Necessity is the mother of invention, and finance's brightest minds are really needy these days.
Bankers are likely to mine their balance sheets over the next few quarters and use accounting rules more than ever to squeeze out revenue, observers say. The Federal Reserve Board has just undercut the ability to use such revenue to satisfy stress test capital requirements, but there is still plenty of incentive to offset losses stemming from continued credit deterioration.
Within that context, bankers will do just about anything to prevent more losses and capital erosion, even if it means doing so with lower-quality earnings. In the longer term, the objective will be to demonstrate that the biggest companies are done spilling red ink and have what it takes to emerge from the recession stronger, observers say.
R. Scott Siefers, an analyst at Sandler O'Neill & Partners LP, said capital creation is "of paramount importance" to bankers and investors, regardless of whether it is allowed to meet the stress test requirements. "We've become so used to capital destruction the last few years, so anything that reverses the trend would be welcome," even if it includes some "unconventional" methods.
Kevin Jacques, the chairman of the finance department at Baldwin-Wallace College and a former Treasury Department economist, said: "You want to get out of the whole context of negative quarterly earnings. You want to convince Wall Street that things are getting better, and the best way to do that is with positive earnings per share."
Accounting gimmicks are often the best way to produce earnings, particularly for companies that have bought distressed competitors. An obvious place to turn would be the loan books, where acquirers took significant writedowns when deals closed and could now reap substantial gains if they can sell those loans.
James Reichbach, the managing partner who heads Deloitte & Touche USA LLP's banking practice, said he is starting to see sales among the 19 companies that went through stress tests. "They are producing positive, appreciable gains, and we'll see more of that over the next few months."
Jeff Davis, the director of research at Howe Barnes Hoefer & Arnett Inc., said bank balance sheets "are like warehouses, and you can always find something that you can sell at a gain."
Siefers said he is cautiously optimistic about gains on sales. "Success hinges on how liquid and efficient the market remains for selling distressed assets."
The same rules apply to potential gains from selling securities and bonds, whose values had increased early this quarter but are now starting to reverse themselves. Observers said a number of companies recorded such gains in April, but they may be less likely now.
Jacques said last year's acquirers could also book hefty gains from holding on to marked down loans as a result of the accretable yield — the difference between the value of the loans held on the balance sheet and the expected cash flow.
Davis said some bankers could also back out of funds allocated to employee benefit plans, tax reserves or litigation reserves. "It is totally gaming the system … but now is the time to find stuff you've accrued over the years and reverse it. You can also change the timing of a fee schedule to pull the fees forward and delay the expenses."
Such gamesmanship may be why the Fed decided bankers may use revenue-related capital to address only 5% of the shortfalls revealed by the stress tests.
Analysts cited other ways companies have created earnings in recent quarters that could be replicated through the year. Bank of America Corp. booked a $2.2 billion first-quarter gain from mark-to-market adjustments on debt tied to Merrill Lynch & Co. And B of A said Wednesday that it expects to create $1.8 billion of capital by lowering its deferred tax deduction.
Bankers see such moves not as manipulating the numbers, but as working within current accounting rules.
"This is always discretion and judgment, but it is limited," said an accounting executive for a large banking company, who asked not to be named. However, "there will be an emphasis on beating [earnings] expectations over the next two quarters."
Some say bankers may also be able to generate earnings from acquisitions. Because of an accounting rule that went into effect this year, companies that make acquisitions at prices below fair value can book "negative goodwill" as a one-time gain during the quarter the deal closes.
JPMorgan Chase & Co. booked a $1.3 billion fourth-quarter gain, because the fair value of nonfinancial assets acquired from Washington Mutual Inc. topped the deal price. The gain helped the New York company post a gain for a quarter when many others reported losses.