Analysis: Wall Street banks profit from their weakness

By Lauren Tara LaCapra

NEW YORK (Reuters) - The tempestuous bond markets of the third quarter could result in surprising gains for U.S. banks, but investors are unlikely to be impressed.

JPMorgan Chase & Co <JPM.N> said on Thursday that about one-fourth of its profit in the quarter resulted from an accounting oddity known as debt valuation adjustments, or DVAs. They are paper gains that occur when investors price more risk into a company's bonds, leading to a reduction in liabilities.

Investors, dismayed that so much of JPMorgan's profit came from an accounting quirk rather than cash-generating business, sent the bank's shares 4.8 percent lower. Its Wall Street rivals are likely to report similar results, analysts said.

"We're likely to see these DVA gains across all of the big capital markets players," said Shannon Stemm, a financial stock analyst at Edward Jones.

Before JPMorgan's results, analysts had forecast DVA gains of $1 billion for Morgan Stanley, <MS.N> and $300 million for Goldman Sachs Group Inc <GS.N>.

But because the two banks faced more severe bond-market stress than JPMorgan during the third quarter, they may report even larger DVA figures, analysts said. Those gains could be the only profits the two banks have to show for the quarter.

The rule that pertains to DVA, known as FAS 159, is part of rulemakers' efforts to make balance sheets more transparent by forcing companies to record changes in the market values of some assets and liabilities.

But the rules can make a company's financial statements more confusing, too, as when Lehman Brothers recorded a DVA gain of $1.4 billion just days before it filed for bankruptcy.

As the European debt crisis intensified in the third quarter, most U.S. bank debt weakened as investors grew jittery about the exposure of U.S. financial institutions. Morgan Stanley's debt was among the worst performing of the major banks, indicating that it may record the biggest gain, analysts said.

But experts cautioned that forecasting DVAs is difficult, because every bank funds its operations with a different combination of debt, and companies have some leeway for valuing the liabilities, particularly when they trade infrequently.

"It drives me crazy as an analyst," said Jack Kaplan, of Carret Asset Management, which has $1.4 billion in assets under management and holds JPMorgan shares and some Morgan Stanley debt. "It's nearly impossible to predict and you don't know if the rest of the market is factoring it in or not."


Morgan Stanley, in particular, has seen enormous paper gains and losses that were difficult to forecast.

The bank reported a DVA gain of $1.4 billion in the third quarter of 2008 as the credit crisis reached its pinnacle, only to post a DVA loss of $6 billion the following period after the U.S. government stepped in with a multibillion-dollar bailout.

Analysts on average are forecasting a profit of 30 cents per share for Morgan Stanley, according to Thomson Reuters I/B/E/S. But it looks as though the only reason analysts see the bank in the black is a big DVA gain they are factoring in.

Half of the 24 analysts who cover Goldman believe the company will report its second loss in 50 quarters as a public company, according to Thomson Reuters I/B/E/S. The average estimate is a profit of 15 cents per share.

The estimates would be lower if not for hundreds of millions of dollars' worth of expected DVA gains.

Of course, none of that means investors or analysts view DVA as a good thing, nor do they equate changes in debt value as the same kind of income banks earn from fees or changes in asset values.

"People consider DVAs accounting noise," said Matthew Morris, director of corporate advisory services in the Dallas office of RGL Forensics. "It's counter to common sense because as the company weakens this is somehow a net positive thing"

(Editing by Dan Wilchins and Steve Orlofsky)