Bank Profits Are Worse Than They Look

Four of the six largest U.S. banks posted profit declines in the second quarter. Goldman Sachs (GS) had the biggest drop—82 percent—partly because of a wrong bet that markets would become less volatile. Goldman also had to pay $550 million to settle claims by U.S. regulators that it misled investors when creating securities linked to subprime mortgages.

Results for the big banks would have been worse without a pair of accounting adjustments worth a total of $8 billion of additional revenue: a reduction in money set aside for bad loans and gains resulting, paradoxically, from the lower market value of the firms' own bonds.

Bank of America (BAC), JPMorgan Chase (JPM), and Citigroup (C) booked gains of about $1.5 billion each by reclaiming money they had set aside to cover loan losses; they did so at least partly based on changes in internal estimates of future defaults. At Bank of America, the largest U.S. bank, the change accounted for 38 percent of pretax income. The share was 21 percent at JPMorgan, the second-biggest bank, where Chief Executive Officer Jamie Dimon urged investors to discount the gain. While a reduction in estimated loan losses is good, "we don't consider that earnings," Dimon told analysts on July 15. "I've always called that ink on paper. It means nothing, O.K.?"

The six banks, which also include Morgan Stanley (MS) and Wells Fargo (WFC), booked more than $3 billion of "debt valuation adjustments," or DVAs, based on an accounting rule adopted in 2007 that lets them mark their own bonds to market value. The rules reflect the possibility that they could buy back their debt at a discount—something they rarely do. At Morgan Stanley, DVAs added $750 million to revenue, accounting for 45 percent of pretax income.

Such gains helped mask a decline in the earnings that matter—interest income, or the difference between the interest a bank collects and what it pays out. Bank of America's interest income fell by 6.2 percent from the first quarter, to $12.9 billion, as its loan book shrank by 2 percent. Fewer consumers are choosing to add to their debt loads, so "core revenue growth is difficult," Bank of America CEO Brian T. Moynihan told investors on July 16.

The bottom line: Accounting adjustments are making bank earnings look better, even as a sluggish economy makes it hard to increase lending.

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