Wall Street's Latest Illusion
Turning Losses into Paper Profits
By ANDREW BARY  | MORE ARTICLES BY AUTHOR
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ALTHOUGH WALL STREET PROFITS ARE under pressure by a host of forces, the tough times also have provided a little-known financial benefit: Some Wall Street titans have been able to book gains from the declining value of their own debt.

These non-cash gains bolstered the bottom lines of Morgan Stanley (ticker: MS), Goldman Sachs (GS) and Lehman Brothers (LEH) in their first fiscal quarters, ended Feb. 29, helping them beat consensus earnings estimates. They had reported the same type of gains in 2007, mostly in the fourth quarter, as credit markets worsened.

Investors, however, should take little comfort from these accounting gains, for two reasons. They provide no cash benefit and, more important, merely reflect investors' growing concerns about the companies' financial health.

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.
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Once again, Wall Street has found a way to turn dross into (sort of) gold.

"It does sound counterintuitive, but this is a natural consequence of fair-value accounting," says Robert Willens, a tax and accounting expert who heads the New York consulting firm that bears his name. He points out that financial companies that elect to use fair-value accounting under rules established by the rule-making Financial Accounting Standards Board must reflect the fair values of both their assets and their liabilities.

In their fiscal first quarters, Morgan Stanley reported a $848 million gain related to the widening of its credit spreads, while Lehman booked a $600 million benefit and Goldman Sachs recorded $300 million in profits. Merrill Lynch (MER), JPMorgan Chase (JPM) and other financial companies haven't yet reported results for the first quarter. During 2007, JPMorgan had a $1.3 billion gain resulting from wider debt spreads.

Bear Stearns (BSC), which reached a deal to be purchased by JPMorgan, hasn't reported its first-quarter results, but it likely had a sizable liability-related gain as investors shunned its debt. If Bear Stearns had hurtled toward bankruptcy, it might have generated a multi-billion-dollar accounting gain because its debt prices would have tumbled. Obviously, those non-cash gains would have been a mere accounting illusion and useless to the firm and its equity holders.
Table: Silver Lining

Brad Hintz, the brokerage analyst at Sanford Bernstein, has written that investors should be wary of accounting gains resulting from declining debt values. "We do not believe that the marks taken on outstanding long-term debt represent high-quality revenues," Hintz wrote in a recent note on Morgan Stanley, a company that he rates Outperform.

Hintz noted that virtually all long-term debt matures at par, meaning that "mark-to-market gains generated during the life of any issue of long-term debt reverse over time. We are skeptical that earnings generated in this way justify any P/E multiple." Hintz's view is that investors shouldn't seek to capitalize, or assign a price/earnings multiple, to what may be the lowest-quality source of income for a financial company.

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.

The Bottom Line:
The debt-related gains have allowed some firms to top analysts' earnings estimates. But investors should ignore the gains, which simply reflect the firms' deteriorating finances.

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.