Bit of a shock to read that Europe's MoneyWeek, a respected financial publication, has just revealed the truth about the state of the U.S. banking sector. Who knows, next they might discuss silver suppression by JPM?

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The US banking recovery is a sham

By Associate Editor David Stevenson - MoneyWeek

July 16, 2010

Let's hear it for the bankers!

There may be plenty of gloom gathering elsewhere. But the moneylenders – or some of them at least – seem to be doing very nicely. For example, US giant JP Morgan Chase has just revealed a staggering 76% jump in its second-quarter profits.

So is it safe to buy US bank shares again?

No. Those bumper profits are nothing like as good as they appear on the surface. Nor will the figures set to be reported by other US lenders be as good as they first appear.

Racking up a $4.8bn profit in just three months is no mean achievement for anyone. But in an industry supposed to be at death's door two years ago, it's particularly noteworthy.

Yet that's what JP Morgan Chase, America's second biggest bank as measured by assets, has just done. Not only was the firm's quarterly profit up by more than 75%, it proved far better than even the most optimistic estimate by the experts.

What's more, it's part of a steadily rising trend in improved results.

The chart below shows JPMorgan's recent quarterly profits. These have now climbed right back to 2007's high point. That's nothing short of amazing. And it's more than enough to get bank bulls quite excited again.

Source: Bloomberg

But hang on a minute. Maybe there's a con trick being played here.

For one thing, JP Morgan hasn't achieved any 'real' growth. The bank's revenues actually fell by 8%. Investment banking and fixed-income trading results both dropped.

So where did all the money come from?

The figures aren't as good as they first seem

Well, the bank only turned in such a 'good' result because it slashed its "provision for credit losses" by two thirds, from $9.7bn to $3.4bn. In other words, all (and more) of JP Morgan's latest profit was due to the bank making a much lower allowance for bad debts – loans that could go sour because the debtors can't repay to the bank the money they've borrowed.

Fine, the bank's accountants may have called this right. But there have to be question marks. "People can debate whether that's artificially inflating the quality of earnings," says Christopher Wolfe at Fitch Ratings. "If you think banks have identified their problem assets, then that's valid. If you think banks have problem loans they haven't come clean about, then that would be a concern."

But this isn't just about bad debts – or JP Morgan. As Bradley Keoun and David Henry at Bloomberg point out, other US banks will be pulling strings to make their results look good: "Bank of America and Wall Street firms are now depending on an accounting benefit last used in the depths of the credit crisis to prop up their results".

New accounting rules artificially inflate earnings

The arcane-sounding FASB 157 rule may seem deadly dull, but for bankers it's very important – and very controversial, too. Here's how it works. When banks want to borrow money, they often do so by selling bonds. These are in effect IOUs. FASB 157 lets these banks pretend they'll buy back their IOUs at current market rates, even though they may have no real intention of doing so.

Now let's say that a bank's IOUs drop in price – for example, because it's reckoned by the market to be dodgier than was previously thought, meaning that the risk of holding those IOUs rises.

Although the face value – the actual amount owed on the IOUs – stays the same, the bank is now allowed to assume that it owes less money to its creditors. So it can book the difference between the previous IOU value and the current, lower price as a profit.

Bank of America, the biggest US bank by assets, may record a $1bn second-quarter gain from writing down its debts to their market value, says Keith Horowitz at Citigroup. Morgan Stanley will also probably record $1bn in such debt valuation adjustments in the second quarter, he says, equal to 60% of his estimate for the firm's pre-tax income.

Chris Kotowski at Oppenheimer is very clear what this really means. It's an accounting "abomination", he says, because fluctuations in the value of the debt don't change the amount the banks owe.

Then there's 'mark to model'. To cut a long story short, this lets banks put valuations on their assets that are more likely than not to be higher than a true market price. In turn, that difference can be added back to boost profits.

Banks will be in the firing line as the economy turns down

For investors who've tried to assess stocks in the sector by taking their profit numbers at face value, it's all a huge worry.

Even worse, for banks this could now be as good as it gets. As the US economy heads into double dip territory, which looks increasingly likely, judging by yesterday's US economic data, lenders are going to be right in the firing line.

Extra losses on commercial property, home loans, consumer loans, credit cards… you name it, America's lenders will really feel the pinch again if the economy nosedives. And bank profits could be crushed. Superstar banking analyst Meredith Whitney – one of the few to foresee the sector's 2007 problems – still pulls no punches. Last week she slashed her second-quarter earnings estimate for Goldman Sachs from $4.75/share to $1.70 due to a "heinous trading environment".

Already 90 US regional banks have gone bust this year. Many more could follow. In short, it could all get very nasty indeed.

Meanwhile, the US senate has just approved a new bank regulation bill, which is not good news for big American lenders. We'll have more on this later today. But it all means that instead of buying US banks right now, selling seems to make much more sense.

You may already have done that. But if you fancy a punt on bank share prices falling sharply, there are ways of doing so. Like buying the Ultra Short Financial Proshares ETF (NYSE: SKF). It 'short sells' financial stocks – for every 1% the sector drops, the ETF rises around 2% (although it doesn't track precisely because of the way it's structured). Of course, it's risky – shorting always is. And you have to get your timing right. But if you reckon bank shares are heading south, this could be one to watch.