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.

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