Accounting Antics Lift I-Bank Earnings - Barron's

Barron's Andrew Bary thinks Wall Street brokerages are using some fancy accounting in order to post estimate-beating earnings even as things worsen for the sector.

Here's his argument: Companies issue debt to raise funds. When investors shun its debt, holders have a harder time reselling it, causing its yield to rise and its price to fall. In theory, then, the issuing company could presently buy its own debt back for cheaper than it could have in the previous quarter, resulting in an accounting gain.

Firms have been booking the gains, and they're not insignificant. In their Q1 reports, Morgan Stanley (MS) reported an $848M gain; Lehman (LEH) $600M; and Goldman (GS) $300M. JPMorgan (JPM) hasn't reported Q1 yet, but it squeezed out a $1.3B gain in 2007.

Bary's contention, and that of analysts like Bernstein's Brad Hintz, is that since the companies have no intention of retiring the debt on the cheap, the gains are fairy tales -- because the debt will eventually mature at par, and mark-to-market gains will reverse over time. Lehman's Q1 of $0.81/share (vs. $0.70 consensus) would have been a lot less shiny $0.11/share without the accounting gain. Morgan Stanley's $1.45/share (vs. $1 consensus) would have been merely in-line.

Meanwhile, debt spreads have tightened as investors seem to think the worst is behind us -- which could mean a reversal of these gains in coming quarters.

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Here's what I don't get: Surely analyst consensus estimates take these adjustments into account. If so, how can Bary contend that the mark-to-market adjustments are allowing investment banks to (subversively) beat estimates? Also, as Bary concedes, mark-to-market works both ways -- assets are also marked to market. One could easily argue that much of the debt securities massively written down over the past two quarters is destined to mature at par, assuming the issuers don't default in the meantime.

Comments

[jay sackstein:]

jpm great stock $60.00 per share really soon

2008 Apr 06 04:12 PM

[ItsJustMe:]

The quarterly financials are not audited so therefore you don't have pesky auditors asking uncomfortable questions about the likelihood of your mark-to-market assumptions. I suspect the analysts didn't anticipate the brazenness of the IB's since they were desperate to show positive earnings in the wake of the Bear Stearns bankruptcy.

Also, the likelihood of the IB's staying solvent (at least now with help from the Fed) is much greater than all the underwater homeowners eventually paying everything off. As a CPA and former auditor, I can tell you that writing down your own debt would not pass the smell test with me unless it came with a going-concern opinion.

I suspect their own CPAs will tell them the same thing come year-end unless they want to go the way of Arthur Andersen...

2008 Apr 06 04:16 PM

[BxCap:]

"Assuming the issuers don't default" -- You really have to read about the sheer volume of foreclosures, notice of defaults, and "squatting" that is going on in this country, as people with loans they cannot even make payments on (regardless of the declining LIBOR), have stopped, knowing that they cannot sell the property, but comfortable knowing that their mortgage holder cannot afford more foreclosure expenses. We are not yet at a housing "bottom" and yet one mind entertain the idea that the future holds "par" value for these leveraged debt instruments? People like Meredith Whitney, Bill Ackman, Whitney Tilson, and now Brad Hintz have shown you that the financial shenanigans detailed by forensic accountants (i.e. Dr. Howard Schilit) in their books, are alive and well! Quarterlies are not audited, as the first commenter pointed out. We won't make it to year end though, before we find out the reality of what happens when loan non-payments start to domino.

2008 Apr 06 04:38 PM

[rbarsom:]

I worked at Lehman. They were cool guys, just really really crooked.They were selling inventory stock of Motorola. At the time I was 26 and justt kinda thought everything was normal because they all drove really nice sports cars.

2008 Apr 06 04:57 PM

[SA Editor E...:]

Fantastic comments ItsJustMe and BxCap. This line, in particular, "I suspect the analysts didn't anticipate the brazenness of the IB's since they were desperate to show positive earnings in the wake of the Bear Stearns bankruptcy," makes the whole issue much clearer.

2008 Apr 06 05:35 PM

[Fighting Yoda:]

Yes, Barron's article does not look at both sides of the argument. Both Markdowns and Markups will happen in the future- curently they are being marked to market or hope or whatever.

2008 Apr 06 06:33 PM

[bd5star:]

Not being an expert in finance or accounting, I can only assume that this little " slight of the pen" as it were, was an intentional delaying tactic to give these institutions a little time to strengthen their cash stockpiles in anticipation of what might occur if and when this knowledge becomes more mainstream?

2008 Apr 07 12:16 AM

[User 42264:]

MTM-ing liabilities is crazy, its totally different from MTMing assets. Firms should not benefit from an increased bankruptcy premium on itself, especially under the Going Concern tenet.
The reason why liabilities should not be MTMed:
Market prices in a default probability and loss given default to price a Bond. Even if default probability goes up but, Loss given default remains the same, market value of the bond decreases.
However, if the firm were to default and liquidated, the creditor would get the same amount.
So I guess if Loss Given default changes, then there may be a case to MTM down liabilities. However, if this parameter remains the same and only default probability goes up, MTM-ing of liabilities is wrong!

2008 Apr 07 08:26 AM

[User 42264:]

MTM-ing liabilities is crazy, its totally different from MTMing assets. Firms should not benefit from an increased risk premium on itself, especially under the Going Concern tenet.

The reason why liabilities should not be MTMed:
Market prices in a default probability and Expected loss given default to price a Bond. Even if default probability goes up but, Loss given default remains the same, market value of the bond decreases. In both scenarios if the firm were to default and get liquidated, the creditor would get the same amount.

So I guess if Loss Given default changes, then there may be a case to MTM down liabilities. However, if this parameter remains the same and only default probability goes up, MTM-ing of liabilities is wrong!

2008 Apr 07 08:42 AM

[stretcho44:]

This practice will become the standard as the GAAP and IFRS standards converge.

The other side is when the debt is securitized and simply passed through to other investors. The asset has to be marked to market which books a loss but the liability could not until the recent FaS Rule 159 became effective. Mortgage REITs have large negative EPS simply because the of the writedown of only one side. When FAS 159 is applied the book values of these companies take a good positive jump. They have their problems and risks but as a group have a 25% short interest, yield 20% in dividends and will show a large jump in book value when Q1 earnings are released.

In this case, FAS Rule 159 makes a lot of sense.

2008 Apr 07 02:12 PM

[johnthebear:]

If FAS 159 is used for REITs, will it change the earnings per share or just economic/tangible book value, and thereby not really change the value of the stock?

If so, how do you see it affecting earnings reports and values of REITs with Q1 reports?

2008 Apr 11 08:44 PM