Morgan Stanley was among the latest of the big “bulge bracket” banks to report results. And quite an eye-popping report it was too. The bank’s profit rose to $2.15bn, from a loss of $91m a year ago. Or did it? Pundits referred somewhat darkly to an “accounting gain” that generated $3.4bn of gains in the firm’s profit-and-loss account. Strip that out and the profit per share comes out around two cents. Include it, and you get $1.14 per share. So how did it do this?
It’s all down to accounting rules. Here’s the potted version. Banks are supposed to report the value of assets (what they own, or are owed) and the value of liabilities (what they owe others) at ‘fair value’. In short, that means at a market valuation when the accounts are drawn up, or at a best estimate of what that would be. And therein lies the trick that generates these big one-off gains. Imagine you are a bank that owes $100m in outstanding tradable IOUs – debt in other words.
Thanks to some of the investment and trading risks you have taken on, those IOUs are now deemed by the debt markets to be a riskier bet. How do you know? One clear sign is that the value of your debt has fallen in the open market. Since IOUs often carry a fixed rate of interest, the effect is to “widen the spread” (that’s the City jargon for it) between the yield on your debt and the equivalent yield on something very safe, such as US Treasuries. In accounting terms, this piece of bad news is actually a win.
What investment banks do
What investment banks actually do to earn their huge profits.• Watch all of Tim’s videos here
Let’s say your IOUs were originally worth $100m. Now they are priced at only $95m. Imagine you immediately repaid any of these loans. You’d be shelling out just $95m in cash to clear an IOU off your books that’s recorded at $100m. The difference is a $5m gain. And it’s that type of gain – also known as a “debt valuation adjustment” – that Morgan Stanley was able to book this year. That’s the joy of so-called “mark to market” accounting rules. And that’s yet another reason why we’re not keen to buy into any but the very best banks.