Banks Debt Valuation Accounting Rules Need A Revision

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Let's face it. As if it wasn't bad enough trying to compare the performance of the world's biggest banks side-by-side, it is now getting more difficult to even compare the performance of a single bank over consequent periods. And while huge differences in the way different banks report their figures is to blame for the former, it is easy to zero in on the reason for the latter - the debt valuation adjustment ( DVA ) accounting rules which the banks have been employing for a few years now. By its very nature, the DVA is extremely volatile, boosting a bank's income statement by billions of dollars one quarter and pushing it deep into the red the very next quarter. As a result, the underlying operating performance of a bank's trading division is lost under heavy accounting profits and losses often leading to misleading conclusions.

In this article, we highlight the extent to which results at the country's biggest investment banks - Goldman Sachs ( GS ), JPMorgan ( JPM ), Morgan Stanley ( MS ), Bank of America-Merrill Lynch ( MS ) and Citigroup ( C ) - have been affected by accounting for DVA over the last few quarters.

See the full Trefis analysis for Goldman Sachs | JPMorgan | Morgan Stanley | Bank of America | Citigroup

Understanding DVA: The Advantages & The Pitfalls

The accounting rule of debt valuation adjustment was adopted in 2007 to give investors a better understanding of the value of a company's debt at a given time. As credit spreads change over a period, a company's outstanding debt securities appreciate or depreciate. So, it definitely makes sense to convey to investors the amount of actual change in the value of debt by marking it to market.

Now, as debt is essentially a liability for a company, if the value of the debt in the market decreases, this would mean the company owes less money to its debt holders in notional terms. So, the accounting rule allows the company to report this difference as a gain in the income statement. Similarly, an appreciation in the value of debt means the company has to report the difference as a loss in the income statement.

The problem here is quite evident. Ironically, the rule found immediate takers among the financial institutions as the economic downturn was already upon the industry. With the financial sector being hit the hardest in 2008, the value of their debt plummeted in the market. And the banks were only too happy to report huge profits on these declines to boost their income statement over quarters when their operating incomes had turned negative.

But then, bad times don't tend to linger for too long.

The Situation As It Stands Now

It should be evident here that whenever the global debt market improves, banks are going to include a loss from DVA in their income statements. How much? The table below based on quarterly figures announced by the country's Big Five helps answer that question:

($ million) Q1'11 Q2'11 Q3'11 Q4'11 Q1'12 Q2'12 Q3'12 Q4'12 FY'11 FY'12
Morgan Stanley -189 244 3,410 216 -1,978 350 -2,262 151 3,681 -4,401
Citigroup -229 147 1,888 -74 -1,376 198 -799 -510 1,732 -2,487
Bank of America -657 423 1,709 -474 -1,434 -156 -582 -276 1,001 -2,448
JPMorgan -46 165 1,900 -567 -907 765 -211 -567 1,452 -920
Goldman Sachs 41 85 450 20 -224 6 -370 -126 596 -714

Morgan Stanley stands out among the banks for the sheer magnitude of DVA related gains/losses over two consecutive years - benefiting from a $3.7 billion gain in 2011 and losing $4.4 billion in 2012. This would cloud one's understanding of how well Morgan Stanley's trading business is actually doing as the figures would be bloated or impaired by a significant value each quarter.

A better idea of the impact can be obtained from the chart below, which shows Morgan Stanley's fixed-income trading yield. Using the reported revenues from the fixed-income trading desk each year, we arrive at a yield figure of 2.81% for 2011 and the significantly lower 1.07% in 2012. The intuitive conclusion here would be that the bank's trading performance was dismal in 2012, considering the trading portfolio size remained nearly constant.

This couldn't be farther from the truth as fixed-income trading revenues for 2012 were $5.6 billion compared to $4.4 billion in 2011 - without the impact of DVA, of course. And this discrepancy propagates all the way to the bottom line.

Maybe it's time the DVA accounting rule was modified to ensure that the figures each bank reports give details about changes in the value of debt while not messing up with the income statement itself.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

This article appears in: Investing , Investing Ideas , Stocks , US Markets

Referenced Stocks: C , DVA , GS , JPM , MS



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