The Accounting Move That's Goosing Bank Profits

Look under the hood of bank earnings releases and you’ll see the banks are booking outsized paper gains in the third quarter from an accounting trick that’s legitimate under current rules.

Without the move, some of the big banks -- Citigroup (NYSE:C), Morgan Stanley (NYSE:MS) and JPMorgan Chase (NYSE:JPM) -- would have missed their third-quarter consensus earnings estimates.

In fact, 54% of the profits for four banks -- Bank of America, Citigroup, JPMorgan and Morgan Stanley -- came from this accounting maneuver.

Citigroup was able to book a profit, even though its revenue fell when you take out its paper gains from the move.

Bank of America reported a nice $6.2 billion profit for the third quarter -- but 27% of that profit, or $1.7 billion, came from the paper gains resulting from this accounting move. The beleaguered bank told investors it beat analysts’ earnings estimates. It said it had 56 cents a share in profit. But strip out the paper profits from this accounting move and BofA earns 44 cents a share.

Citigroup said it beat analysts’ consensus estimates as well, with $1.23 earnings per share. Not so fast -- take out the $1.9 billion it said it got from this accounting trick and it misses analysts estimates of 81 cents a share, with a lower 64-cents-a-share result.

There’s more. Goldman Sachs’ 84-cents-a-share loss turns into a deeper $1.66 loss. Analysts were expecting a 16-cent loss. Ouch.

JPMorgan Chase kicked off the third-quarter earnings season announcing it booked $1.9 billion in paper profits from this move. So its reported $1.02 profit morphs into 73 cents a share in earnings.

The move, called a debt or debit-valuation accounting [DVA] gain, “does not relate to the underlying operations of the company,” JPMorgan’s chief executive Jamie Dimon, 55, said in a statement accompanying the bank’s third quarter earnings release.

Same story for Morgan Stanley. Its $1.15 a share result was actually an ugly 3 cents a share when you remove this accounting gain.

The DVA move lets banks book in their earnings results paper gains that they get to come up with all on their own.

Put simply, 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, the housing crisis, slowing economic growth, Standard & Poor’s downgrade of the U.S. government’s credit rating and chronic worries that Europe’s avalanche of debt problems could ripple through to U.S. banks, 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 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 here, for one. When credit spreads widen, that means investors believe there is a 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. Banks are liable to pay investors back at par at the maturity date.

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 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.

Banks Are Goosing Profits Higher

Source: Third quarter earnings releases

Banks Boosting Profits Higher

Source: Third quarter earnings releases