How Deteriorating Crediworthiness Can Make You Millions (If You're a Bank)
It's not quite as laughable as it might seem at first glance that the latest tranche of investment-bank earnings reports showed hundreds of millions of dollars in profits from the fact that those banks' bonds had fallen in value. Morgan Stanley alone booked $390 million, or about 26% of its third-quarter profit, from the fact that its bonds are now worth substantially less than they were when they were issued.
That kind of profit might not, as Moody's says, constitute "high-quality, core earnings". But it's not entirely an accounting fiction, either. After all, a bank can make money on the asset side of its balance sheet if it buys assets at a low price and then they rise in value: it's called mark-to-market accounting. So the same bank sells bonds at a high price and then they fall in value, there's a mark-to-market profit there, as well.
Any investment bank worth its salt is at all times actively managing its liabilities. That means it's on the lookout for the kind of opportunities available to the quick and the market-focused: it might see an attractive swap rate between dollars and Chilean pesos, for instance, quickly issue a bond in a Chile, and swap its liability into sub-Libor funding in dollars. Banks' CFOs can also buy back their own debt in the secondary market, especially if they think it's trading at a substantial discount to fair value. In that case, the profit on the bonds' fall in price isn't just mark-to-market, it's real. If I sell you a bond for $1 and then buy it back for 90 cents, I've just made 10 cents in cash.
Which is not to say that these are the kind of earnings that banks like to crow about. But in times like these, they're not about to look a gift horse in the mouth, either.
Felix Salmon arrived in the United States in 1997 from England, where he worked at Euromoney magazine. He also wrote daily commentary on Latin American markets for the former news service Bridge News, freelanced for a variety of publications, helped set up the New York bureau of a financial website, and created the Economonitor blog for Roubini Global Economics. He has been blogging since 1999 and now writes the 'Market Movers' blog for Portfolio.com.
Salmon is a graduate of the University of Glasgow.