In the past year or so, Vox has been positive about the major U.S. banks. Certainly, they earned their distressed prices by their mistakes and misbehaviour in the financial crisis but, by and large, there are plenty of great franchises that have traded at deep discounts to their normal value. Better to buy on the cheap and suffer a bit of volatility in the near term in order to get long-term rewards, I’ve said.
That doesn’t stop me, however, from warning about the accounting machinations that the banks often highlight (or bury) when they sell their earnings tale. And in all likelihood, investors will need to drill down in the numbers released in the second-quarter earnings season, which kicks off Friday.
In the summer of 2011, I noted that bank earnings benefited from what’s called “reserve releases.” Every quarter, banks set aside money to cover problem loans – a “provision” – by recording an expense and building up a loan-loss reserve. When the banks judge their reserves to be large enough, they cut down on the provisions, and earnings rise as a result.
While we may see some of that in the second quarter, the bigger issue this year has been the even-more-arcane world of debt valuation adjustments.
Under current U.S. accounting rules (as well as the International Financial Reporting Standards that apply to Canada’s public companies), when a company’s own debt falls in price – which often happens when the company is deemed less creditworthy – the debt is cheaper to retire. So that particular liability is worth less, which, perversely, means the company can record a (non-cash) gain – even if the debt remains on the books and its credit quality has deteriorated.
It also works the other way: As the debt gains in value, the liability is more expensive to extinguish, and the company records a (non-cash) loss.
Consider the magnitude of some recent adjustments, per research conducted by Fitch Ratings. Bank of America Corp. reported a $4.8-billion (U.S.) loss from debt and credit-swap valuations in the first quarter, knocking its pretax income down to less than $1-billion. Citigroup Inc., JPMorgan Chase & Co. and Morgan Stanley also recorded at least $1-billion in valuation losses for debt and derivatives.
The good news, one supposes, is that when you exclude these paper losses, the profits look better. The trouble is, the banks have been more than happy to highlight these losses in their earnings releases, while being a lot more circumspect when valuation gains boost earnings.
Take Bank of America. In the third quarter of 2011, a $4.5-billion debt valuation adjustment was the major contributor to $6.2-billion in profit. But through the headline, six sub-headlines, and the first paragraph of the earnings release, there was nothing to be heard of the non-cash gain. It was introduced in the second paragraph.
In 2012’s first quarter, in which the adjustment nearly wiped out all of the bank’s profit? Why, it was the second headline: “Results include negative valuation adjustments of $4.8-billion pretax … from the narrowing of the company’s credit spreads.”
Waterloo, Ont., native Peter Tchir, now running TF Market Advisors in Connecticut, says that when banks highlight the paper losses to explain subpar profits, but minimize their impact when earnings are good, it “makes it looks like they are trying to trick the media and investors and make the story better than it is.”
But, he said in mid-April posts on his blog on the firm’s website: “Investors aren't stupid. They will do the work. They will figure out the differences … Then, not only will they be disappointed with what the firms tried to trick them on, they will question what else is being done.”
“If you are willing to ‘massage’ (sounds better than manipulate) the way you report each quarter's earnings to make it seem the best, what else are you willing to ‘massage’?” he asks.
It is always a question investors should ask, no matter how cheap and appealing a potential investment may be.