Bank Investors Beware

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Two years after the big bank bailout, should investors rest easily and buy banks hand over fist like successful money managers Bill Ackman and Bruce Berkowitz? Or are the banks just out on bail, waiting another trial?

The answer is in the middle. Earnings are better, sure, but not as good you think.

Over the last two weeks, the major U.S. banks -- Citigroup (NYS: C) , Bank of America (NYS: BAC) , Morgan Stanley (NYS: MS) , Goldman Sachs (NYS: GS) , JP Morgan (NYS: JPM) , Wells Fargo (NYS: WFC) , and US Bancorp (NYS: USB) among them -- have reported third quarter earnings. It was largely a mixed bag, with weak trading results and tepid loan demand somewhat offset by continued improvement in balance sheet strength and overall credit metrics.

However, in a few cases -- particularly Citigroup, Bank of America, JP Morgan, and Morgan Stanley -- one adjustment caused earnings to look far brighter on the surface than in reality.

Weak means strong?
The headline atop Citi's earnings release is:

CITIGROUP REPORTS THIRD QUARTER 2011 NET INCOME OF $3.8 BILLION, COMPARED TO $2.2 BILLION IN THIRD QUARTER 2010

Wow! Not bad, right? However, reading further, Citi admitted that things aren't quite so rosy:

THIRD QUARTER 2011 REVENUES OF $20.8 BILLION INCLUDED $1.9 BILLION OF CVA

What's a CVA? A CVA -- or credit valuation adjustment -- is a fairly esoteric accounting policy which allows banks to book earnings as their credit spreads widen. In other words, it's not really earned money at all, but a reflection of investor sentiment toward a bank's creditworthiness.

The reasoning behind this policy is a little wonky. The Financial Accounting Standards Board, or FASB, tells the bank to report a gain because it could conceivably repurchase its own debt on the open market at a discount to par value. Thus, we end up in an Alice in Wonderland situation where weakening banks -- or at least those perceived to be weak -- report record-breaking "earnings." (Ask your friendly neighborhood FASB policymaker why that makes sense. As Charlie Munger joked to a group of Fools a couple of years ago, a CVA adjustment would have meant that Lehman Brothers had the greatest earnings in history the moment before its bankruptcy.)

Gimme the numbers
Let's take a look at just how material these CVA's (including a related measure called debit valuation adjustments -- DVA) were to a few major banks' revenue and net income this past quarter:

Citigroup

$3,771

$1,938

$2,518

67%

Bank of America

$6,232

$6,200

$2,388

38%

J.P. Morgan

$4,262

$1,900

$3,062

72%

Morgan Stanley

$2,153

$3,400

$45

2%

Source: 3Q 2011 Earnings Releases from Citigroup, Bank of America, J.P. Morgan, and Morgan Stanley. *Assumes 38% tax rate.               The most important column is the last one, showing the percentage of the bank's reported earnings which were "clean" -- that is, didn't include the bizarre accounting entry. Clearly, these CVA's are big numbers and not simply rounding errors. In the case of Morgan Stanley, their CVA represented almost their entire reported earnings -- that's the one most to avoid. Bank of America isn't much better with more than half. Even the "standout" of the group, J.P. Morgan, would have had 28% of its earnings wiped away had it not booked a CVA.

To be fair, I don't believe the banks are purposely trying to mislead investors -- they are simply following the rules. But in the minefield of bank earnings reports, the CVA is a particularly treacherous beast -- it not only doesn't represent real earnings, but it causes a systematic overstatement rather than an understatement.

Banks are opaque enough without this. Investors beware, especially of Morgan Stanley.

At the time this article was published Tom Jacobs is the advisor of Motley Fool Special Ops, a special situations and opportunistic value service. He has a checking account at Citibank even though big banks make him nervous. You can follow him on Twitter @TomJacobsInvest. The Motley Fool owns shares of JPMorgan Chase, Bank of America, Wells Fargo, and Citigroup. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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