Investment banking and its fantasy profits

By Ignacio de la Torre | Although it seems to have gone unnoticed, investment banking has once again shown the way to pull the world out of its great and recurring debt difficulties. What was the last accounting note of Lehman Brothers? A huge profit. Let’s see why.

The 2011 result of the third quarter tells us that investment banking produced profits following the fall in market value of the debt of  the banks themselves. That is, if the risk of failure of, say, Morgan Stanley, goes up, the price of its bonds goes down as a consequence and, therefore, the bank increases its own profits. Intuitive? So, this is why Lehman’s last accounting entry was such a huge profit.

In total, the top five investment banks have obtained profits (close to $15 billion) thanks to this technique in the third quarter. Their equity position is, too, affected by an equivalent amount, as well as by extension their solvency situation, measured in relative (value at risk) or absolute terms (leverage). Thus, over 80% of the benefit of the investment bank’s third quarter of 2011 is due to mere fantasy.

Bank of America‘s $6.2 billion profits also include an extra $3.6bn and again a profit, due to the fall in market value of its debt, of $1.7bn. Citigroup‘s profits have risen by 74% up to $3.8 billion, but thanks to a profit resulting from the fall of its debt by $1.9 billion. Morgan Stanley made a profit of $2.15 billion dollars of which $3.4bn were in fact lost market value of its debt, and JP Morgan published a profit of $1.9 billion, beating market expectations with gains of $1.02 per share compared to the estimated 91 cents (the stock fell 4.8% afterwards… the market is not as simple as it looks).

Unfortunately, this practice is also being used in Europe. UBS has published a profit of 1.8 billion francs due to the fall in market value of its debt. Its total profit was one billion francs, meaning that without this trick the bank would be losing, not profiting as it apparently is, because of its trading scandal ($2.3 billion in losses).

The logic behind accounting as profit when the risk of bankruptcy rises and the value of liabilities falls is that the bank will have the capacity of buying back the debt, that is, it is assumed that it will be able to find the cash needed to buy this debt and amortise the debt re-purchase, which is questionable in itself.

This particular method was a victory of the banking lobby (with the honorable opposition of Goldman Sachs, which has nonetheless never hesitated to take advantage of this technique for its own results) when the regulator applied the mark to market rule to their assets. The banks argued that if the accounting system forced them to apply the market value to their assets, it should also be applied to liabilities. The principle of prudence, then, was transgressed.

As the Financial Times pointed out on October 24, if you are a VISA customer and you feel that you have a higher risk of not paying your card bill, you just must repay the part of the loan that you are not going to pay and enter the difference as a profit in your family account.

Leaders, entrepreneurs and citizens, all should learn from such a wise accounting system. Greece would solve its problem immediately, as its bonds traded at 40% of their face value; it could note a large influx as a result of multiplying 60% per the notional value of its debt so there would not be a deficit but rather impressive profit, giving peace of mind to the German taxpayer, too. Berlusconi would be saved, as Italy would also obtain a similar effect by entering a profit correlated to the 8% off its traded bonds traded (the third largest sovereign bond market in the world), and Spain could do the same with its 3% off. Fantastic, literally.

Ignacio de la Torre is finance master degree’s academic director at IE Business School.