Statement 159 - Debt Valuation Adjustments - Déjà Vu 2008.

Statement 159, adopted by the Financial Accounting Standards Board in 2007 allows banks to book profits when the value of their bonds falls from par. This rule expanded the daily marking of banks’ trading assets to their liabilities, under the theory that a profit would be realized if the debt were bought back at a discount. How convenient...

I commented previously about the first quarter being the perfect game, the second quarter will be seriously different for Banks profits this time around.

A fast and furious tightening of credit spreads allowed Banks to publish record profits for 2009.

With the recent increase in volatility in conjunction with a reduction in debt issuance in the second quarter, banks have had a hard times to reap in similar profits they made in Q1.

As per below's Bloomberg article, Banks are now using the same accounting trick they used previously to boost their profits in a difficult trading environment.

http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=a3Eg4vzAbneA

“What’s on investors’ minds are the macroeconomic issues, as reflected by the interbank market in Europe, the very low yields on U.S. Treasuries and recent data on economic growth, jobs and housing,” Credit Agricole Securities USA analyst Michael Mayo said in an interview. “To the extent that the earnings power is less, the banks would not generate as much capital, so there’s less capital available to absorb future losses.”

The capital buffer is shrinking...and the DVA (Debt Valuation Adjustments) are returning with a vengeance.

DVA Gains:

"Including Bank of America, the four banks probably had debt-valuation adjustments, or DVAs, amounting to an average of 18 percent of pretax income, based on Citigroup Analyst Keith Horowitz’s estimates."

Accounting ‘Abomination’

"In practice, it’s an accounting “abomination” because fluctuations in the value of the debt don’t change the amount the banks owe, said Chris Kotowski, an analyst at Oppenheimer & Co. in New York."

David Hendler, Senior Analyst from CreditSights Inc. sums it up nicely in the Bloomberg article quoted above:

“When the prevailing winds of credit spreads tighten, they make a lot of money, and when spreads widen, they can’t make as much,”

Hence the recourse to DVA accounting practices.

When the game is not going your way, just change the rules...

Another nice move from FASB in 2007.

FAS 157 was reviewed in 2009 to allow more flexibility and issued in September 2006.

http://en.wikipedia.org/wiki/Mark-to-market_accounting

"On March 9, 2009, In remarks made in the Council on Foreign Relations in Washington, Federal Reserve Chairman Ben Bernanke said, "We should review regulatory policies and accounting rules to ensure that they do not induce excessive (swings in the financial system and economy)". Although he doesn't support the full suspension of basic proposition of Mark to Market principles, he is open to improving it and provide "guidance" on reasonable ways to value assets to reduce their pro- cyclical effects.

On March 16, 2009, FASB proposed allowing companies to use more leeway in valuing their assets under "mark-to-market" accounting, a move that could ease balance-sheet pressures many companies say they are feeling during the economic crisis. On April 2, 2009, after a 15-day public comment period, FASB eased the mark-to-market rules. Financial institutions are still required by the rules to mark transactions to market prices but more so in a steady market and less so when the market is inactive. To proponents of the rules, this removes the unnecessary "positive feedback loop" that can result in a deeply weakened economy.

On April 9, 2009, FASB issued the official update to FAS 157 that eases the mark-to-market rules when the market is unsteady or inactive. Early adopters were allowed to apply the ruling as of March 15, 2009, and the rest as of June 15, 2009. It was anticipated that these changes could significantly boost banks' statements of earnings and allow them to defer reporting losses. The changes, however, affected accounting standards applicable to a broad range of derivatives, not just banks holding mortgage-backed securities.

In January 2010, Adair Turner, Chairman of the UK's Financial Services Authority, said that marking to market had been a cause of inflated bankers' bonuses. This is because it produces a self-reinforcing cycle during a rising market that feeds into banks' profit estimates."

Basically, FAS 157 enabled banks to boost earnings in good times and pay themselves record bonuses and suffer catastrophic losses during the credit crisis, generating excessive margin calls on derivatives trades.
At the same time FAS 159 for DVA, enables banks to increase earnings in bad times.

The issue was anyway excessive leverage in conjunction with inappropriate accounting principle FAS 157, which led to seismic losses in US banks. Whereas in Canada bank leverage was capped to around 20 times. The capital buffer was therefore more significant. RBC still boast a AAA Rating.

The shadow inventory of REOs (Real Estate Owned, following rises in foreclosures) is putting additional strains on banks earnings. Inevitable adjustments to interest rates would as well put additional pressure on Banks Balance sheets. The current steep yield environment is helping tremendously banks in shoring up capital, provided their play is short duration (2 to 4 years). The risk is higher for Banks if they start buying longer duration trades on MBS (Mortgage Backed Securities). MBS are more abundant than US treasuries or short term liquid investments and are also offering higher yields as well. The temptation is there...and the risks are real if there is a sudden rise in interest rates.