Wall Street: Earnings Numbers Are Worthless!

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The logic is good.  But the reality is that it completely debases the earnings numbers. 

I am talking about the Financial Accounting Standard Board’s (FASB) 2007 rule that has banks booking earnings and losses based on how their debt trades.  And it skews P/E ratios and net income numbers.

When a bank’s debt reduces in value, the bank reports a gain, reflecting the possibility that the bank can buy back its debt for a lower price.  The opposite occurs when the debt rises in value.  The bank records a loss because, theoretically, the bank could buy it back for more than it issued the debt for.  The rule is called the debt value adjustment (DVA), and it has investors wondering what financial numbers are worthwhile and which are worthless.

For example, a bank’s debt could increase in value – showing that the bank’s creditworthiness has improved – but the bank records a loss.  Confusing, I know.  According to The Wall Street Journal, “major banks and securities firms have posted almost $4 billion in cumulative DVA gains over the past year, but big DVA losses are expected in the third quarter.”

The Big Players

“We never look at earnings, ever,” JPMorgan (NYSE: JPM) CEO Jamie Dimon said last year.  “It’s just we have to deal with it and describe it, and it distorts all of our numbers.”

JPMorgan is expected to post a $550 million charge in the third quarter, as a result of the DVA, a Morgan Stanley (NYSE: MS) report says.  The number could represent a large percent of the company’s earnings – and the loss is not an actual expense.

Like JPMorgan, Bank of America (NYSE: BAC) is expected to post a charge next quarter.  However, it is expected to be to the tune of $1.9 billion.  The loss is expected to come from two sources.  First, it is expected to adjust the value of its own debt.  Second, it is expected to change the value of some Merrill Lynch structured liabilities.  What is the bank’s reward for its debt increasing in value?  Large losses.

Citigroup (NYSE: C) is having a similar problem.  Citigroup is expected to post a $1.6 billion charge from DVA in the third quarter, according to Morgan Stanley’s report.  The charge is a huge hit to the bank, whose financial strength has come a long way since the stock traded for as little as $1 during financial crisis.  Like Bank of America, Citigroup is being punished as it becomes able to float its debt at a lower rate.

Finally, the DVA rule has Morgan Stanley investors wondering how the bank is really doing financially.  Morgan Stanley posted a $216 million DVA gain in Q4 2011 when its debt sank, only to record a $2 billion loss in Q1 2012.  In the second quarter this year, the company whipsawed back to a $350 million DVA gain.  For investors, Morgan Stanley’s earnings have looked more like a roller coaster ride than an accurate portrayal of company performance.  The question beckons: how will this rule be fixed?

Change We Can Believe In – Hopefully

The FASB came to a tentative agreement this past June that it would change the rule, though a final ruling would not likely happen until later this year.  Under the proposed rulings, the FASB would put DVA under “other comprehensive income,” a column that does not affect the major earnings number.  Other comprehensive income houses non-operating changes like currency fluctuations and pension liabilities, such as when a company’s pension accounts shift in value.

But for the banks’ sake – and for investors’ sake, let’s hope that the FASB can come to a ruling fast.  Otherwise, the earnings numbers and P/E ratios on Yahoo! Finance aren’t that useful, after all.

An Oppenheimer analyst puts it best: “They cannot get rid of this rule fast enough in my opinion.”

Dig Deeper

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ChrisMarasco has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America, Citigroup Inc , and JPMorgan Chase & Co. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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