Return of "clever" accounting for banks

Income of $4.2 billion, or $1.26 per diluted share, from continuing operations applicable to Morgan Stanley for the year ended December 31, 2011, compared with income of $4.5 billion, or $2.45 per diluted share, a year ago.

Net revenues were $32.4 billion for the year compared with $31.4 billion a year ago. Results for the year included positive revenue of $3.7 billion, or $1.34 per diluted share, compared with negative revenue of $873 million a year ago related to changes in Morgan Stanley's debt-related credit spreads and other credit factors (debt valuation adjustment, DVA).

The firm executed several key strategic actions in 2011 which affected earnings including: the conversion of the firm's Series B Preferred Stock held by Mitsubishi UFJ Financial Group, Inc. (MUFG) into common stock which resulted in a negative adjustment to earnings per share of approximately $1.7 billion, the previously announced settlement with MBIA which resulted in a pre-tax loss of approximately $1.7 billion and the restructuring of the sale of Revel Entertainment Group, LLC (Revel) which resulted in a net tax benefit of $447 million. In addition, results for the current year also included a pre-tax loss of approximately $783 million arising from the firm's 40% stake in a Japanese securities joint venture (Mitsubishi UFJ Morgan Stanley Securities Co, Ltd or MUMSS) controlled and managed by our partner, MUFG.3

Full-Year Business Highlights

Equity sales and trading net revenues of $6.8 billion included positive revenue of $619 million related to DVA and reflected broad-based market-share gains.

Fixed income and commodities sales and trading net revenues of $7.5 billion, including positive revenue of $3.1 billion related to DVA and the negative impact of MBIA, reflected strong results in interest rate products.

INSTITUTIONAL SECURITIES

FULL YEAR

Institutional Securities reported pre-tax income from continuing operations of $4.6 billion compared with $4.4 billion in 2010. Net revenues for the current year were $17.2 billion, inclusive of MBIA, compared with $16.2 billion a year ago. DVA resulted in positive revenue of $3.7 billion in the current year compared with negative revenue of $873 million a year ago. The year's pre-tax margin was 27%. Due to the impact of DVA in the comparative periods, the following discussion for sales and trading focuses on current year results.

FOURTH QUARTER

Institutional Securities reported a pre-tax loss from continuing operations of $779 million compared with pre-tax income of $448 million in the fourth quarter of last year. Net revenues for the current quarter were $2.1 billion, inclusive of MBIA, compared with $3.6 billion a year ago.
 
DVA resulted in positive revenue of $216 million in the current quarter compared with negative revenue of $945 million a year ago. Due to the impact of DVA in the comparative periods, the following discussion for sales and trading focuses on current period results.

“DVA has caused a lot of confusion because banks are allowed to record gains as their credit quality deteriorates,” says David Kelly, director of credit products at Quantifi. “While there are pros and cons to including DVA in earnings, most people see it as accounting gimmickry that doesn’t reflect any true economic value. We hope this paper will shed some light on the issue.”

“DVA is not only driven by the bank’s credit spread but also by the underlying market-risk factors of the portfolio,” says Dmitry Pugachevsky, director of research at Quantifi. “The volatilities of the individual risk factors contribute substantially to the volatility of DVA. We expect more banks to look more closely at hedging DVA to mitigate earnings volatility.”