Extra! Extra! Citigroup may be profitable!

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Citigroup CEO Vikram Pandit says that “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.” This was in a pep-talky memo to employees, and we’ve all learned to be dubious of what banks claim are profits. But with the federal government throwing money at them (not so much through TARP as through the various Fed liquidity programs) and competition in the lending business from nonbanks dramatically reduced, it only makes sense that banks’ profits would start improving.

The key is something called net interest margin—the difference between what the banks pay for funding and what they charge on loans. It’s been on a downward trend since the mid-1990s—and for bigger banks in particular it’s been absolutely plummeting since 2002. The reason, contends fixed income analyst David Goldman, is:

Because banks used loans as a loss leader to get more profitable fee business. The foolish investor community thought that fee business was less cyclical than lending and rewarded bank equity performance for this ruse.

And because banks had locked in lots of big corporate credit lines at extremely generous terms, the interest margin—which normally rises during recessions—continued to decline in 2008. That’s got to turn at some point, and early indications are that this quarter may be that point.  The bottom-line impact could still be wiped out by further declines in the value of banks’ existing assets. And of course any improvement in bank profits comes straight out of the hides of businesses and consumers. But it means that the hope that currently troubled banks could earn their way out of trouble may not be entirely delusional.