NEW YORK (Fortune) — Just as Credit Suisse’s reputation for prudent risk management went up in a $2.85 billion puff of smoke this week, the bank’s seemingly impressive earnings are looking tenuous because of an obscure accounting rule.The little-noticed financial accounting standard rule 159 allowed Credit Suisse to report $1.2 billion in gains on its 2007 income statement simply because of the widening of the credit spreads in own debt. Simply put, about 16 percent of the bank’s $7.43 billion in annual net income exists solely on paper.What’s more, Credit Suisse’s investment banking division would have posted losses in the third and fourth quarters without FAS 159. Instead, the bank reported pre-tax profits of $6 million in the third quarter and $328 million in the fourth quarter. Credit Suisse (CS) isn’t the only bank benefiting from the opaque accounting rule. Morgan Stanley, Lehman Brothers (LEH, Fortune 500) and Goldman Sachs (GS, Fortune 500), among others, have all reported stronger earnings because of it. While the rule is clearly a boon to investment banks, it’s problematic for investors already reeling from multi-billion write-downs by Citigroup (C, Fortune 500) and others on complex assets whose underlying values remain a mystery. Credit Suisse on Tuesday announced a $2.85 billion write-down on some mortgage-related bets, surprising investors who thought the bank had deftly avoided the worst of the credit crunch. Here’s how FAS 159 works: A company can assign a fair (or market) value to its financial assets and liabilities - such as bonds - in order to smooth out earnings. Say a bank sells debt, an IOU, at $1,000 par value. Because of broader credit-market concerns and a slowdown in earnings, that debt trades down to $800. The $200 differential, under standard 159, is allowed to be counted as mark-to-market income, without the bank having engaged in any business activity. The bank then details its use of the rule in footnotes to its regulatory filings.While FAS 159’s underlying goal is laudable, in practice the rule allows banks to claim non-cash earnings that could prove ephemeral. In short, it distorts the real picture of a bank’s success at successfully trading, underwriting and advising clients.In fairness, the rule has the ability to cut the other way for investment banks. As the debt gets closer to maturity, or appreciates in price, the price changes count as a mark-to-market loss on their income statements. In reality, the effect of this paper loss would almost certainly be minimized by the bank’s improved profits.Morgan Stanley (MS, Fortune 500) used the rule to recognize $390 million, or about 26 percent of its net income, from the drop in price of its bonds. Similarly, Bear Stearns booked (BSC, Fortune 500) a $225 million gain from its structured note portfolio in its third quarter. Without it, the firm would have been in the red.Some analysts oppose the rule. CreditSights analyst Simon Adamson calls it the concept of fair value accounting taken to the extreme and has been sharply critical of investment banks - especially Credit Suisse - for using it. In a report Tuesday, he said the rule distorts comparisons between Credit Suisse and its rivals like Deutsche Bank that use other standards.A Credit Suisse spokesman declined comment. Moody’s Investors Services has also warned investors about FAS 159, noting that it risks giving false perceptions of a bank’s financial strength. The agency says it does not consider such gains to be high-quality, core earnings. Banks, of course, can hardly be blamed for taking advantage of an accounting trick that’s perfectly legal. But investors looking to make a smart bet might want to scour the footnotes first to see if the reported earnings are artificially high.
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Investment Guide February 21st, 2008
