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. Read more »
I have nothing particularly useful to tell you about Citi’s earnings – they were good, yay, well done Vik, one day maybe you’ll be able to pay a dividend – so let me ask you some useless things. My favorite useless thing is DVA, which is the thing where if you are a bank you “lose” “money” when your credit improves and you “make” “money” when your credit gets worse, which is in some ways the opposite of right though also not, like, totally away from reality. Citi suffered thereby for its virtue:
Citigroup reported improved first-quarter earnings on Monday, with steady growth in the bank’s globe-spanning consumer businesses and a rebound in investment banking from a poor previous quarter.
Net income was $3.4bn in the first quarter compared with $3.2bn a year earlier as revenue grew just 1 per cent to $20.2bn. Those measures exclude the impact of so-called “debt valuation adjustments” – an accounting rule that makes companies take gains or losses from swings in the price of their own debt. On a reported basis, including DVA, Citi’s net earnings were down at $2.9bn.
So three useless thoughts/questions for you on that:
(1) WTF guys: Read more »
Financial institutions normally prefer not to have everyone think they’re a shitty credit, because that can lead to doom, or MF Doom, or glitchy intimations of doom that quickly get sorted. But it can also sometimes lead to profit.
Sometimes that profit is fake, or fake-ish. When banks book a mark-to-market profit on their own credit spreads widening, that looks … a little fake. We don’t particularly object here, since it reflects a sort of economic reality, but it is probably temporary – your liabilities roll forward and eventually either you pay them off at par, in which case your DVA gains fritter down to zero through PnL, or you don’t, in which case the permanency of your accounting gains are not of much interest to most people.
In any case, because it looks fake, or fake-ish, banks actually don’t much abuse the privilege. Thus most of the DVA gains that banks booked last quarter were on derivatives, where US GAAP requires you to mark DVA to market, or on derivatives-looking things like structured notes where it seems more plausible than not. You don’t see a lot of banks taking a lot of DVA gains on vanilla debt.
So when you have $295bn of public debt (with, I don’t know, maybe a 2 year weighted average duration, whatever) and your CDS blows out by 300bps in a quarter, you don’t book $18 billion of gains. You book, um, $4.5 billion. You never get to taste most of that delicious credit widening.
Now, if only there were a way for a bank to (1) get a gain on its vanilla public debt and (2) make it permanent. Like, say, this, from Bank of America’s 10-Q filed today:
Read more »
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. Read more »