Bank profits boosted by wonky accounting rules

Bank profits boosted by wonky accounting rules

TIM KILADZE

Globe and Mail Update

Posted on Thursday, October 13, 2011 1:24PM EDT

The market is mad at JPMorgan today. Not only were earnings weak, but their drop was falsely offset by a $1.9-billion (U.S.) ‘debt valuation adjustment,’ which masks the bank’s poor performance.

What exactly is this ‘adjustment’? Simply a mark-to-market accounting tool. When the Financial Accounting Standards Board re-wrote global accounting rules, it adopted a guideline known as Statement 159. Under this provision, banks can book a gain when the value of their debt falls, because they theoretically owe less money. The vice-versa is true when the debt’s value rises.

This adjustment is in line with the mark-to-market rules that were supposed to give investors a better sense of a bank’s value in falling markets. Except DVAs, as they are known, aren’t really doing that. If JPMorgan owes somebody money, and the market value of this debt drops because credit spreads widen, the amount that JPMorgan has to cough up at maturity doesn’t change. JPMorgan’s interest payments don’t change either.

This was a real issue back in 2008 because Morgan Stanley recorded gains of $5.1-billion when its bond spreads widened. Just a year later, they had to be reversed because markets improved, Bloomberg noted last year.

Big picture, this just means DVAs are the new credit loss provisions. Coming of the crisis, the banks boosted their profits by releasing the money they had put aside to protect against big losses. Now they’re benefiting from accounting valuations. Neither of these stem from real money earned each quarter.