Bank debt confusion makes an unwelcome comeback

October 5, 2011

By Peter Thal Larsen and Antony Currie
The authors are Reuters Breakingviews columnists. The opinions expressed are their own.

The parallels between the current market turmoil and the 2008 meltdown become more striking by the day. The latest crisis throwback is the bizarre earnings boost created by banks’ deteriorating creditworthiness. UBS says widening spreads on its own debt added 1.5 billion Swiss francs to its bottom line in the third quarter. Accountants, rather than banks, are to blame. But financial firms are still inconsistent and selective when reporting this perversity.

Since 2007, banks have had to report changes in the fair value of their own liabilities. When the market price of debt falls, liabilities are, from an accounting perspective at least, reduced, allowing the company to recognise a profit. Conversely, rising bond prices produce a loss.

For banks, the effect was particularly pronounced in 2008. As credit spreads soared, many booked large one-off gains: Morgan Stanley enjoyed a $5.1 billion profit that year. Those benefits reversed when debt spreads subsequently tightened. Now that markets are tumbling again, lenders are reaping spurious benefits. For UBS, the gain partly offsets the $2.3 billion hole left by its rogue trader, allowing it to report a modest, but psychologically important, net profit for the quarter.

Bank regulators ignore this accounting quirk: gains and losses on debt are excluded from capital calculations. But not all banks are equally transparent. Some have shown tendency to emphasise the losses while downplaying the gains. In 2007’s third quarter, Lehman Brothers quietly used the gains to offset leveraged loan writedowns. And it took an analyst’s question to force Bank of America to admit that $2.2 billion of its first-quarter 2009 revenue came from gains on Merrill Lynch debt. Moreover, banks like Citigroup and UBS include fair value gains and losses in the results of their investment banking arms, while the likes of Credit Suisse and HSBC keep the fluctuations out of divisional reporting.

Banks say they have little influence over the fluctuations, though Goldman Sachs seems to be one of the few that has minimized the effect with hedges. And Europe, at least, is phasing out the accounting rule in 2013. But inconsistent reporting makes it harder to filter out the noise. At a time when investors’ confidence is lower than ever, that’s something banks can do without.

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