The Fed says that Citi needs another $5,500 in capital to weather any additional economic crises it might face. It isn’t true. Citi needs a lot more capital than that just to weather current conditions. If a real crisis occurs, Citi will become a flat-liner; it might die anyway.
If you want to protect your portfolio, don’t listen to the optimistic forecasts coming from Washington and don’t stop at the reported income number. Look at the fair value disclosures within SEC filings, adjust reported earnings for these fair value gains and losses, and then you will obtain the truth.