Banks Gaining From Their Declining Debt

An interesting article in this week's Barron's about how fair-value accounting is allowing companies to boost earnings by recognizing "gains" from being able to buy back their declining debt at cheaper prices. As mentioned in the article: "When a company's credit weakens and the yield on its debt rises relative to risk-free Treasuries, the debt becomes worth less to the holder. The financial company, which is the debt issuer, then takes a gain, because theoretically it could buy back its debt below face value." Given the level of exposure, the gains are not insignificant. For the first quarters, widening credit spread allowed Morgan Stanley to report $848 million in gains, Lehman Brothers reported $600 million, while Goldman Sachs reported $300 million. Of course, given that most of the long-term debt matures at par, any gains realized will reverse over time. But in the short-term when losses need to be covered, fair-value accounting allows for higher reported earnings, even though these earnings do not really justify the P/E ratio generated. As the market starts to move up, a reversal of recent accounting gains will be necessary.

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