2Q Bank Earnings: Tricks But No Treats

By Karen Rogers - July 23, 2012 | Tickers: BAC, C, GS, JPM, NES.DL | 0 Comments

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At first blush reported 2Q bank earnings weren’t half bad.  Goldman Sachs (NYSE: GS) beat the street with $6.6 billion in revenue, and the London Whale aside, JPMorgan Chase (NYSE: JPM) reported $5 billion in revenue.  But if you want to know how the banks truly fared, just look past the smoke and mirrors and see the accounting tricks that were used to improve earnings.

Debt Value Adjustment (DVA) allowed JPMorgan Chase to add an additional $800 million to this quarter’s reported revenue, an amount which accounted for 10% of their earnings.  What is DVA?  It’s a recognized accounting practice under Financial Accounting Standards Board (FASB) Rule 159 which allows a company to recognize a market decline in the value of some debt instruments as income. As such, JPMorgan could legally report a decline in their credit default swaps value as additional earnings.

But DVA wasn’t the only way JPMorgan improved their earnings.  The bank erased their London Whale loss by taking a $1.7 billion dollar tax write-off, reduced their loan reserves (YOY) by $1.6 billion, and increased their mortgage servicing value by $233 million. The effect of this accounting sleight of hand was to add an additional $0.12 per share to their reported EPS.

Citibank (NYSE: C) reported investment banking revenue of $854 million, a 21% decline from 2Q 2011.  Equity market revenue, reported at $550 million, represented a 29% decline from 2Q 2011.  To improve their financial standing, Citibank took a debt value adjustment of $219 million to help book an additional $213 million this quarter.  A full 1/3 of Citibank’s quarterly profit was composed entirely of adjustments to its loan loss reserves. 

But Citibank wasn't the only financial institution to suffer a steep decline in profit.  Goldman Sachs investment banking revenue dropped to $1.2 billion, a decline of 17% from 2Q 2011.  Equity underwritings likewise took a hard hit, coming in at $240 million, a 37% decline from 2Q 2011.  Helped in part by approximately $10 million in DVA, Goldman Sachs managed to beat street estimates and reported 2Q revenue of $6 billion.

Without using debt value adjustments, Morgan Stanley (NYSE: MS) would have missed Wall Street’s estimates by nearly 15%;  revenue would have come in at $6.6 billion instead of the reported $7.58 billion.  DVA contributed $0.16, or 57%, of Morgan Stanley’s $0.28 EPS.  Morgan Stanley’s woes are not confined to just a lackluster quarter.  They’re still trying to move some $50 trillion in derivatives from their holding company over to Morgan Stanley Bank, NA, thereby making the FDIC and taxpayers responsible should default occur.

No discussion of smoke and mirrors accounting would be complete without Bank of America (NYSE: BAC).  The bank posted earnings that, in fact, weren’t earnings.  Bank of America’s pretax income was $3.4 billion of which $1.9 billion, or 56%, came from a reduction in loan loss reserves.  Their investment bank fees were down $1.1 billion from 1Q 2012 along with net revenue decreasing from $462 million in 1Q 2012 to $336 million 2Q 2012.  Without the help of debt value adjustment magic, Bank of America’s total revenue would have been down $2.1 billion from their 1Q 2012 amount.       

DVA allows a company to restate a decrease in their debt value as earnings. It distorts income by making it appear that a company is more profitable or less unprofitable than it really is.  There’s talk of FASB reconsidering the debt value adjustment rules that currently allow this mixing of debt value reduction with earnings.  Given the difficult financial climate, this is one change that can’t be implemented too soon.

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