The Controversial Issue of Debt-Induced Gains
WSJ Online reports: While the bond-market mess made the earnings reports for the big investment banks feel like a game of roulette, there was one area where they were almost guaranteed to win: profits generated by the falling value of their own debt.
That allowed the firms to book hundreds of millions of dollars in profit, helping to offset multibillion-dollar charges they had to take on commitments to fund leveraged buyouts.
• The Situation: Banks like Citigroup, Bank of America and J.P. Morgan could benefit from an accounting rule that will allow the firms to generate profit from drops in values of their own debt.
• The Debate: Accounting rule makers signed off on the treatment, but critics question whether it undermines the nuts-and-bolts figures.
• Bottom Line, Literally: It could be blurry, as the move may offset some credit-crunch losses and mitigate otherwise sharp earnings hits.Now some banks may be set to similarly benefit from their own misfortune. Financial titans such as Citigroup Inc., Bank of America Corp., and J.P. Morgan Chase & Co., which will report third-quarter results next month, all opted earlier this year to start applying market values to some of their own liabilities, according to the research service the Analyst's Accounting Observer.
This means they, too, might see a boost to profit from declines in the value of their debts during the summer credit crunch. "It might not be unusual at all to be seeing gains on debt issued hitting earnings in the third quarter," the Analyst's Accounting Observer said.
Officials at Citigroup, J.P. Morgan and Bank of America declined to comment.
The brokers and banks are doing nothing wrong or improper in booking such gains. The accounting rules as they stand allow the practice. But some investors are crying foul, saying the rules shouldn't have been changed to allow for such gains.
Here is how the accounting method works: Say $100 million of bonds issued by a bank falls in value by $5 million, or 5%. Under new accounting rules adopted by the banks and brokerages, some liabilities are valued at market prices instead of being recorded at their historical cost. The decline in the bonds' value means the bank's liabilities fell by $5 million. The difference between the current price of $95 million and the original $100 million creates an equivalent gain that ends up on the income statement and boosts profits. Conversely, if the bonds gained in value, it would mean the bank's liabilities went up, producing a loss.
Any gains at the banks could potentially offer one bright spot in what is expected to be an otherwise gloomy quarter. Banks likely face write-downs in the value of commitments that they have made to fund leveraged buyouts and will need to increase reserves for soured loans.
The emergence of debt-induced gains, even if they only offer a slight respite from overall market woes, has rekindled longstanding debate about whether such profits should be allowed. The opportunity for companies to benefit in this way only recently emerged, thanks to new accounting rules that allow companies to apply market prices to their own liabilities.
Opponents of the practice of booking such gains worry that they erode earnings quality and possibly open a new way for executives to massage earnings.
Yet brokerage executives defended the gains, saying they were more than just an accounting gimmick. During his firm's earnings call, Sam Molinaro, Bear Stearns's chief financial officer, said "the gains were real," adding that "there's someone on the other side of that trade who lost money."
Mr. Molinaro added that his firm could have easily used financial instruments to cancel out, or hedge, the impact of any change in the value of Bear's own credit standing. But the firm ruled that out, he said. Bear later recognized about $225 million in gains from the change in value of structured notes it sold investors.
The idea of allowing companies to profit from falls in their own liabilities proved controversial when accounting rule makers debated the idea.
It may also require investors to "rethink how we are going to evaluate a company's debt-to-equity ratio," Prof. Ketz said. "In the past, we would think that if a firm was having problems they would show a higher debt ratio, but now if they are performing poorly, the debt is going to be going down in value."
Full Story: online.wsj.com |
