If you are in the business of selling derivatives you have to value them from time to time, because counterparties want to know what their thing is worth, and regulators want to know how deep in the hole you are. This is not always as easy as valuing a stock by just going out and getting a quote. But the principles can be stated sort of simply: you just take an integral of your net discounted cash flows over every possible future state of the world, appropriately probability weighted.*
Easy to say, but hard to do, because you have only so much direct access to possible future states of the world. Fortunately there are rules of thumb for this, of greater or lesser reliability, which exclude the unlikely and immaterial states of the world (your BAC warrants are worth zero if the world ends this Friday, but that’s unlikely; you’re perhaps equally likely to eat a bacon bowl or a salad for lunch tomorrow, but your choice will have only an immaterial effect on the value of your BAC warrants). All of these methods, however, provide only market-sanctioned guesses about the fair value of your derivatives; if the future world moves in ways not contemplated by the moving parts of your model your calculations are just wrong.
This is, I’ve always thought, a nice way to think of the world, and certainly more conceptually satisfying than “it’s worth what people will pay for it” or “it’s worth what the formula says.” And once you get into thinking of things this way, you can have fun thinking of all the possible things that (1) are not trivially unlikely and (2) would have a not trivial effect on your stuff.
Like, it turns out, your own demise. It may seem sort of ghoulish to say “well, the nice thing about my horrible quarter is that I’m less likely to pay out on my debts, so I’ve made money on that” – but you have. There are states of the world where you’re bankrupt. In those states, you get to collect on all your derivative assets and not pay out on your liabilities (subject to netting etc.). It’s awesome! Not really. But it’s true.
Or to put it another way, over-the-counter derivatives are a zero-sum bet between two parties. If your counterparty has to mark down the derivative on their books because your credit had an accident, then that counterparty “lost” “money,” for some appropriate values of those words. If they lost money then you made money. No one else could have. (But wait, you say. No one else “lost” “money” – it’s just a temporary markdown. Congratulations, you are a European bank.)
This is why the bellyaching about debit valuation adjustment (“DVA”)** seems a little overblown. You’re just valuing a derivative. It will move around in value for lots of reasons. You can say that some of those are “good” reasons, and some are “bad” reasons, but they’re all reasons about the expected probability and size of future cash flows.
Also: it’s not cheating. Or, sometimes it’s not cheating. Under US accounting rules, what I said above is just what you do for derivatives. You value them at fair value, and if the fair value of your derivative liabilities goes down because you have gotten closer to death’s door, then them’s the breaks.
It is not, however, necessarily what you do for things that are not “derivatives,” particularly including your own bonds. There, you get to choose. Bond by bond. In practice, it appears that all the banks fair value at least some if not all of their structured notes, but wouldn’t go so far down the ridiculous-hole as to fair value their vanilla debt.
Now. Sadly the disclosure from the banks who have reported is murky and I’ve been unable to find really clean numbers but consider:
“DV01,” emphasis on the quotation marks, is (1) the dollar effect of 1bps of CDS spread change on DVA this quarter, divided by (2) total debt or derivatives liabilities, as the case may be, expressed in basis points. Total debt seems to me like the maximum pool of stuff that could be DVA adjusted (if you pretty much elect to fair value everything); derivatives liabilities is the minimum pool of stuff that could be DVA adjusted (if you fair value nothing but what you have to). This is not particularly science-y.
But it’s interesting to think about what these numbers can mean. Directionally, having a higher pseudo-quasi-”DV01″ here could mean one of two things:
- Good for you! You’ve convinced counterparties to trade with you without collateral, either by issuing tons of structured notes or just by sheer force of will or smartness or credit rating.
- Bad for you! You’ve failed to hedge your DVA and will have creepy earnings volatility. Or you’re just fair-valuing everything in sight and/or cooking your books.
* It’s best not to think too hard about the word “appropriately.”
** I feel like I used to call it “CVA benefit,” but DVA seems to be winning the disclosures-and-press horse race so whatevs.
I can't wait until OWS protesters start to complain about this.
If accounting is done mainly for the use of the owners of the company than a company taking gains on its own credit spreads widening, whether just on structured products or on its entire debt structure, seems misleading at best. Who cares if you don't have to pay your counterparties in full if your ownership has been zeroed out?
great, you get to monetize it in a bankruptcy. but it is misleading in your book value and earnings as a going concern
DVDA?
Are bonuses calculated on the "adjusted" results? Opps….
So at lunch in high school we used to try to draw out how this would work…just to visualize…never could figure it out…where does the fourth guy put his legs???
Bingo. DVA willfully ignores correlation. DVA gains are inherently unrealizable for shareholders. In bankruptcy, the shareholders are zeroed anyway. And none of these banks ever seem to be in a position to unwind these derivatives or buy back debt at the depressed values underlying DVA gains.
Would love to see how MS looks in this table.
Matt–
You will do all right on L1 of the CFA.
-guy who would like to remind Matt that he is still a big believer of skeeving around the city alone during CFA "study breaks"
Da*n! looks like JPM needs to start hauling some AG ore out of Jamies house before that house of cards collapses!
please redo this with MS
-finally coming around to matt
So Matt, since you were once a lawyer, please offer legal advice. Consider the following. I have fixed-term cash-backed loan from my bank. My income has increased since the time it was issued, and my total debt load has decreased. For my 2011 personal tax return, I plan on booking a loss on this account, given that my ability to re-pay has increased, which reduces the implied spread to compensate for my credit risk. I have precedence on my side, correct? Please advise.
This is not accurate.
Forgetting bankruptcy for the moment, every day banks and their clients enter into new derivatives and restructure or unwind old ones. Assume client A entered into a 10yr swap two years ago with Bank B and wants to unwind now that it is $10mm in their favor and Bank B has recently become a bigger credit risk (spreads have widened).
If they unwind this swap at par they will receive $10mm and the bank will have to come up with $10mm to pay them.
Why would the bank agree to unwind at par? It wouldn't. It will have to go out into the market and raise $10mm cash immediately to pay off that future liability now. It would much rather keep the swap on for the next 8 years and make those payments over time. It could, however, be induced to unwind for the right price. That price is $10mm less DVA.
You can also look at it this way. Given the banks recent spread widening, Client A should be holding a larger credit reserve (CVA) against the $10mm derivative asset it is holding on its book. If they were able to unwind it at par, they would see an immediate gain of $10mm + CVA release. So transacting at par would actually lead to a gain. They should be willing to unwind at the level where they don't gain or lose money ($10mm less CVA). It turns out that one person's CVA (client A) is another persons DVA (client B).
You actually saw this work in some cases with the monolines during the 07-08 crisis. Counterparties had hedged monoline expsoure which allowed them to mark down their exposure without taking losses and then settle the underlying derivatives below par with the monolines.
Most larger banks are valuing and dynamically hedging these valuation reserves (see goldman story from link above). When you enter into an uncollateralized swap you are taking views on the underlying, your credit, and your counterparties credit. You can't choose which risks you'd like to value and not value on your balance sheet.