Statement 159 Helps Unhealthy Banks Book Healthy Earnings

Straight from the “Only in America” file: Second quarter earnings were so bad…they were great!

Yes, dear readers, it’s true, many of America’s largest financial firms are producing such dismal operating results that their reported earnings might actually benefit.

Are you confused yet?

Here’s how it works: A bizarre accounting rule that came into existence three years ago allows banks to book profits when the value of their own bonds falls. The tortured logic behind this nonsensical “Statement 159” accounting rule is that a bank could, theoretically, repurchase its bonds at a discount, thereby booking a “profit” between what it could have paid for the bonds and what the bank would have paid to retire its bonds at maturity. (An insightful story from Bloomberg News provides additional detail.)

This quirky little accounting gimmick produces something called a debt-valuation adjustment gain, or “DVA Gain.” The more distressed a bond might be, the greater its drop in value and thus, the greater its “profit.” Obviously, this logic is patently illogical. “Could have” or “would have” has nothing to do with reality. If a bank wishes to book a profit by buying back its bonds on the cheap, then the bank should actually buy back its bonds on the cheap – not receive credit for a transaction it does not conduct.

But America’s accounting poobahs see it differently. Therefore, thanks to the “Statement 159” rule, many of America’s unhealthiest financial institutions will post some relatively healthy earnings results for the second quarter.

Bank of America may record a $1 billion second-quarter gain from writing down its debts to their market value, according to Citigroup’s banking analyst, Keith Horowitz. Morgan Stanley might also book a $1 billion DVA gain in the second quarter. That figure would represent about 60% of Morgan Stanley’s pretax income for the quarter.

Horowitz estimates that the DVA gains for America’s largest banks will contribute about one-fifth of their profits for the quarter. That’s a big number, especially in the context of a 30% drop in reported profits for the quarter. In other words, if you subtract DVA gains from the profits Wall Street expects, the big banks’ operating earnings would drop more than 40% from the second quarter.

Bank of America’s earnings, for example, will likely drop about 40% from the first quarter – and 45% year-over-year – even with $1 billion in DVA gains! That’s a pretty dire result for a bank that is supposed to be reaping the fruits of an economic recovery.

The reasons for the collapsing earnings are not hard to come by. For starters, the banks probably did not repeat their near-record trading profits from the first quarter. Additionally, the financial markets have not provided a friendly environment for either proprietary trading or investment banking.

“The Standard & Poor’s 500 Index fell by 15 percent from a 19-month high in April,” Bloomberg News reports, “curbing stock-trading revenue and prompting companies to cancel or postpone new share offerings and hold off on mergers and acquisitions that Wall Street bankers advise on to generate fees. US bond sales fell to $335.8 billion in the second quarter, down 37 percent from both the first quarter and the second quarter of 2009. It was the lowest amount since the fourth quarter of 2008.

“The weaker trading environment,” Bloomberg News continues, “highlights how banks are suffering from lackluster demand for their basic products: loans to companies and consumers. Loans and leases held by US banks shrank for the sixth consecutive quarter to $6.88 trillion as of June 30, according to Federal Reserve data, which include an accounting change. Delinquencies on commercial real estate loans rose to 7.5 percent in May from 6.42 percent in March, according to Moody’s Investors Service.”

Hmmm… Seems like the recovery might still be on ice.

Eric Fry
for The Daily Reckoning