Alright, Bank of America, you win. FT Alphaville thought Citi was the worst when it came to being obtrusive about taking gains on the deterioration of their own creditworthiness. Citi’s DVA of $1.9bn was “Liabilities at Fair Value Option”. Fine.
BofA would like to introduce you to its “FVO on structured liabilities” in its Q3 earnings, moving from a mere $214m in the second quarter to $4.5bn in the third. And it looks like the third quarter of last year was a good one in terms of creditworthiness, hence a bad one in terms of completely fictitious revenue from the firm’s own debt.
Bank of America Corporation today reported net income of $6.2 billion, or $0.56 per diluted share, for the third quarter of 2011, compared with a net loss of $7.3 billion, or $0.77 per diluted share, in the year-ago period. Revenue, net of interest expense, on a fully taxable-equivalent (FTE) basis rose 6 percent to $28.7 billion.
There were a number of significant items that affected results in both periods. The most recent quarter included, among other things, $4.5 billion (pretax) in positive fair value adjustments on structured liabilities, a pretax gain of $3.6 billion from the sale of shares of China Construction Bank (CCB), $1.7 billion pretax gain in trading Debit Valuation Adjustments (DVA), and a pretax loss of $2.2 billion related to private equity and strategic investments, excluding CCB. The fair value adjustment on structured liabilities reflects the widening of the company’s credit spreads and does not impact regulatory capital ratios.
So if the “fair value adjustment on structured liabilities” reflects the widening of Bank of America’s credit spreads..
.. are they insinuating that the $1.7bn in DVA wasn’t?? In other words, is Bank of America’s DVA number the gain on its hedging against counterparties? Or is it “here’s where we have some of our DVA referencing ourselves, and here’s where we keep some other DVA referencing ourselves?” Please let us know your thoughts below and we’ll try to get to the bottom of it ourselves too.
Here’s a little more:
Results include DVA gains of $1.7B in 3Q11 compared to gains of $121MM in 2Q11 and a loss of $34MM in 3Q10. 12% of the 3Q11 DVA was incurred in the equity business.
For one, still not sure what DVA is.. for two, what on earth does it have to do with the equity business?
Meanwhile only an additional $0.5bn in litigation expense versus $1.9bn in Q2. Also deposit balances were up $77bn to $1,050bn.
Under the heading “Building a fortress balance sheet”:
Regulatory capital ratios increased significantly during the third quarter compared to the second quarter of 2011, with the Tier 1 common equity ratio at 8.65 percent, the tangible common equity ratio2 at 6.25 percent and the common equity ratio at 9.50 percent at September 30, 2011.
The company took advantage of its strong liquidity position to reduce short-term debt by $17 billion and long-term debt by $28 billion during the third quarter. The parent company’s time-to-required funding increased to 27 months from 22 months in the second quarter of 2011.
The company continued to strengthen the balance sheet by reducing risk-weighted assets by $33 billion from the second quarter of 2011 and $117 billion from the third quarter of 2010.
While those CVAs/DVAs or whatever you want to call them do not impact capital ratios, whenever Bank of America does raise additional debt, it gifts a bigger base to revalue.
Perverse incentives, anyone?
Update (17:15 UK time): Thank you for all the comments. We’ve done some digging and have a few ideas.. and still more questions.
First, why “structured” liabilities? One train of thought is that these relate to retail products. For example, you walk into a Bank of America branch in Charlotte, North Carolina and you’d like an investment that has a return profile equal to the S&P 500. Hand over some cash to the bank, clip coupons equal to the S&P 500, and back comes your principal at the agreed upon maturity date. Now, how is such a product structured?
It’ll be like a credit-linked note. The cash from the investors can be used by Bank of America as funding. The way that it does this is by “investing” the proceeds in its own debt such that the maturity profile of the debt matches the maturity profile of the retail product. A swap, or derivative, takes care of the returns mimicking the S&P 500.
If the bank elects to measure its debt, that is indirectly held by retail investors, at fair value, then widening credit spreads (i.e. a deterioration in perceived creditworthiness of the bank) translates to a gain. However, this doesn’t make the bank less liable to pay the investors back at par at the maturity date. In short, it is ridiculously misleading to book such gains. Asides from that, they will only, ultimately, have to be reversed out.
Bank of America – “FVO on structured liabilities” – $4.5bn
Citi – “CVA on Citi liabilities at fair value option” – $1.6bn
JP Morgan – “debit valuation adjustments (“DVA”) on certain structured and derivative liabilities” – $1.9bn
They sound kinda similar.. but we’ve given up trying to figure out if they are all the same. As an accountant, do variations like these make life interesting or hellish? We wonder.
Second, over on the trading side of things, there are two possible things to mark when it comes to credit spreads, i.e. counterparty risk.
1. The risk that the bank that is reporting results will default and therefore not pay out. FT Alphaville would expect these to be labelled as “DVA”. That is, if the reporting bank owed other banks a lot of money on various derivative positions, but the bank’s creditworthiness deteriorated, then the claims could be marked down by the logic of DVA because the bank may default before paying out to its counterparties.
That, conceptually, strikes us as utterly mad. US bankruptcy has a safe harbour specifically for swap counterparties to be able to close out at fair value. In other words, filing for bankruptcy is unlikely to alleviate a bank of the requirement to pay out. Even the extreme, where this bit of accounting should surely make sense, is in fact ludicrous.
Bank of America – “DVA trading adjustment” – $1.7bn
2. The risk that the counterparties of the reporting bank will default. There are many ways to hedge against one’s counterparty exposures. One may use credit default swaps, credit indices, bonds, equities, and all other manner of derivatives. One can also adjust inventory levels to move the net short position to counter the net long when the bank is in-the-money to a counterparty.
CVA can therefore be net of hedges or can just consider the mark on the hedges.
Citi – “derivatives CVA net of hedges” – $333m
JP Morgan – “credit valuation adjustments (“CVA”) on derivative assets, net of hedges” – $(691)m (<-loss)
Reality check. Is compensation based on cash flows or accounting measures like revenues or even EPS? Do the types of adjustments discussed above go into those accounting measures? Yes, they do. Doesn’t that mean there is a cashflow impact, i.e. in the form of inflated compensation?