HSBC: Live by the accounting gimmick, die by the ....

In the first quarter, many banks announced surprised profits in-line with YOY profit returns. Unfortunately, in Q3 accounting tricks will cause sizable losses that will need to be covered by operating profits.


For Q1, HSBC reported ".. a jump in trading income, strong performance in Asia and a $6.6 billion gain on the falling value of the bank's own debt, which helped HSBC earn a pretax profit "well ahead" of the same period last year, the bank said in a trading update."

With the artificial support programs of the Federal Reserve coming online slowly and the credit crisis in full swing, the market value of HSBC debt liabilities dropped $6.6B in the quarter. Accounting rules allow companies with a decrease in value of the debt they issue to claim the decrease in value as a decrease in liabilities and thus claim a paper increase in profit on the decline, and HSBC took full advantage of it.

But did HSBC catch the spirit of this rule when it included is event as earnings? The catch to this rule is that it assumes that the 1) the decrease in the value of the debt does not correlate to the credit impairment and/or possible impairment of the ability of the company to service their debt 2) that the company is able to free the capital to retire the debt in the open market. HSBC generates a huge amount of cashflow, so their ability to service their debt threatened at this point. But considering their effort to maintain capitalization levels in the face of consumer finance losses, whether or not the company is in the position to retire the debt in the open market is entirely debatable.

Since HSBC reported their 1st quarter results, high yield corporate bonds and corporate bonds in general have been on a tear. Some high yield corporate bonds, particularly of financial services companies, have seen increases in value of over 50% since March lows. The junk bond rebound is evidenced by the performance of HYG since March, returning close to 20% return in three months.

In addition, HSBC will face additional losses due to accounting treatment of stockholder gains related to their Q2 rights offering.

(1)

Accounting gimmicks are paper gains and losses, but just as they glossed over Q1 pain they may cause additional strain when the losses are reported in unison with the consumer banking problems evidenced by home price declines, and increases in credit card default rates. HSBC should be expected to announce similar losses to the previous quarter in this lending area. But when the overall earnings are measured, accounting strategies will prove to be a double edged sword.

The author is short HBC at this time but has not chosen a short position to recommend.

(1) Breaking Views, July 21, 2009, "Loss in Translation" by John Foley