Since Wells Fargo announced last week that it expected record first quarter profits, I have been looking for some kind of reality-based explanation. Certainly the market liked the news. But what does it mean, this alleged $3 billion in profits? Today we received some additional news, as KBW downgraded the stock:

Wells Fargo & Co., the second- biggest U.S. home lender, may need $50 billion to pay back the federal government and cover loan losses as the economic slump deepens, according to KBW Inc.’s Frederick Cannon.

KBW expects $120 billion of “stress” losses at Wells Fargo, assuming the recession continues through the first quarter of 2010 and unemployment reaches 12 percent, Cannon wrote today in a report. The San Francisco-based bank may need to raise $25 billion on top of the $25 billion it owes the U.S. Treasury for the industry bailout plan, he wrote.

First-quarter net income rose 50 percent to about $3 billion, Wells Fargo said last week in announcing preliminary results that topped the most optimistic Wall Street estimates and sparked a 32 percent jump in the stock. The bank attributed the profit to a surge in mortgage originations and revenue from Wachovia Corp., acquired in December. Full results are scheduled for April 22.

“Details were scarce and we believe that much of the positive news in the preliminary results had to do with merger accounting, revised accounting standards and mortgage default moratoriums, rather than underlying trends,” wrote Cannon, who downgraded the shares to “underperform” from “market perform.” “We expect earnings and capital to be under pressure due to continued economic weakness.”

I added the bold type there. In other words, do not read too much into these "record profits." Also bear in mind that some of last week's bullishness came after the government announced that all banks passed their stress tests. Unfortunately, the stress tests relied heavily on internal data and analysis performed by the companies themselves, with minimal government oversight. As the market rallies on the idea that banking problems have been overblown, and are largely behind us, bear in mind that this "good news" is coming from the very same people and companies that have lied so often during the past two years.

At the same time, as investors and traders, we should consider the trillions that have been paid out to these financial institutions, and the myriad consequences. Karl Denninger reports that GS may be getting ready to report their second best quarter in history.