Last week's Barron's contained a good story by Andrew Bary on gains being recognized by investment banks on their marked-down debt. I've been a bit surprised by the number of people who've asked about this in the following week: it's not new news. I wrote dedicated reports about it last March, again in June, and once more in November. And it's not as scary as it sounds - Bary's piece was sharp and insightful, and shows that there's a skeptical audience out there when it comes to including such gains in the earnings stream that investors should capitalize. And he quoted some other knowledgable folks who believe this kind of earnings element should not be capitalized by investors.
Got that? D-O N-O-T C-A-P-I-T-A-L-I-Z-E. It's about the same level of quality in earnings that you'd expect from a sale of sale of equipment or a product line. Nobody would capitalize that in the stock price.
"Do not capitalize" is not the same thing as "Ignore." There's still information in those gains - some of it pretty obvious at first, in the case of the investment banks, less obvious if it occurs in something like industrials.
Wrap your head around the concept behind recognizing a gain on a liability depreciation before going too far. Think of something on the asset side of the balance sheet: a debt instrument held by a firm as an investment. The debt instrument increases in value because the company is an improving credit. The appreciation goes into income and it's non-cash. It can't be spent. Market participants probably wouldn't get too excited about that kind of earnings stream; they might figure that it could be easily converted into cash, but they also wouldn't expect it to be necessarily repeatable. On the other side of the balance sheet, if a firm's liability decreases in value, the market for the debt is giving the company an opportunity to improve itself: it'll take less cash to retire some of the debt. Forgiveness of debt is a gain, in anyone's book.
Neither side is a completed transaction - the firm doesn't sell the debt instrument, nor does it buy back its cheaper debt. Both ingredients go into income anyway, and the investor's job is to sort out what they don't like, as they always have. And the disclosures are good enough that discerning guys like Bary can pick out the skeevy earnings effect. (Another
good piece in a similar vein was done by
Jesse Eisinger in
Conde Nast Portfolio last month.)
The balance sheet is just showing what it's supposed to show: the firm's rights and responsibilities at a given point in time. If the written down debt is available, managers ought to consider buying it in just as if it were stock.
On to the the finer points on the markdown of debt, some additional information it provides: you've got credit markets saying that the firm's prospects stink. That's valuable information that investors should take into account and they wouldn't have it if there
wasn't a mark-to-market on the debt. If the credit markets see a freight train coming, one should look for a corresponding writeDOWN of an asset on the other side of the balance sheet - and if there isn't one, they should suspect that one may be coming. This is pretty obvious in the case of investment banks; if you saw something like this happening on an industrial firm's balance sheet, you might be getting an insight you wouldn't expect. Regardless, these gains are not the gravy train the Statement 159 electors think it is.
So far, these are pretty rare: to get this kind of treatment last year, a firm would have had to make an election to do so in the first quarter of 2007. By our count, only 68 firms adopted this treatment in 2007, with financials far and away the majority. More will have a chance to do so in the first quarter of 2008.