There will be no shortage of fanfare and scrutiny this Friday when JPMorgan Chase & Co. (JPM) reports second quarter earnings. Investors will be watching closely to try and discern the extent of the damage caused by the now famous London Whale trade. For Jamie Dimon, it is just as well that the public focus squarely on the direct consequences of the ill-fated derivatives bet. The more investors focus on what JPMorgan says about the trade, the less likely they are to pay attention to what really matters: the multiple ways losses can be disguised in 10Qs.
In a previous article, I noted that it is possible for the company to hide losses by reclassifying certain 'assets' as Level 3 instruments:
"If JPM moves a large portion of its credit derivatives to Level 3, it will be allowed to value those assets largely according to its own models. The concern is that JPM will not value the assets conservatively...and will report earnings that could easily mislead the average investor who likely has no idea that losses may be (legally) hidden in the way the firm values its Level 3 'assets'. Indeed, academic research has shown that the larger the bank, the more likely the firm is to use Level 3 valuations to 'manage' earnings"
As disconcerting as this may be, the number discerning investors should watch closely is the "benefit from debit valuation adjustments" (DVA). DVA essentially allows firms to recognize revenue and net income gains when their CDS spreads widen during a reporting period. This is quite possibly the most counter-intuitive, oxymoronic accounting maneuver in the history of finance: as creditworthiness deteriorates, net income and revenue are 'generated.' This is possible because:
"...the closer a bank is perceived to be to default the cheaper its debt trades, potentially allowing it to buy back its outstanding debt at a discounted rate and book a gain."
The gains then are predicated upon a theoretical debt repurchase. Put another way, if a company's bonds drop from 100 cents to 75 cents on the dollar and the company marks these liabilities to market, the 25 cent difference shows up as 'savings.' By some estimates, the widening in JPMorgan's CDS spreads during the second quarter could translate to a $1 billion DVA gain, wiping 'clean' a fairly large chunk of the multi-billion dollar loss incurred by the company's CIO desk.
This of course, is nothing new. In the third quarter of 2011, JPMorgan's results were benefited to the tune of .29 cents per share by DVA. The firm only earned $1.02 per share during the period, meaning fully 28% of earnings were attributable to a widening of the firm's CDS spreads.
Investors should be aware of this come Friday. The important thing to remember about DVA 'gains' is that the company must still repay its debts in full at maturity - the 'savings' are entirely illusory. It is entirely reasonable to think that their will be a substantial DVA gain on the books for JPMorgan during the second quarter (JPMorgan CDS rose from 97 basis points at the beginning of April to 137 basis points at the end of June). Anyone considering the shares should take this into account when calculating things like price-to-earnings ratio. This is just one more worry to add to the laundry list of concerns for JPMorgan shareholders. Short JPMorgan or long JPMorgan puts.