Tuesday, October 18, 2011

Smoke and Mirrors

Breaking: BAC reports phantom earnings.

Market watchers were introduced to a new acronym last week: DVA, which stands for "debit valuation adjustment." In its third-quarter earnings report on Thursday, JP Morgan Chase disclosed that it was booking $1.9 billion in a pre-tax benefit from DVA gains. Unschooled analysts immediately hit up their Bloombergs for a quick refresher in DVA. Turns out that DVAs are an accountant's way of making lemonade out of lemons. A company doing bad can make it look like it is doing good. How does it do it?

Last we checked, credit spreads on the big banks were widening, indicating an emerging suspicion among speculators that one or more of these babies might actually default. For any bank, that's BAD. Bonds previously issued by an at-risk bank start trading at a discount as investors begin to worry about possibly losing their principal. The debt shows up on the bank's balance sheet as a liability, which must be paid down over time.

Here is where it gets interesting. The Financial Accounting Standards Board (FASB) has given the banks the green light to mark their debt liabilities to market, viz. "at the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date" (ASC 820). For the issuing bank, that is GOOD. It means that the liability on the company's books can be discounted as the bonds lose value. The company is allowed to book a profit commensurate to the difference between the bond's face value and its market price.

The "profit" is pure fantasy. The company has not actually engaged in a real-time transaction to buy back any of its debt. It is still on the hook for full payment of principal plus interest. The debt is still a lemon. But, as Boston Globe sportswriter Bob Ryan points out, "corporations often employ bookkeepers who can do with numbers what Rajon Rondo can do with a basketball." He means something magical. In the bank's case, the debt liability is simply revalued on the shaky assumption that the company could, if it wanted to, buy back all its debt, all at once, at a momentary price in a thin secondary market fraught with huge friction costs. Not gonna happen.

Even JPM's CEO, Jamie Dimon, confesses to the gimmickry. "The DVA gain," explained Dimon on Thursday, "reflects an adjustment for the widening of the Firm's credit spreads which could reverse in future periods and does not relate to the underlying operations of the company" [emphasis mine]. Yesterday another of the mega-banks, Citigroup, showed that it uses the same cookbook, announcing a third-quarter pre-tax DVA gain of, you guessed it, $1.9 billion. What a coinkydink!

Enter Bank of America, a veritable warehouse of lemons. For its quarterly earnings (announced this morning), BofA squeezed out a DVA gain of $1.7 billion, not quite up to JPM and Citi's level of performance, but still not bad for worst-of-breed. BofA did not stop there. It also recorded a "fair value adjustment on structured liabilities" of $4.5 billion, another phantom gain (see page 5 here). Back out those two accounting treatments, and you get zero dollars of net income. Then back out the proceeds ($3.6 billion) from a one-time asset sale. You are left with a core business that is still losing money hand over fist.

So why invest in any of these behemoths? It is a question that I have put to officials at the Maine State Retirement Fund (MainePERS), which continues to hold substantial stakes in both BAC and JPM, top-ten holdings as recently as fifteen months ago. The reason they fell out of the top ten is not because portfolio managers sold when the selling was good, but because the share prices have collapsed. As of September 30, we (i.e. MainePERS beneficiaries and guarantors) still hold over 2.6 million shares of BAC and over a million shares of JPM. In the third quarter alone, those BAC shares were down 44%, or more than $12.6 million.

I advised to sell the Santa Claus rally, which raised the stock to over $13 a share. Then, eight months later, I said sell the Saint Warren rally, which saw $8 a share. Today BAC has a six-handle, and it is difficult to see from the company's latest earnings report any possible catalyst for a rally from here. Rather, looming bank failures in Europe could be the catalyst for further downside.

[update, 2 p.m.--]

Bloomberg is just out with the explosive revelation that Bank of America has shifted derivatives from its Merrill Lynch unit to a federally insured subsidiary. This has essentially exposed U.S. taxpayers to the risk that these derivatives might blow up, in which event counterparties would have first claims to the firm's assets (including $1.04 trillion in cash deposits) prior to any bankruptcy resolution. William Black, a federal bank regulator during the Savings & Loan crisis of the early '90s, is quoted as saying that BofA has succumbed to the "enormous temptation to dump the losers on the insured institution. We should have fairly tight restrictions on that."

The safe harbor for derivatives counterparties is a legacy of the George W. Bush Administration, which in 2005 championed passage by Congress of the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), a misnomer if ever there was one, as the ones being protected were reckless lenders and speculators. Consumers, far from being protected, were further subjugated.

Yves Smith at nakedcapitalism.com explains BofA's move this way:

Remember the effect of the 2005 bankruptcy law revisions: derivatives counterparties are first in line, they get to grab assets first and leave everyone else to scramble for crumbs. So this move amounts to a direct transfer from derivatives counterparties of Merrill to the taxpayer, via the FDIC, which would have to make depositors whole after derivatives counterparties grabbed collateral. It’s well nigh impossible to have an orderly wind down in this scenario. You have a derivatives counterparty land grab and an abrupt insolvency...This move paves the way for another TARP-style shakedown of taxpayers, this time to save depositors. No Congressman would dare vote against that. This move is Machiavellian, and just plain evil.

Maybe this is why MainePERS considers BAC a safe investment. If the bank should fail, taxpayers will be picking up the tab.

[update, 9 p.m.--]

Karl Denninger at market-ticker.org uses italics, bolding, AND underlining to reinforce his view:

[T]his sort of movement of liabilities should be flatly prohibited...That the firm's ratings have deteriorated and thus it may be required to post additional capital against these positions by those counterparties does not justify shifting the risk to depositors simply so the bank can avoid posting collateral against a deteriorating credit picture, which for all intents and purposes shifts the risk to the taxpayer since the FDIC has a line of credit at Treasury.

And John Hussman, in his weekly market commentary, has this:

[T]he transfer is clearly driven by the intent to get around capital adequacy regulations, and runs precisely opposite to the right way to create a good bank and a bad bank. It saddles the good bank - the taxpayer insured one - with the questionable liabilities, while "giving relief" to the holding company. This is really preposterous.

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