DVA's Bring the Bank Earnings Noise

NEW YORK ( TheStreet) - Did Bank of America ( BAC) report a 2011 profit? Did Morgan Stanley ( MS) 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), Citigroup ( C) and Goldman Sachs ( GS) 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.

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

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

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

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

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

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

Had Lehman Brothers not gone bankrupt in September 2008, it would likely have booked a big earnings gain on the skyrocketing cost to insure the firms debts as its trading counterparts ran for the hills. However, in its bankruptcy, those prospective gains evaporated into thin air. Meanwhile, for a firm facing insolvency, calculating its earnings gain if it were to buy back all of its debt seems to be an 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 Morningstar who covers investment banks and institutional brokerages. Wong says most analysts first began to understand DVA's in early 2008 when the crisis was picking up and see little use in accounting for the fair value bank's liabilities - discarding their impact on earnings.

Tchir of TF Market Advisors began working with credit default swaps as a trader with Bankers Trust in the mid 1990s and doesn't see why CDS prices would be used to impute earnings based on the fluctuating value of a firms debt. While he questions the practicality of fair valuing liabilities and DVAs, Tchir makes the point that by using Troubled Asset Relief Program funds and other aid during the crisis, some banks did create real gains by repurchasing their debt at a discount. With the European Central Bank currently providing long-term refinancing, he adds that some European banks may also create real DVA earnings.

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

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

In 2011 and 2012 earnings releases, Morgan Stanley has prominently featured both DVA gains and losses. "This firm has continually, and on as many cases as possible emphasized DVA and split it out for investors," 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 earnings release," says David Wells a Goldman Sachs spokesperson of the firm's accounting practices. Spokespeople for JPMorgan, Citigroup, and Bank of America declined to comment on their fair value accounting outside of 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, analysts excluded the treatment in the firm's far stronger-than-expected earnings, and for its peers. Headlines on the Morgan Stanley's earnings varied with some reports focusing on the firm's loss, while others focused on its earnings beat and ex-DVA profit. It's a signal that though insiders, regulators and even credit rating agencies exclude DVA, there's still plenty of confusion.

Dmitry Pugachevsky a director of research at risk management specialist Quantifi, argues that, in effect, banks now have two separate DVA and non-DVA earnings. Pugachevsky, who formerly headed JPMorgan's counterparty credit modeling unit, sees more of a use for credit valuation adjustments, another part of fair value bank accounting that calculates expected losses stemming from the deterioration of a firm's trading counterparts.

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

As bank investors struggle with recent earnings statements, the conflict over DVAs may give investors reason to consider whether a push for more fair value accounting or a step back would help. "There is a huge debate about whether you should fair value assets," says Core of MIT.

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

-- Written by Antoine Gara in New York.

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