Legalized Fraud

And if all others accepted the lie which the Party imposed – if all records told the same tale – then the lie passed into history and became truth  ("1984," George Orwell)

JPM reported $1.02 of earnings per share, ahead of the Wall Street Einstein consensus expectation of 92 cents.  HOWEVER, 29 cents - or 28% - of the reported number included a non-cash accounting gain which resulted from JPM exploiting a very controversial accounting rule that lets a bank essentially create income when the market value of its outstanding debt goes down in value.  Without this fictitious income, JPM would have reported 79 cents, well short of expectations.  Please read that again if you don't believe that you really read what I just wrote.  The truth is that if pour through JPM's earnings results with a critical eye, you'll see that underneath this accounting fiction that JPM's underlying business fundamentals are deteriorating.

How can serious investors trust ANY kind of earnings report that is put out by ANY financial institution?  What's appalling is the way the financial media looks at the headline numbers reported by JPM and lauds it for "beating" earnings and revenue expectations and remarks at what a great job JPM is doing.  And then casual investors turn on Bloomberg TV and see the accolades being tossed out or open the newspaper tomorrow and read how JPM's earnings report exceeded expectations, leaving said investor/observer with the impression that things are improving in our system.

The fact of the matter is that JPM's accounting presentation is legalized fraud.  The reporting of it by the financial media - which is financially supported by the advertising and promotional revenues paid by banks like JPM - is outright Orwellian.  Our entire economic and political system is on the very frightening slippery-slope toward the dystopic vision presented by writers like Orwell, Rand and Huxley.

Let's review how this legally fraudulent accounting gimmick works.  To be honest, I'm not even sure how the Financial Accounting Standards Board (FASB) OR the SEC ever allowed this idea to be made into a rule. It's literally legalized fraud. Although it's available to use for any company/entity, it was designed to apply specifically to Wall Street banks - any entity "with available-for-sale and trading securities" (the quote is from "Summary of Statement 159," FASB). In other words, this rule was designed to permit banks to further manipulate their accounting income (i.e. non-economic, cash-based earnings).

Here's how it works:  if the market value of a company's debt obligations (bank debt, bonds, etc) goes down in value, the company is permitted to recognize "accounting" income measured by the amount that the holding value (book value) of the debt obligation declines.  In other words, the company can create income based on the amount the book value of their debt declines, even though this decline typically reflects a higher degree of risk and financial instability.  The "income" is created by assuming that the company could go out into the market place to purchase and retire this debt at a big discount to what would be owed on the debt (the par or principal amount) at maturity.  You may need to think about this for a minute to really understand how the rule works, so that you can understand how pathetically flawed the logic is behind the rule.

Here's the coup de grace of this rule's absurdity, straight from FASB: "The fair value option is applied only to entire instruments and not to portions of instruments." In other words, in order for a company to book this accounting gain, it must take the full amount of market value decline on the entire debt issue - for each debt issue being used for this purpose -  under the completely mythical assumption that it could theoretically go out to the market buyback the entire amout of each debt issue at market value, thereby creating savings by retiring this debt at a discount rather than paying it off as it matures. Sound like anything that is anywhere even remotely close to being realistic, especially for companies with 100's of billions in debt outstanding?  The fact is, that when the market value of a company's debt obligations declines like this, it becomes even less likely that the company has the ability to go out and spend any cash to repurchase its debt.  This happens in reality very rarely.

I really can't believe that anyone, especially JPM CEO Jamie Dimon, can take JPM's earings with this accounting bullshit layered in and present them with a straight face. Seriously. The fact that reporters in the financial media are doing celebratory back-flips over this earnings report is a testament to the degree of absurdity and lack of accountability that has enveloped our system.  That Dimon can present this garbage is an egregious insult to anyone who understands accounting and finance.  It truly is Orwellian.

The golden truth is that most Wall Street analysts, if they even understand anything beyond simple GAAP accounting, will gloss over this earnings abortion and move on by explaining that JPM's balance sheet is stronger than is required by the regulators.  Dimon refers to this as JPM's "fortress" balance sheet.  Without having the time to delve into the research and calculations required, I would bet my entire net worth that if I went line by line through JPM's asset base and applied true market value standards to its assets, that its book capital would fall well below regulatory requirements.  In fact, that's the reality for every Too Big To Fail bank.

Given that we've witnessed the big banks create massive paper earnings first using "mark to market" fair value accounting on their assets, creating gains for income reporting purposes and fictitiously marking up crap assets for regulatory purposes, and then use the "reserve release" gimmick to generate fictitious earnings last quarter, and now this "debt valuation adjustment" fraud to generate paper earnings this quarter, I can't wait to see what accounting fiction they roll out for the 4th quarter. 

Rest assured that this is entirely fiction and fraud made possible by a system entirely based on paper currency and phony "accrual" accounting rules that have value based on what the Government decides to tell us its worth.  So yes, JPM is only playing by the "rules."  But it's also fair to say the big banks like JPM paid the politicians handsomely to have those rules put in place.  We'll know we've truly transformed into Orwell's vision when the banks announce that the losses they are reporting are really gains.  Oh wait, that's what DVA accounting is...got gold?