After what's now an obvious pullback from the brink of
death that banks were staring at earlier this year, plenty of
folks think third-quarter bank earnings will come charging
back, kicking butts and taking names.
And they may. Factors fueling profits at
Goldman Sachs (NYSE: GS) and
JPMorgan Chase (NYSE: JPM) -- huge trading
gains thanks to the loss of competition post Lehman and Bear
Stearns -- are still alive and well. And ultra-low interest
rates are still hugely beneficial for more prudent lenders
like
Wells Fargo (NYSE: WFC).
But one potentially overlooked factor could have a big,
ugly, impact on some banks' bottom lines this quarter.
Earlier this year, as things hit the fan in unison, an odd
accounting rule allowed troubled banks to offset losses at
just the right time.
It went like this: As bankruptcy fears loomed, banks' debt
plunged in value. As the value of that debt fell, clever
accountants assumed banks could repurchase their own debt on
the cheap. If they repurchased debt below par, the difference
between par and the depressed repurchase price could be
booked as profit, since it would be a transfer of wealth from
existing bondholders back to the company. Even if the bank
had no intention -- or even means -- of repurchasing the
debt, it still got to book the spread as income.
Quite literally, the closer banks got to bankruptcy, the
higher their accounting profits would become. (This is why
your son or daughter shouldn't major in accounting).
But now that panic has evaporated and
optimism is backin full bloom, debt spreads are
contracting. That means the other side of this insane
accounting rule takes hold: As debt spreads contract, the
same banks that benefited earlier this year will be forced to
book losses.
Who are these banks?
Citigroup (NYSE: C) and
Bank of America (NYSE: BAC) were two of the
biggest beneficiaries of this accounting quirk:
Bank
Q1 Reported Income
Gains from Widening Debt Spreads
Citigroup
$1.6 billion
$2.5 billion
Bank of America Continued... |