Jan 11 As Wall Street banks begin reporting earnings next week, analysts and investors are once again prepared for big accounting charges related to changes in the firms' own credit spreads.
The charges stem from the improving corporate bond markets. When bonds that banks have issued become more valuable, banks take charges known as "debt valuation adjustments," or DVAs, to reflect the fact that buying back debt would be more expensive. When their bonds weaken, banks can record gains.
Based on movements in banks' credit, debt valuation adjustments may result in charges as high as $1 billion for Morgan Stanley and anywhere from $250 million to $500 million for JPMorgan Chase & Co and Citigroup Inc, said Dmitry Pugachevsky, director of research at analytics firm Quantifi.
Bank of America Corp said earlier this month that its fourth-quarter earnings will include a charge of approximately $700 million related to tightening of its own credit spreads. It declined further comment on Friday.
During the quarter, Bank of America's credit default swaps fell by 0.43 percentage points, or 24 percent, according to data from Markit, which tracks credit-default-swap movements. Credit-default swaps measure the cost of protecting a company's debt against default, and falling values indicate a company is perceived as less likely to default.
Investors and analysts have come to ignore big swings in earnings related to DVAs, which banks have been recording since 2008, when accounting rule allowed the option of accounting for debt on this basis. At the time, DVAs were a boon to banks, allowing them to record profit as they were punished in bond markets.
"It doesn't really reflect true state of earnings or true standing of the bank but, nevertheless, results will swing depending on changes in the spread," said Pugachevsky.
Banks that opted for this accounting treatment hoped that it would make their earnings more stable-- in good times, negative DVAs would cut into profits, but in bad times, positive DVAs would boost the bottom line. In the current environment, bank profits are not growing as impressively as their debt values, resulting in a big drag on profit.
FASB has tentatively agreed to allow changes in the value of debt to influence a bank's equity rather than its income. But the U.S. accounting standard-setter has not yet implemented its decision.
Credit default swap levels for Morgan Stanley and Citigroup dropped by 24 percent last quarter, according to Markit, while JPMorgan's fell by 26 percent. Pugachevsky does not expect Goldman Sachs Group Inc to report a big DVA loss because while its credit default swap prices dropped 22 percent, it typically hedges against DVA swings. Other banks do not.
Morgan Stanley and JPMorgan declined to comment on any potential DVA charge. Representatives of Citigroup and Goldman did not immediately respond to requests for comment.