I have noted over the past week that, without accounting gimmicks, bank earnings have been nothing short of abysmal in the second quarter. One of these accounting tricks is the 'debit value adjustment', wherein a widening of a firm's CDS spread during the reporting period turns out to be a good thing, as it lowers the price of the firms' debt thus theoretically making it possible for them to buy it back for a cheaper price than what they issued it for. This theoretical repurchase gets booked as a gain. Put another way, the debt is a liability, and when the price of that debt falls, the liabilities are reduced as the firms mark them to market.
This little trick is not going to last forever, as the FASB is set to make banks report this item separately in "Other Comprehensive Income" soon. In the meantime, DVA gains helped Citi (C) and JPMorgan (JPM) book an extra $213 million and $800 million respectively this quarter. Now that Morgan Stanley (MS) has reported, the fact that DVA gains accounted for 10% of JPMorgan's earnings looks pretty good by comparison. Debit value adjustments accounted for 16 cents of Morgan Stanley's second quarter EPS which sounds ok right up until you find out that they only earned 28 cents.
So just to clarify: the fact that Morgan Stanley became less creditworthy during the second quarter (MSCD5 wider by nearly 135bps from April to June) accounted for 57% of EPS.
Without DVA, the firm missed Wall Street's revenue target by nearly 15% ($6.6 billion versus expectations of $7.58 billion). You can just go down the line and pick a bad stat from there: fixed income down 70% sequentially and 59% YOY, equities trading down 36% YOY and 38% sequentially, etc, etc.
The best (worst) part of the report however is this:
"As a result of a rating agency downgrade of the Firm's long-term credit rating in June, the amount of additional collateral requirements or other payments that could be called by counterparties, exchanges or clearing organizations under the terms of certain OTC trading agreements and certain other agreements was approximately $6.3 billion, of which $2.9 billion was called and posted at June 30, 2012."
This is what happens when you can't move enough of your $50 trillion (notional) in derivatives from your holding company to your bank. Recall that, in the wake of persistent downgrades, the firm is attempting to move its derivative positions to Morgan Stanley Bank NA (which is higher rated) to avoid the kind of collateral requirements described above. More importantly, is the issue of the rest of the $3.2 billion that could be called.
This quite clearly sets off a number of alarm bells for shareholders of Morgan Stanley. Saying that their are 'some concerns' going forward somehow doesn't seem to adequately convey the urgency. Short Morgan Stanley or long MS put options.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
