Illustration by Victor Kerlow
JPMorgan Finds a Good Mate for Its Trading Loss
Enough about the trading losses at JPMorgan Chase & Co. (JPM) Check out all of those offsetting gains.
Last month when JPMorgan first acknowledged that some of its chief investment office’s derivatives trades had gone haywire, it tried to soften the blow by pointing to a big chunk of freshly realized investment profits that reduced the unit’s overall loss.
The trading loss so far for the second quarter was about $2 billion, before taxes, the company said May 10. However, the same office had also realized a $1 billion pretax gain from sales of securities this quarter, which JPMorgan said it hadn’t factored into its previously issued earnings forecasts. The obvious impression JPMorgan left was that it had sold securities and booked gains as a way to mitigate the loss.
There’s nothing wrong with that under the accounting rules. The problem is with the rules themselves, which create needless complexity for investors, along with ample opportunities for companies to manipulate the timing and size of their earnings.
The trading loss came from derivatives that had to be marked at their fair market values each quarter, with changes hitting earnings immediately. By comparison, the securities that JPMorgan sold were classified as “available for sale.” Such investments are marked to market on the balance sheet each period. Generally speaking, however, quarterly fluctuations in their value don’t get included in net income or regulatory capital.
Instead, unrealized gains and losses on available-for-sale securities go into a holding tank on the balance sheet called accumulated other comprehensive income, where they may sit for years before being released into net income. Had JPMorgan labeled these same securities as “trading” assets instead, any changes would have counted in earnings and regulatory capital already, before JPMorgan sold them.
So, by classifying the securities as available-for-sale, JPMorgan in effect had created a reservoir of earnings on its books that it could tap at its discretion for financial- reporting and regulatory purposes. This wouldn’t be possible if the rules required full fair-value accounting for all securities.
JPMorgan said it had $8.4 billion of paper gains in its $381.7 billion portfolio of available-for-sale securities as of March 31, almost all of which were bonds of some sort. JPMorgan’s income statement would have better reflected the company’s actual economic activity, had its earnings included all of those changes in value as they happened.
As they stand, the accounting standards encourage actions that may run contrary to companies’ economic interests. Jamie Dimon, JPMorgan’s chief executive officer, made a similar point during the company’s May 10 conference call. Dimon said the company could take more gains to offset the trading loss if it wanted to. “But usually it’s tax-inefficient, so we’re very careful about taking gains,” he said.
Another problem for investors: Often it’s hard to tell if a company has sold its best investments to make earnings look better, while holding onto its losers. Cherry picking, or “gains trading,” was a big problem during the 1980s savings and loan crisis. At least with JPMorgan, which classifies only $11 million of its bonds as held-to-maturity, almost all of the changes in the values of its securities must be recorded on the company’s balance sheet each quarter.
The U.S. Financial Accounting Standards Board for decades has used accumulated other comprehensive income as a dumping ground for gains and losses that it has deemed too volatile to include in earnings. Other examples include changes in the values of corporate pension plans and foreign currencies.
Recently the FASB passed new rules to require that such gains and losses be disclosed more prominently. Yet it still lets companies keep them out of net income. General Electric Co. (GE), for instance, showed an accumulated other comprehensive loss of $22.1 billion as of March 31, mainly due to pension plans. GE’s net income last quarter was about $3 billion.
Historically, the Federal Reserve and other banking regulators had been advocates of using accumulated other comprehensive income as an earnings-smoothing mechanism -- and a backdoor way of limiting volatility in the regulators’ standard capital metrics. (The term “capital” refers to the financial cushion companies have on hand to absorb future losses.) Yet even the regulators have done an about-face of sorts.
This month, U.S. banking regulators proposed rules under which most of the items in accumulated other comprehensive income would start being counted in banks’ regulatory capital, including unrealized gains and losses on available-for-sale securities. Had those rules been in full effect already, there would have been less incentive for JPMorgan to sell winners to offset its trading losses.
The policy shift had been a few years in the making, after a wave of collapses by financial companies that showed seemingly robust regulatory capital. If even the banking regulators can now agree that such gains and losses should be included in capital, there’s no good reason for the accounting-rule makers to keep excluding them from companies’ earnings. Volatility is just another word for reality. A change is overdue.
(Jonathan Weil is a Bloomberg View columnist. The opinions expressed are his own.)
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