Here’s How Investment Banks Book Profits on Losses

Investment banks are making a significant amount of their earnings by betting against themselves. Debt valuation adjustments — which allows banks to book profits when the value of their bonds falls from par — accounted for ~25% of JPMorgan Chase’s (NYSE:JPM) Q3 profits. Already forecast were gains of $1 billion for Morgan Stanley (NYSE:MS) and $300 million for Goldman Sachs (NYSE:GS) as a result facing more bond market stress than JPMorgan.

Rules such as FAS 159 — which pertain to debt valuation adjustments — can be confusing, as evidenced by Lehman Brothers filing for bankruptcy just days after reporting a $1.4 billion DVA gain. Ironically, these rules are meant to make companies more transparent by forcing them to record changes in the market values of some assets and liabilities. Analysts say that Morgan Stanley (NYSE:MS) may record the biggest gain because its debt was among the worst performing amongst major banks (NYSE:KBE).

“But experts cautioned that forecasting DVAs is difficult, because every bank funds its operations with a different combination of debt, and companies have some leeway for valuing the liabilities, particularly when they trade infrequently,” according to Reuters.

Nice. Now we’re in a world where the more your debt has paper losses, the higher the profit you can book on it under the theory a profit would be realized if the debt were bought back at a discount. Did you think black magic was eradicated from Wall Street? Think again.