DVA's Bring the Bank Earnings Noise

NEW YORK ( TheStreet) - Did Bank of America ( BAC) report a 2011 profit? Did MorganStanley ( MS) have the only loss orthe 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'sdebt as revenue, highlighting the biggest reason why bank earnings arestill murky four years after the onset of the financial crisis.

Accounting gains based on the rising cost to insure a bank's debtsamid tanking markets, and losses as those costs and markets recover, areswinging the recent earnings of Bank of America, Morgan Stanley, JPMorgan ( JPM), Citigroup ( C) and GoldmanSachs ( GS) by billions. Although analysts, ratings agencies, regulators and tradersgenerally ignore those swings, they stand as the best example of whybank financial statements remain convoluted as firms struggle to proveto investors that their earnings are recovering in the wake of thecrisis.

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

Morgan Stanley, Bank of America, JPMorgan and Citigroup sawbillion dollar-plus gains on DVAs in the third quarter of 2011 amidfears of a European meltdown. In the first quarter of 2012, they sawslightly smaller sized losses as markets recovered. The biggestproblem is that those gains and losses appear to be high on accountingimagination and short on reality, even if they decide whether aquarter 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, ofthe accounting method. Core and other accounting experts say that thepractice - 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 thepotential for firms try to use swings as an undeserved benefit.

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

Still, DVAs are reported differently by each bank, and even within a firm, their treatment on earnings releases has varied overtime. That uncertainty highlights broad concerns over DVAs, such aswhether they should be taken seriously or dismissed, if banksmanipulate them to their benefit, and whether they give any addedinsight into a firms' financial condition.

"My guess is that a lot of banks put these things in 2007 and 2008to make their earnings look better," says Core of MIT on the optionalfair value of some liabilities ahead of the financial crisis. When thecrisis hit and the value of bank liabilities tumbled, DVAs cushionedbank earnings, potentially helping some firms survive. Core arguesthat the fair value of only the assets and liabilities that a firmchooses provides a minimal benefit. "Why does it have to be so difficultfor me to understand what a banks performance is?"

For more on risks to bank earnings, see Europe'sstorms may be headed to the U.S. and why ratingsdowngrades are a lasting risk

"You would think on a number this big or important there would bea standard way to see it, which would give people more faith and trustin what the earnings actually are," says Peter Tchir, founder of newlyformed money manager TF Market Advisors, which doesn't currently holdpositions in banks. "You're not even sure if you're comparing applesto apples, or apples to oranges."

While it's hard to determine exactly what assets and liabilitiesbanks currently fair value on a quarterly basis, DVA gains and lossesare mostly created from the marking the trading prices of a bank'soutstanding debt. Presently, banks use the prices of credit defaultswaps the cost to insure their debt as a means of deriving those debt costs. If swaps are rising in price, accounting rules imply thata bank's ability to repay its liabilities is lower, diminishing theirworth. That logic also says that the decline in liabilities is apositive for bank shareholders, leading to an earnings gain.

At the most basic level, the biggest question is whether thepractice even makes sense?

Had Lehman Brothers not gone bankrupt in September 2008, itwould likely have booked a big earnings gain on the skyrocketing costto insure the firms debts as its trading counterparts ran for thehills. However, in its bankruptcy, those prospective gains evaporatedinto thin air. Meanwhile, for a firm facing insolvency, calculatingits earnings gain if it were to buy back all of its debt seems to bean exercise that borders on the absurd.

"It's when the wheels are falling off of the bus that the credit spreads widen out, so no bank generally is going to take advantage of that situation," says Michael Wong an equity analyst with Morningstarwho covers investment banks and institutional brokerages. Wong saysmost analysts first began to understand DVA's in early 2008 when thecrisis was picking up and see little use in accounting for the fairvalue bank's liabilities - discarding their impact on earnings.

Tchir of TF Market Advisors began working with credit defaultswaps as a trader with Bankers Trust in the mid 1990s and doesn't seewhy CDS prices would be used to impute earnings based on thefluctuating value of a firms debt. While he questions the practicalityof fair valuing liabilities and DVAs, Tchir makes the point that byusing Troubled Asset Relief Program funds and other aid duringthe crisis, some banks did create real gains by repurchasing theirdebt at a discount. With the European Central Bank currentlyproviding long-term refinancing, he adds that some European banks mayalso create real DVA earnings.

Still, a key question is whether the press, analysts and or evenbank CEO's treat DVA gains and losses the same as they swing quarterlyearnings by over $3 billion, in some cases.

Bank of America and Citigroup seem to do a better job highlightingwhen DVAs hurt earnings in recent quarterly earnings releases thanwhen they're a benefit. Meanwhile, when reporting its full year profitin 2008, Morgan Stanley was happy to note a $5 billion DVA gain onpage six of its earnings release. When the DVA turned to a $5.5billion loss in 2009, Morgan Stanley highlighted the impact in bolded bullet points at the top of the first page of itsearnings release.

In 2011 and 2012 earnings releases, Morgan Stanley has prominentlyfeatured both DVA gains and losses. "This firm has continually, and onas many cases as possible emphasized DVA and split it out forinvestors," says Mark Lake, a Morgan Stanley spokesperson.

"We enacted the fair value option in 2007. We used to disclose DVAs on the analyst call but now we do it in the earningsrelease," says David Wells a Goldman Sachs spokesperson of the firm'saccounting practices. Spokespeople for JPMorgan, Citigroup, and Bankof America declined to comment on their fair value accounting outsideof when they opted into the treatment.

In Morgan Stanley's most recent quarter, analysts and investors expected a $2 billion DVA loss that turned the bank's overall net income to a loss, but they didn't focus on it. Instead, analystsexcluded the treatment in the firm's far stronger-than-expectedearnings, and for its peers. Headlines on the Morgan Stanley'searnings varied with some reports focusing on the firm's loss, whileothers focused on its earnings beat and ex-DVA profit. It's a signalthat though insiders, regulators and even credit rating agenciesexclude DVA, there's still plenty of confusion.

Dmitry Pugachevsky a director of research at risk managementspecialist Quantifi, argues that, in effect, banks now have twoseparate DVA and non-DVA earnings. Pugachevsky, who formerly headedJPMorgan's counterparty credit modeling unit, sees more of a use forcredit valuation adjustments, another part of fair value bankaccounting that calculates expected losses stemming from thedeterioration of a firm's trading counterparts.

Banks opted to disclose those adjustments, or CVAs, in a move toshow how they manage their trading books - a parallel to how theyreserve for losses on ordinary loans. CVAs accounted for nearlytwo-thirds of investment banking losses during the financial crisis,estimates Pugachevsky.

As bank investors struggle with recent earnings statements, theconflict over DVAs may give investors reason to consider whether apush for more fair value accounting or a step back would help. "Thereis a huge debate about whether you should fair value assets," saysCore of MIT.

For more on bank investing, see whyJPMorgan is the Apple of the banking sector.

-- Written by Antoine Gara in New York.

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