A COMPREHENSIVE VIEW ON BANK PROFITS / THE WALL STREET JOURNAL

HEARD ON THE STREET

JULY 28, 2009, 4:32 P.M. ET.

A Comprehensive View on Bank Profits

By MICHAEL RAPOPORT

If banks' earnings look better, you can partly thank accounting rulemakers.

The Financial Accounting Standards Board's relaxation of controversial mark-to-market accounting rules in April gave banks new flexibility regarding impairment charges. Wells Fargo and State Street were two whose second-quarter earnings benefited.

It's another reason, along with one-time gains, that earnings at some banks may not be recovering as much as investors think.

FASB eased the mark-to-market rules under pressure from banks and some in Congress. The changes help banks avoid reductions to earnings when taking "other-than-temporary" impairment charges for losses on toxic investments.

Now, they can shift impairment charges on debt securities into "other comprehensive income" on the balance sheet -- as long as they intend to hold onto a beaten-down security. And they have to classify the loss as "non-credit," meaning it stems from external forces like reduced liquidity rather than the weakness of the investment. Earnings aren't hurt.

Naturally, that gives banks an incentive to classify losses as non-credit. Many did so in the first quarter -- the first period they could -- thus preserving hundreds of millions of dollars in earnings. Jack Ciesielski of The Analyst's Accounting Observer has calculated that, without the changes, 45 banks he studied would have reported earnings a median 42% lower.
The effect doesn't appear as pronounced in the second quarter -- but some banks are still realizing sizeable benefits. Wells Fargo had $664 million in second-quarter pre-tax impairment charges added to other comprehensive income but not assessed against earnings, on top of $334 million in the first quarter. Had this been charged to earnings, pretax second quarter income would have been 14.1% lower.

State Street, which adopted the FASB changes for the first time this quarter, said $103 million of its impairment charges were "not related to credit," so they were kept out of earnings. Without this, its pretax earnings would have been 13.8% lower. A State Street spokeswoman said the move reflects the bank's position that the assets involved would mature at full par value.

Shunting the impairment charges to other comprehensive income instead of earnings helps the banks another way, too: They avoid reductions in their regulatory capital. Thus, some key capital ratios like Tier 1 capital get at least small boosts.

One benefit: The FASB changes may make banks more willing to acknowledge impaired investments, since now this admission doesn't have to hurt profits. Without the changes, the banks might not be as willing to admit those impairments.

Still, investors should watch for more indications this is giving the big banks a hand. Securities filings may reveal more than the banks' quarterly press releases, which don't always break out the detail. Meanwhile, many smaller banks are only now adopting the change. They may yet cash in.

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