Banks, Liabilities, Profits

This Bloomberg article explains very well, how banks book paper profits through their own outstanding bonds falling in value.

Merrill Lynch & Co., Citigroup Inc. and four other U.S. financial companies have used an accounting rule adopted last year to book almost $12 billion of revenue after a decline in prices of their own bonds.
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The debate over what is known as Statement 159 adds to the number of accounting techniques called into question as the U.S. debt market unravels. Investors have criticized banks for booking some writedowns in an accounting category called ``other comprehensive income'' that bypasses their income statements.
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Here's how it works, according to Richard Bove, an analyst at New York-based Ladenburg Thalmann & Co. A company decides to designate $100 million of its subordinated bonds as subject to mark-to-market accounting. The price of the bonds drops to 80 cents on the dollar from 100 cents. So the firm books $20 million on the ``presumed savings that you have on your liabilities,'' Bove said.

``In the real world you didn't save a dime,'' he said. ``You still owe the $100 million. It's another one of these accounting rules that basically takes you further and further away from reality.''

The Federal Reserve, Federal Deposit Insurance Corp., Office of the Comptroller of the Currency and Office of Thrift Supervision objected to the rule before its passage, saying in a joint 2006 letter to the FASB that it would ``have the contrary effect'' of increasing a bank's net worth at the same time its ``financial condition is deteriorating.'
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Merrill designated about $166 billion of liabilities, or 17 percent of its total, as fair-value instruments subject to mark- to-market accounting at the end of 2007, according to its annual report. Included in the amount were $76.3 billion of long-term borrowings and $89.7 billion of payables under securities- financing transactions.

Prices for the firm's bonds tumbled over the past year: Its floating-rate notes due in January 2015 are trading at about 87 cents on the dollar, compared with about 100 cents last June.

Merrill has said its gains from the liabilities don't add to true earnings power. In a spreadsheet posted on its Web site, Merrill says that investors who want a ``more meaningful period- to-period comparison'' should exclude the $2.1 billion of revenue recorded in the first quarter.

Merrill spokeswoman Jessica Oppenheim declined to comment. The company owns a passive 20 percent stake in Bloomberg LP, the parent of Bloomberg News.

Lehman to Goldman

Lehman, the fourth-biggest securities firm, has reported $1.9 billion of gains related to a widening of its own bond spreads. Citigroup, the largest U.S. bank by assets, has booked $1.7 billion; Morgan Stanley $1.7 billion; JPMorgan Chase & Co., the third-biggest bank, $1.7 billion; and Goldman Sachs $550 million.
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So far, most banks' writedowns are ``unrealized,'' meaning they've been unwilling or unable to liquidate distressed assets. If prices reversed, the banks would record mark-to-market profits.

The same is true for the liabilities. Companies can't ``realize'' the mark-to-market gains on their debt unless they buy it back at the discounted price. They're unlikely to do so, because the deterioration in creditworthiness means they'd have to replace the debt with higher-cost borrowings, Willens said.

``No one's going out in the market and actually retiring this debt,'' Willens said. ``It's a shell game.''

David Moser, Merrill's managing director for accounting policy, acknowledged that concern in an April 10, 2006, letter to the FASB.

``It seems counterintuitive that when a company's credit spreads are widening, it would recognize a gain in earnings,'' Moser wrote. ``The amounts are typically not realizable and therefore less relevant.'
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Worthington estimates that similar tightening of bond spreads at Merrill, Morgan Stanley, Lehman and Goldman Sachs may cause them to reverse $5.96 billion of revenue by the end of the year.
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``Equity may be overstated as a result of these illusory gains that may never be realized, hindering the analysis of the equity cushion to absorb losses,'' S&P Chief Accountant Neri Bukspan wrote in a letter to the FASB.

If and when the ``illusory'' revenue is reversed as losses, the banks and brokers may have to work harder to convince investors to ignore them, Willens said.