Betting the Business

Something about yesterday’s earnings announcement by JPMorgan has folks rattled:

Third-quarter results included the following significant items:$1.9 billion pretax ($0.29 per share after-tax) benefit from debit valuation adjustment (“DVA”) gains in the Investment Bank, resulting from widening of the Firm’s credit spreads…

The market is pricing JPMorgan’s outstanding debt with higher spreads, i.e., at a lower value, so JPMorgan books a GAIN equal to the creditors’ market value losses.

Commentators on JPMorgan’s announcement are troubled by the paradoxical result that a higher probability of default–or some other cause of higher spreads–produces an earnings gain. Readers can find commentary on this here, here and here, among many other places.

If assets and liabilities are going to be accounted for using any version of market value, then there is no way to get around the fact that a drop in the market value of a liability must be a gain to the company. The problem arises not from the market valuation of JPMorgan’s debt, but from a failure to see how this one item fits into the larger picture of the company’s earnings and valuation. If the market’s assessment of the company’s future is driving down the value of the company’s debt, that’s not good news for the company as a whole. If the company’s future is less secure, then the multiple that’s applied to its regular earnings should be much less. Properly assessed, this bad news will always swamp the bump in value from the market valuation of liabilities. In the case of JPMorgan, that means the “value” of its other long-term earnings has declined by a lot more than the $1.9 billion pretax bump from the debt valuation adjustment. It’s that decline that analysts ought to be discussing.

By the way, it’s not just bank accounting statements that occasionally exhibit this paradoxical result. It strikes non-financial companies, too. Here’s some text from Constellation Energy’s FY 2007 10K, as that company began to adopt SFAS No. 157, Fair Value Measurement:

SFAS No. 157 requires us to record all liabilities measured at fair value including the effect of our own credit risk. As a result, we will apply a credit spread adjustment in order to reflect our own credit risk in determining fair value for these liabilities which will reduce the recorded amount of these liabilities as of the date of adoption. As a result of this change, we expect to record a pre-tax gain in earnings of a range of approximately $10-$15 million in the first quarter of 2008.

But for most non-financials, the scale of the valuation adjustments in liabilities on the books at market value are usually much smaller than they are for financials.