There has been a lot of buzz lately over the idea that, “America's Back!” Indeed, the economy is growing again, Job growth is recovering, retail sales are doing better… oh, and the banks have fully recovered in miraculous fashion from the financial crisis that nearly brought the world economy to its knees only a year ago.

That is what the chart below would suggest (via paul.kedrosky.com):

In fact, the dramatic rebound in corporate profits is largely due to the recovery in the financial sector. However, in his latest weekly letter John Hussman pokes a rather large hole in the “America's Back” thesis:

A year ago, the Financial Accounting Standards Board (FASB) suspended rule 157, which had previously required banks to mark their assets to market value when preparing balance sheet reports. The basic argument was that fair values were not appropriate because there was “no market” for troubled assets. Certainly, the FASB could have implemented something at least modestly reasonable, such as 2-year or 3-year averaging, but instead, they changed the rules to allow “substantial discretion” in the valuation of bank assets in their financial reports.

What is the result of this “substantial discretion”? The answer is soaring bank profits as the very same institutions that were literally insolvent only a year ago simply decline to write down bad loans today. The result of this is improved capital ratios (making them look solvent) and a massive boost in their quarterly earnings results. Hussman believes this will end badly:

Investors are deluding themselves about the solvency of the banking system. People learned in the 1930's that when you don't require the reported value of assets to have a clear and tangible link to the value that the assets would have in liquidation, bad things happen. Yet this is what regulatory and accounting rules are allowing for the banking system at present. While I do believe that bank depositors are safe to the extent of FDIC guarantees, my impression is that the banking system is still quietly insolvent.

And even if the banks survive, the process of rebuilding their balance sheets, regaining solvency, will be a long and painful one:

Indeed, it's possible that banks might be able to report fairly healthy “operating earnings” to investors, and then somewhat more quietly write off losses as “extraordinary” charges over a period of years. This type of outcome is beginning to look possible, because investors evidently don't mind repeatedly having their pockets picked as long as “operating earnings” come in above analyst estimates.

Unfortunately, in that sort of world, the economy would likely be hobbled for a long period of time, as Japan has discovered over the past couple of decades. With banks focused primarily on survival and recapitalization, retained earnings would be directed to making the existing liabilities whole, rather than contributing to productive new investment.

Deleveraging, deleveraging, deleveraging. That is the theme of the current economic cycle and Richard Koo's area of expertise.

So is America really back? Or are the banks just playing a shell game with their earnings and liabilities? I think the latter is more accurate and time will tell how strong the economy really is and its true prospects in the face of the current deleveraging cycle.

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