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DVA's Bring the Bank Earnings Noise

NEW YORK ( TheStreet) - Did Bank of America (BAC - Get Report) report a 2011 profit? Did Morgan Stanley (MS - Get Report) have the only loss or the biggest earnings beat of any large Wall Street firm in the first quarter of 2012?

The answer to both questions depends on whether investors count hypothetical gains on the trading costs of a firm's debt as revenue, highlighting the biggest reason why bank earnings are still murky four years after the onset of the financial crisis.

Accounting gains based on the rising cost to insure a bank's debts amid tanking markets, and losses as those costs and markets recover, are swinging the recent earnings of Bank of America, Morgan Stanley, JPMorgan (JPM - Get Report), Citigroup (C - Get Report) and Goldman Sachs (GS - Get Report) by billions. Although analysts, ratings agencies, regulators and traders generally ignore those swings, they stand as the best example of why bank financial statements remain convoluted as firms struggle to prove to investors that their earnings are recovering in the wake of the crisis.

The accounting -- called a "debit valuation adjustment" or DVA --creates an earnings gain when market indicators show waning confidence in a bank, and a loss upon a recovery. That potential gain is also equal to the amount a bank would gain if it bought back all of its debt at discounted prices.

Morgan Stanley, Bank of America, JPMorgan and Citigroup saw billion dollar-plus gains on DVAs in the third quarter of 2011 amid fears of a European meltdown. In the first quarter of 2012, they saw slightly smaller sized losses as markets recovered. The biggest problem is that those gains and losses appear to be high on accounting imagination and short on reality, even if they decide whether a quarter will be profitable or loss making for a bank.

"Banks are polluting their income statements," says John E. Core, a professor of accounting at the MIT Sloan School of Management, of the accounting method. Core and other accounting experts say that the practice - the genesis of a 2004 accounting rule change by the Financial Accounting Standards Board called FAS 159 or the "Fair Value Option" - makes bank earnings less transparent, with the potential for firms try to use swings as an undeserved benefit.

JPMorgan, Bank of America, Citigroup, Goldman Sachs and Morgan Stanley all took the FASB option to fair value some assets and liabilities starting in 2007, just ahead of the financial crisis. Once firms take the fair value option, it's binding.
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