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On Debt Gains

Apr 14

Written by: Jack Ciesielski
4/14/2008 6:47 AM

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.

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Pension & Other Benefit Plans: A Look Ahead

Investors in firms with defined benefit pension plans always face the risk of suddenly being pushed farther back in line when it comes to being served their returns. Variability in plan assets and variability in benefit plan obligations are the reason: poor asset returns coupled with sinking interest rates always spell tough times for defined benefit plan funding. In that regard, this year’s asset returns combined with the Fed’s “Operation Twist” add up to “Operation Agony” for defined benefit pension plans. If trends continue along their current path, firms that may have anticipated moving to more realistic pension accounting - like Honeywell, AT&T and Verizon already have done - might forego that decision. It could be just too painful.

Pensions aren’t the only kind of benefit plan affected by Operation Twist. Other postemployment benefit (OPEB) plans share much the same accounting model as pensions, including the calculation of a projected benefit obligation that similarly incorporates a discount rate - one that will also be affected by Operation Twist. The net OPEB obligations were slightly less than pension obligations at the end of 2010, but also promise to grow in 2011. Investors perceive them as less threatening than pension obligations because they don’t require funding. Strangely, there are a number of firms that are recognizing income from these benefit plans - without ever creating a dime of cash for investors.

A recent edition of The Analyst’s Accounting Observer dissects these issues, and is available only to paid subscribers. A condensed version is available for free upon request. To receive it, send an e-mail to Brenda Rappold at brappold@accountingobserver.com, with “PENSIONS” in the subject line.

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