Saturday, April 5, 2008

Barron's on I-Banks

Wall Street's Latest Illusion Turning Losses into Paper Profits

...Here's how the accounting works: 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....

LEHMAN, FOR INSTANCE, REPORTED EARNINGS in its most recent quarter of 81 cents a share, above the consensus estimate of 70 cents. However, the $600 million gain from the reduced value of its liabilities essentially added about $400 million, or about 70 cents a share after taxes. Excluding that gain, Lehman's profits would have been below the consensus.

Morgan Stanley reported $1.45 a share in first-quarter net, versus a consensus estimate near $1 -- what indeed it would have made without liability-related gains.

During 2007, Lehman reported $900 million of these gains; Morgan Stanley, $845 million; Goldman Sachs, $216 million; and Merrill Lynch, $1.9 billion.

When Merrill Lynch and some other major banks report results in the coming weeks, investors should carefully examine them and strip out any liability-related gains, because they merely reflect a worsening in bond investors' perceptions of the firms.

With the stock prices of securities firms rallying last week on news of Lehman Brothers' successful convertible-preferred sale and hopes that the worst may be over for the financial-services industry, debt spreads have tightened. That news is being welcomed on the Street -- even if it means a reversal of debt-related accounting gains of recent quarters.

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