Banks Are Losing One More Source Of Fake Income

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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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Banks Prove That They Are Not Too Big To Fail By Saying "We Can Fail" On A Piece Of Paper, Moving On

One way you could spend this slow week is reading the "living wills" submitted by a bunch of banks telling regulators how to wind them up if they go under. Don't, though: they're about the most boring and least informative things imaginable and I am angry that I read them.* Here for instance is how JPMorgan would wind itself up if left to its own devices**: (1) It would just file for bankruptcy and stiff its non-deposit creditors (at the holding company and then, if necessary, at the bank). (2) If after stiffing its non-deposit creditors it didn't have enough money to pay its depositors it would sell its highly attractive businesses in a competitive sale to willing buyers who would pay top dollar. This seems wrong, no? And not just in the sense of "in my opinion that would be sort of difficult, what with people freaking out about JPMorgan going bankrupt and its highly attractive businesses having landing it in, um, bankruptcy." It's wrong in the sense that it's the opposite of having a plan for dealing with banks being "too big to fail": it's premised on an assumption that the bank is not too big to fail. If JPMorgan runs into trouble that it can't get out of without taxpayer support, it'll just file for bankruptcy like anybody else. Depositors will be repaid (if they're under FDIC limits); non-depositor creditors will be screwed just like they would be on a failure of Second Community Bank of Kenosha.