Bank Earnings Gimmick Under Scrutiny

Morgan Stanley(MS) earned $1.14 per share in the third quarter, $1.12 of which came from the fact that credit market investors wagered on increasing likelihood of the company defaulting on its debts.

That wasn't a typo. And that may be coming to an end.Due to an accounting-related oddity known as a debt valuation adjustment (DVA) Morgan Stanley and other large broker dealers, including Goldman Sachs(GS), Citigroup(C), JPMorgan Chase(JPM) and Bank of America(BAC) have gotten an earnings lift from the fact that their debt has fallen in value. Conversely, if creditors become more positive about these companies, they will see their earnings negatively impacted by the DVA, which comes from an accounting regimen known as "fair value" that was instituted in late 2007.That may change, however, as the Financial Accounting Standards Board is considering doing away with the requirement, according to Robert Stewart, spokesman for the Financial Accounting Foundation, which oversees FASB.That would be welcome news to analysts, who strip out the DVA when looking at earnings."It's a silly rule. They didn't think it our clearly when they put it in place," says Paul Miller, analyst at FBR Capital Markets.Stewart wrote via email that "the fair value option was put in place to address accounting mismatches between the measurement of financial assets and liabilities. For financial institutions that carry many of their assets at fair value, there could be a mismatch when their liabilities, which also are interest-rate sensitive, were carried at cost. A special disclosure of gains and losses attributable to the issuer's own creditworthiness is required to highlight this issue for investors."

The fair value rule requires derivatives to be "marked to market," meaning that companies must report on their market value as it shifts each quarter. Similarly, derivative-linked liabilities must be marked to market, though banks' unsecured debt does not fall under the rule. So, for example, bonds that are tied to the performance of the S&P 500 would be subject to the rule. Many such instruments are sold to retail investors, which explains why Morgan Stanley, which has a large retail brokerage force, typically has such a large DVA.

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