Banks’ Q3 earnings – Trick or treat?

It’s that time of year when the tradition of All Saints’ Day gets blurred with modern commercialism. It is the turning of something scary into something fun, which has become an excuse for children to be rewarded for dressing up and behaving poorly.

In the more grown up world, this quarter’s banking results have been poor and are also dressed up. What’s lurking under the costume?

The oddest thing about this quarter’s bank results is how they turn bad into good by the method in which the banks account for bad news. The banks have for a number of quarters been applying the following make-up to their balance sheets. When their credit quality deteriorates, the value of their debt falls. This looks bad. It reflects their inability to finance and directly affects the future costs of the business when they come to refinance their debt. However, the banks are allowed to take this loss that has been suffered by their bond holders and book it as a profit. You therefore get the oddity that as the outlook for the bank deteriorates, its credit spreads widen, and it is able to book the spread widening on its own debt as a profit.

This has been very significant in the last quarter by a multitude of banks, typified for example by Morgan Stanley, which made $1.14 per share, but with $1.12 per share coming from a widening of its own credit spreads.

In their defence, the banks can argue that they have made a gain because they have sold debt to bond holders who have made a loss. Indeed, if they could buy back the debt at these lower levels they would crystallise the gain. They would also argue they account both ways. So when spreads fall, their profits are reduced.

However, this accounting treatment generally works in their favour. Firstly it makes their profits look less cyclical by increasing them in the bad times and reducing them in the good times – a handy tool for management. Secondly, by definition banks can only issue debt when perceived as a good credit and so are more likely to experience gains from write downs as opposed to losses from an improving credit profile.

The banks and their auditors think this accounting use is sound. We, however, wonder how correct it is. Presumably, using their logic, the accountants and management of Lehman Brothers would argue that the quarter it went bust was its most profitable ever because its debt traded at and near to zero. In fact, that last quarter of trading could well have earned more for the company than its previous 100 plus years of existence. Trick or treat.