• 06 Jul 2012 at 3:14 PM
  • Banks

Banks Are Losing One More Source Of Fake Income

Have you given up on this week yet? Of course you have. Libor Libor Libor Libor, we get it, mistakes were made. Next week though we get the start of bank earnings season, which will at least kick off with a whaling expedition, so that’s something.

One thing that we’ve had to look forward to in recent earnings seasons is getting to talk very seriously about how banks “make money” by becoming worse credits, or less amusingly “lose money” by becoming better credits. This is more or less referred to as “DVA,” for “debit valuation adjustment,” and stems from accounting rules that allow and/or require banks to reflect changes in the fair value of certain of their liabilities – including changes in fair value due to their own deteriorating or improving credit – in their accounting net income. The counterintuitive result is that the worse the bank looks, the better its earnings look. This provides cheap irony, which is a valuable social function because earnings reports are often pretty boring and what else are we going to talk about; it also provides countercyclical bank confidence-boosting (though not countercyclical actual capital), which is also a valuable social function especially if you take away other countercyclical confidence-boosters like lying about your unsecured borrowing costs. (Libor Libor Libor.)

The effect should be particularly interesting this quarter as there’ll be dueling credit effects on earnings. On the one hand, bank credit is broadly wider – I see JPM 5y CDS +44bps for Q2, C +50, BAC +38, GS +46, MS +45 (from Bloomberg CMA) – and when I last did any math on it 1bp of CDS spread seemed to translate into anywhere from ~$2mm (for GS) to ~$22mm (for JPM) of DVA earnings. So there’s potentially $2bn in imaginary earnings in those numbers.

On the other hand this quarter featured the surprisingly (?) rare confluence of (1) bank credit worsening as measured by credit markets and (2) bank credit worsening as measured by credit rating agencies, in the form of the Moody’s mass bank downgrading. Unlike CDS widening, which creates imaginary earnings, mass bank downgrading hurts earnings – in particular, because it triggers collateralization or unwinding of derivative trades, which both costs real money (it costs money to get money) and causes a DVA loss (because the uncollateralized derivative liability whose fair value was less than par because your credit is less than perfect, becomes a collateralized derivative liability whose fair value is roughly par because your collateral is roughly perfect, so the fair value of your liabilities goes up). Coincidentally I once eyeballed that DVA loss at around $2bn among the five big US derivative-dealing banks, so perhaps the competing effects of credit embaddening this quarter will just about cancel each other out and we’ll have to talk about actual money-related earnings or, failing that, Libor.

We’ll have to get used to that, since the whole DVA dance will soon end – or, rather, it will be reduced, and soonish. Ish. From the Financial Accounting Standards Board:

The Board discussed the presentation of changes in fair value that result from a change in a reporting entity’s own credit risk for financial liabilities that are designated under the fair value option and, thus, measured at fair value with all changes in fair value recognized in net income (FVNI). The Board decided that an entity would present such changes separately in other comprehensive income (OCI). The Board also decided that cumulative gains and losses recognized in OCI associated with changes in own credit will be recognized in net income upon the settlement of the liability. In addition, the entire risk in excess of a base market risk, such as a risk-free interest rate, would be considered as the change in own credit or an alternative method that an entity deems as a more faithful measurement of such a risk.

So changes in the value of your bonds (but not I guess derivatives?) due to your own credit quality will no longer affect the reported income/EPS/ROE that you care about, but will instead be shunted to the Other Comprehensive Income that you don’t care about. Sort of like the changes in the value of your available-for-sale securities portfolio are.

This is hard to argue against. (I think? Give it your best shot.) It’s basically a good thing for banks, who are not huge fans of hard-to-explain DVA-based earnings volatility, and for investors, who have one less fake number to ignore or back out. I suppose it strikes a blow of some sort against intellectual purity (maybe? now one side of the trade will have income/loss for its counterparty’s credit improvement/deterioration, but the other side won’t have offsetting loss/income), but it’s hard to get too worked up about that. It’s the cheap irony that we’ll really miss.

Accounting for Financial Instruments—Classification and Measurement—Joint Project of the FASB and IASB [FASB]

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Comments (93)

  1. Posted by Too Matt; DR | July 6, 2012 at 3:20 PM

    I was hoping for another poorly-chosen personalized license plate story.

  2. Posted by Matt's Vanity Plate | July 6, 2012 at 3:23 PM

    Seen affixed to a Vespa in lower Manhattan as the owner enjoys some nachos and margs:

    CFA LVI*

  3. Posted by Texashedge | July 6, 2012 at 3:39 PM

    "This is more or less referred to as “DVA,” for “debit valuation adjustment,” and stems from accounting rules that allow and/or require banks to reflect changes in the fair value of certain of their liabilities"

    What does DVDA stem from then?

  4. Posted by Guest | July 6, 2012 at 3:48 PM

    Five posts in two days? Someone is going to be two-fisted with the Margs tonight.

  5. Posted by DB Mgmt. | July 6, 2012 at 3:56 PM

    As long as this isn't the latest case of a former VP suing for overtime, you better not have been talking to that Piazza guy Matt!

  6. Posted by Guest! | July 6, 2012 at 4:14 PM

    So this is what Stockholm syndrome feels like…

  7. Posted by Cintas CFA | July 6, 2012 at 4:15 PM

    Its 4:15 – Do you know where your pants are?

  8. Posted by guest | July 6, 2012 at 5:15 PM

    And you thought we would find this interesting why?

    #wheresbesswit

  9. Posted by SellingLow | July 6, 2012 at 6:23 PM

    There were at least two sentences I read three times, pondered, re-read twice, and then said "fuck it." Good work Matt!

  10. Posted by Mark B. | July 8, 2012 at 1:42 PM

    <img src="http://www.mynewcarquote.us/ikea/odd.jpg"/&gt; Practices like this should've been discovered long time ago.<img src="http://www.mynewcarquote.us/xbox/vvv.jpg"/&gt;

  11. Posted by Toffe | July 8, 2012 at 6:21 PM

    That was magnificently incomprehensible. A little like Steven Hawkins: its supposed to be genius, probably is, but completely illegible. This is why FI accounting is total b/s (that is not balance sheet, but the other type). Derivatives are a fiction of imagination, that have become so big that they are real.

    CFA is like a al-Qaeda camp for financial WMD: this is call for return to a simpler world.

  12. Posted by H8r | July 8, 2012 at 7:10 PM

    Matt's mother

  13. Posted by guest | July 9, 2012 at 11:00 AM

    So are FASB and IASB getting blazed when they figure this stuff out?

  14. Posted by pretzel logic trader | July 10, 2012 at 3:37 AM

    Great spin Matt!

    .banking no longer exists…..we have financial institutions which have become vessels for speculative trading operations…for one key reason….these operations produce, ostensibly, the highest risk adjusted returns to the shareholder…..as structured, the opportunities appear to effectively eliminate risk..,…other than when the chickens come home to roost in the form of the occasional $2 Billion blowout….but this is not really a risk…because men like dimon can be rolled in front of congress with an exceptional skill set…that of compulsive deception….and that its far better to continue the criminal trading operations…and occasionally ask for forgiveness…because if permission is asked for the answer would be no…thereby killing the casino operation…..

    The monetary system is irretrievably corrupted….and can be restructured…but will never be within the current electoral paradigm…..the voice which exposes this truth has to be unyielding…it is time.

  15. Posted by cohen | July 10, 2012 at 3:37 AM

    .banking no longer exists…..we have financial institutions which have become vessels for speculative trading operations…for one key reason….these operations produce, ostensibly, the highest risk adjusted returns to the shareholder…..as structured, the opportunities appear to effectively eliminate risk..,…other than when the chickens come home to roost in the form of the occasional $2 Billion blowout….but this is not really a risk…because men like dimon can be rolled in front of congress with an exceptional skill set…that of compulsive deception….and that its far better to continue the criminal trading operations…and occasionally ask for forgiveness…because if permission is asked for the answer would be no…thereby killing the casino operation…..

    The monetary system is irretrievably corrupted….and can be restructured…but will never be within the current electoral paradigm…..the voice which exposes this truth has to be unyielding…it is time.

  16. Posted by pretzel logic trader | July 10, 2012 at 3:38 AM

    .banking no longer exists…..we have financial institutions which have become vessels for speculative trading operations…for one key reason….these operations produce, ostensibly, the highest risk adjusted returns to the shareholder…..as structured, the opportunities appear to effectively eliminate risk..,…other than when the chickens come home to roost in the form of the occasional $2 Billion blowout….but this is not really a risk…because men like dimon can be rolled in front of congress with an exceptional skill set…that of compulsive deception….and that its far better to continue the criminal trading operations…and occasionally ask for forgiveness…because if permission is asked for the answer would be no…thereby killing the casino operation…..

    The monetary system is irretrievably corrupted….and can be restructured…but will never be within the current electoral paradigm…..the voice which exposes this truth has to be unyielding…it is time.

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