Bank Profits Depend on Debt-Writedown ‘Abomination’ in Forecast

Brian T. Moynihan, chief executive officer of Bank of Americ
Brian T. Moynihan, chief executive officer of Bank of America Corp., speaks during a meeting in Charlotte. Photographer: Chris Keane/Bloomberg

Bank of America Corp. and Wall Street firms that notched perfect trading records in the first quarter are now depending on an accounting benefit last used in the depths of the credit crisis to prop up their results.

Bank of America, the biggest U.S. bank by assets, may record a $1 billion second-quarter gain from writing down its debts to their market value, Citigroup Inc. analyst Keith Horowitz estimated in a June 23 report. The boost to earnings, stemming from an accounting rule that allows banks to book profits when the value of their own bonds falls, probably represented a fifth of pretax income, Horowitz wrote.

Investor fears of a Greek default, stalled U.S. economic recovery and tougher industry regulations have rattled markets, snapping banks’ trading streaks and rekindling doubts about their creditworthiness. Prices for Bank of America’s credit derivatives -- used by traders to bet on the likelihood of the firm’s default -- rose by 34 percent during the second quarter, while Morgan Stanley’s doubled and Goldman Sachs Group Inc.’s surged 86 percent.

“What’s on investors’ minds are the macroeconomic issues, as reflected by the interbank market in Europe, the very low yields on U.S. Treasuries and recent data on economic growth, jobs and housing,” Credit Agricole Securities USA analyst Michael Mayo said in an interview. “To the extent that the earnings power is less, the banks would not generate as much capital, so there’s less capital available to absorb future losses.”

Statement 159

In the first quarter, the four biggest U.S. lenders -- Bank of America, JPMorgan Chase & Co., Citigroup and Wells Fargo & Co. -- produced combined profit of $13.5 billion, the most since the second quarter of 2007. That figure probably fell by 28 percent in the second quarter, based on a Bloomberg survey of analysts’ estimates. The banks are scheduled to announce results over the next two weeks, led by JPMorgan on July 15.

The second-quarter results may include gains taken under a U.S. accounting rule known as Statement 159, adopted by the Financial Accounting Standards Board in 2007, which allows banks to book profits when the value of their bonds falls from par. The rule expanded the daily marking of banks’ trading assets to their liabilities, under the theory that a profit would be realized if the debt were bought back at a discount.

Accounting ‘Abomination’

In practice, it’s an accounting “abomination” because fluctuations in the value of the debt don’t change the amount the banks owe, said Chris Kotowski, an analyst at Oppenheimer & Co. in New York.

“Just because Morgan’s credit spreads widened out this quarter doesn’t mean that their ultimate interest and principal payments changed one iota,” Kotowski said. “The market will back it out, both on the upside and the downside.”

Kotowski has been covering the banking industry since 1987 and returns on his stock recommendations over the past year have outperformed the average of peer analysts, according to data compiled by Bloomberg. He has been discounting the valuation gains from his analysis since at least the third quarter of last year, and wrote in an October 2009 report that the “after-effects of a hundred-year storm are not shaken off in a couple quarters.”

Morgan Stanley probably recorded $1 billion in such debt-valuation adjustments in the second quarter, Citigroup’s Horowitz wrote. That represents 60 percent of the analyst’s forecast for the firm’s pretax income. Morgan Stanley booked $5.1 billion of gains in fiscal 2008 as its bond spreads widened, then reversed them in 2009 as markets improved and spreads tightened.

Goldman Sachs may have had $375 million of gains in the second quarter, while JPMorgan had $300 million, Horowitz wrote.

DVA Gains

Including Bank of America, the four banks probably had debt-valuation adjustments, or DVAs, amounting to an average of 18 percent of pretax income, based on Horowitz’s estimates.

Citigroup may have booked $400 million under the accounting rule, estimated Bank of America analyst Guy Moszkowski.

“It’s deja vu to 2008,” said Credit Agricole’s Mayo. “DVA gains are back.”

In the first quarter, an unbroken string of profitable trading days helped Charlotte, North Carolina-based Bank of America post higher profit than analysts estimated, even as unemployment stayed close to a 27-year high. Goldman Sachs, JPMorgan and Citigroup also reported perfect trading quarters, while Morgan Stanley was profitable on 57 of 61 trading days. All four firms are based in New York.

“The credit cycle is clearly behind us,” Bank of America Chief Executive Officer Brian Moynihan told investors in April following the bank’s first-quarter earnings report.

‘Prevailing Winds’

In the ensuing months, corporate-bond yields widened, leading to a “pullback in client participation” and lower fixed-income trading results, Steve Stelmach, an Arlington, Virginia-based analyst at FBR Capital Markets, wrote in a June 30 report. Non-investment-grade bonds lost 0.7 percent last quarter, compared with a total return of 4.82 percent in the first, based on the Bank of America Merrill Lynch U.S. High Yield Master II Index.

“When the prevailing winds of credit spreads tighten, they make a lot of money, and when spreads widen, they can’t make as much,” said David Hendler, a senior analyst at New York-based research firm CreditSights Inc.

The Standard & Poor’s 500 Index fell by 15 percent from a 19-month high in April, curbing stock-trading revenue and prompting companies to cancel or postpone new share offerings and hold off on mergers and acquisitions that Wall Street bankers advise on to generate fees. U.S. bond sales fell to $335.8 billion in the second quarter, down 37 percent from both the first quarter and the second quarter of 2009, according to Bloomberg data. It was the lowest amount since the fourth quarter of 2008.

Lackluster Demand

The weaker trading environment highlights how banks are suffering from lackluster demand for their basic products: loans to companies and consumers. Loans and leases held by U.S. banks shrank for the sixth consecutive quarter to $6.88 trillion as of June 30, according to Federal Reserve data, which include an accounting change. Delinquencies on commercial real estate loans rose to 7.5 percent in May from 6.42 percent in March, according to Moody’s Investors Service.

Citigroup, which is 18 percent owned by the U.S. Treasury Department, probably had net income of $1.54 billion in the second quarter, the average of eight analysts’ estimates in a Bloomberg survey, down 65 percent from the prior quarter and 64 percent from a year earlier.

“Our near-term performance will continue to reflect the pace of economic recovery and the level of activity in capital markets,” Citigroup CEO Vikram Pandit, 53, said in April after the bank’s first-quarter profit almost tripled from a year earlier.

Goldman, Morgan Stanley

Profit probably fell 25 percent at Bank of America from the second quarter of the previous year, 18 percent at San Francisco-based Wells Fargo and 47 percent at Goldman Sachs, the Bloomberg survey shows. JPMorgan’s profit, which probably rose 17 percent from a year earlier, may be 4.5 percent lower than it was in the first quarter. Morgan Stanley’s second-quarter profit, depressed a year ago by a $2.3 billion debt-valuation charge when its CDS spreads were tightening, probably rose sevenfold, according to the survey. Compared with the first quarter, Morgan Stanley’s profit probably fell by 35 percent.

At the same time, banks are adding jobs for the first time in two years in a bet that recent market turmoil will prove temporary and fewer U.S. consumers may fall behind on loan payments. In New York, 6,800 financial-industry positions were added from the end of February through May, the largest three-month increase since 2008, according to the New York State Department of Labor.

‘Unusually Weak’

JPMorgan last month reported that credit-card loans more than 30 days late fell to 4.22 percent from 4.4 percent the previous month. That was the lowest since July 2009.

None of the six largest banks is forecast to report a loss for the second quarter, a contrast with the fourth quarter of 2008 when they had combined net losses of $25.3 billion.

Any optimism was lost on the market for bank stocks. The KBW Bank Index, which tracks the 24 biggest U.S. banks, fell 11 percent in the second quarter after climbing 22 percent in the first three months of the year.

“The first quarter was unusually strong, and the second quarter feels like it is going to be unusually weak,” Moshe Orenbuch, an analyst at Credit Suisse Group AG in New York, said in an interview.

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