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The Power of Imagination

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Citigroup, one of the huge banks being bailed out by taxpayers, was at the top of the headlines again this week:

Citigroup Inc. Chief Executive Officer Vikram Pandit said his bank is having the best quarter since 2007, when it last posted a profit. The shares rose 38 percent and helped spur gains for finance company stocks. “I am most encouraged with the strength of our business so far in 2009,” Pandit wrote in an internal memorandum obtained today by Bloomberg. “We are profitable through the first two months of 2009 and are having our best quarter-to-date performance since the third quarter of 2007.”

Last week the pundits and news anchors quipped that Citi’s share price, which had dropped below $1, was less than an ATM fee. This week’s positive report from the Citi CEO was cited as cause for Tuesday’s major rally in the broader markets.

If it was the cause of the rally, take that as an example of traders responding with emotion rather than hard financial analysis:

You can't blame the market's reaction. Since Feb. 6, the Dow Jones has risen all of five times. Even relatively healthy banks like JPMorgan Chase and Wells Fargo are being treated like basket cases. Anything that can be slightly spun as good news is bound to be clinged to. Just give us any good news -- even if it's not, you know, true -- and the market will run with it.

This is no exception. Citigroup's announcement that "Hey, hey, we're actually profitable!" is twisted, tortured, and largely irrelevant to its ultimate fate.

The gist of Pandit's memo was that operating profit was going gangbusters -- as if operating profit has been the problem all along. The problem is not a bank's ability to generate current income, but its ability to absorb losses on legacy assets that are worth a fraction of their purchase price -- using absurd amounts of leverage to boot.

The memo disclosed numbers that point to an operating profit of about $8.3 billion this quarter, but Pandit didn't give any mention of what asset writedowns would be. "In January and February alone, our revenues excluding externally disclosed marks were $19 billion," he said. Great! Now... uh... about those "externally disclosed marks?" How are those workin' out for you?

I'm not worried that Citigroup can't generate operating profit: I'm worried it's not solvent. There's a big difference. Imagine a person drowning in debt but insisting they're wealthy because their paycheck exceeded their grocery bills. You get the idea.

Markets certainly move on emotion. The famous description of last decade’s dot-com bubble was “irrational exuberance”. But the emotion these days is sour, and investors are both gun-shy and skeptical. I have trouble crediting Tuesday’s rally to Citi’s pretend profitability.

In trying to find profit, investors need certainty. Or, at least predictibility. The market hasn’t had much of that lately. A web of opaque and tightly inter-wound alphabet soup of financial instruments—CDS, CDO, MBS—has been exposed. Nobody knows how much X has promised to Y, and under which conditions of Z that X might be able to pay its debts. Without a robust assessment of risks and obligations, investors can’t be sure what anything is worth.

On Tuesday, Fed Chair Bernanke mentioned that accounting standards might be to be revised. Accounting standards are the rules by which the value of companies are measured. Specifically at issue are rules called “mark-to-market”. That means an asset is worth what someone would pay for it now. Since nobody knows how those alphabet obligations will be unwound, essentially nobody will buy them. They’re basically worthless. Banks that used those instruments as collateral now find their asset base slashed, and have become insolvent.

It might be like having your house burn down and finding your insurance can’t pay. You borrowed against the house, and you can make payments on the mortgage (operating profit), but your bank needs to know there’s something real behind the loan to you, in case you stop making payments. Marking to market, your house is now only worth the land upon which its ashes smoulder. Your bank has a problem.

Bankers insist that marking to market isn’t quite fair. Congress is now considering Bernanke’s suggestion. The rules could be relaxed, so that those worthless assets can be held on the books somewhere between today’s zero value and what the bankers think they’ll be worth in a few years. This would make the banks solvent again, and give investors more certainty and predictability. That seems better fuel for a rally than Citi’s pretend profits.

But changing mark-to-market isn’t too much different than your bank figuring their mortgage against your ash-heap is still good because you’ll eventually rebuild your house. Their books look better, but there’s no house and really no way to be sure you really will rebuild.

Plus, releasing valuation from the constraint of what somebody will actually pay gives the banker an incentive to believe that you’ll build an even nicer house, making their mortgage even more valuable than it was before your house burned down. If assets are not marked to the market, they’re marked to imagination.

I’m sure Congress will hear that argument, and institute controls and oversight to prevent over-valuation. They did such a good job at that with FannyMae…I imagine everything just has to work out fine.