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The Accounting Moves that Goosed Citi's Profits

Citigroup (NYSE:C), the country’s third-largest bank by assets, surprised the markets Tuesday by missing its fourth-quarter earnings estimates, as revenue from its trading desks and investment banking slumped.

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Look under the hood of Citi’s earnings and you’ll see the bank dramatically goosed its profits higher by booking outsized paper gains from an accounting trick that’s legitimate under current rules, and by releasing loan loss reserves into earnings.

The accounting moves Citi deployed include an $8.2 billion release of loan-loss reserves into 2011 earnings, as well as booking in profits $1.8 billion in paper gains on its debt. Taken together, the moves accounted for a sweet 88% of its full year 2011 profit of $11.3 billion. And without the moves, its fourth quarter would have dropped deep into the red.

Citi is relying on the same accounting moves that other banks like JPMorgan Chase (NYSE:JPM) and Morgan Stanley (NYSE:MS) have increasingly used to polish their profit results. (For more, see “The Accounting Move That’s Goosing bank Profits”)

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Citi’s fourth quarter earnings per share came in at 38 cents, 14 cents below expectations of 52 cents per share, and lower than its 43 cents posted in the fourth quarter of 2010.

Citigroup’s fourth-quarter profit came in at $1.2 billion, down from its third quarter profit $3.8 billion and just shy of its $1.3 billion profit in the fourth quarter of 2010. Citi’s revenue dropped 7% from the fourth quarter of 2010, to $17.2 billion.

Full-year profit for 2011 rose more than 6% to $11.3 billion, the second year the bank has posted profits since the housing crisis began.

The bank posted $78.4 billion in full-year revenue, down from the $86.6 billion it booked in sales in 2010. Citi attributed its revenue decline to a $6.4 billion drop in revenue at its bad bank, Citi Holdings, which it has been trying to unwind. Expenses rose to $50.7 billion for the year, up from $47.4 billion in 2010.

The $8.2 billion in loan loss reserves Citigroup released into 2011 earnings is up from the $5.8 billion it deployed in 2010, even though loans grew 14% last year, to $465.4 billion. Taken alone, that $8.2 billion is a sizable 73% of its reported $11.3 billion in 2011 net earnings.

Loan-loss funds are cookie jar reserves, or money it had previously set aside to cover losses on mortgages, credit cards and other loans.

If it didn’t release $1.5 billion of loan reserve funds into fourth quarter earnings, Citigroup’s $1.2 billion fourth quarter profit would have instead been a loss.

And Citigroup booked a paper gain of $1.8 billion on its debt for 2011, which reflected a sharp increase in the market’s perception of the riskiness of its debt.

Other major banks like JPMorgan Chase and Morgan Stanley have used this accounting adjustment to get a similar earnings boost. In fact, 54% of the third quarter profits for four banks -- Bank of America (NYSE:BAC), Citigroup, JPMorgan and Morgan Stanley -- came from this accounting maneuver.

Without this paper gain, Citi says its revenue from its securities trading desks and banking businesses -- including its fixed income, equity and investment banking businesses -- would have dropped a deeper 29% from the prior year period, versus the 10% decline it reported, to a full year $3.2 billion.

Citigroup’s chief executive, Vikram Pandit, said in an internal memo to employees that the bank still faces stiff headwinds to profit growth from around the world.

“The weak global economy negatively affected market activity, and many of our clients reduced their risk, especially in the fourth quarter,” Pandit said in the memo.

Pandit added: “We’ve shown that we can weather a tough environment without investors, regulators and other observers questioning our safety and soundness. Our capital strength remains among the best in the industry and actually rose once again in the last quarter.”

Citigroup got $45 billion TARP bailout money, which it has since repaid, as well as an initial government backstop to its troubled balance sheet of about $306 billion. It has split itself into a good and bad bank, Citicorp and Citi Holdings, respectively.

Pandit has been battling to pare back Citi's gargantuan balance sheet built up by predecessor Sanford Weill. Pandit notes in his internal memo that “Citi Holdings assets declined an additional $90 billion during the year,” to $269 billion.

Pandit added that the bank expects Citi Holdings assets will be cut down “to just 12% of our balance sheet.”

But it’s the paper gains that banks get from valuing their debt that is grabbing the attention lately.

Called a ‘debt valuation adjustment’ or ‘credit valuation adjustment,’ the move lets banks book in their profits paper gains that they get to come up with all on their own.

Here’s how the moves works: A bank or company borrows in the credit markets to fund its operations. It does so by issuing bonds, which are essentially loans the bank pays interest on. But the banks' own debt has been getting pummeled lately for a variety of reasons. Namely, worries that Europe’s avalanche of debt problems could ripple through to U.S. banks, the ongoing housing crisis, slowing economic growth, and Standard & Poor’s downgrade of the     U.S. government’s credit rating, among other things.

However, when a bank’s bond drops in value because no one wants them, an odd accounting rule enacted in 2007 says a bank can book a paper profit based on that drop in value, what’s called below par value.

The theory is the bank would realize a profit if it bought back its own debt at that lower value. (DVA’s close cousin is the CVA, or credit valuation adjustment.)

So what that means is that banks can include paper gains in their profits based on bets against their own survival -- when the value of their own credit quality worsens. The higher the risk a bank defaults on its debt, the bigger the gains they get to take from DVAs.

But there’s a lot of guesswork here.

For one, the banks under the accounting rules get to come up with their own measure of the gains they can take here, based on their assessment of the trading values of their debt. They use widening credit spreads in the swaps market, for one. When credit spreads widen, that means investors believe there is deterioration in the creditworthiness of a bank.

Now, all of this doesn’t mean the bank will not pay investors back on their bonds at par when the bonds mature. But what it does mean is that banks will have to reverse these gains at a later date, under the rules. So, should investors be cheering earnings that really are about the worsening creditworthiness of banks?

And there’s another issue with this accounting move. Remember when the banks squawked and got the guys who set the rules for how companies must book their profits to back down on   what’s called mark-to-market accounting, because the rule would have hammered their profits because of their bad bets?

That rule essentially says companies must book the value of their assets as if they were to sell them in that same quarter, even if they weren’t going to do that.

So when the housing crash happened, bank asset values plunged, and bank profits were going to get socked. After the banks hollered, the rule-setters, the Financial Accounting Standards Board, gave a reprieve on the rules to protect the banks.

So, now the banks want their cake and eat it too. They’re price tagging the drops in the value of their own bonds, then booking the difference in their profits. Keep an eye on this one.