Find out what credit adjustments can do for you | FT Alphaville

Find out what credit adjustments can do for you

Valuation adjustments were the hot new item during New York bank earnings week.

Everywhere we looked, bank CDS spreads were widening, leading — paradoxically — to a positive adjustment to earnings.

Quick recap: US accounting rules allow banks to use “fair value” accounting, which requires them to make adjustments for “nonperformance risk” (the risk that an obligation will not be met), including their own. When their own creditworthiness deteriorates, banks chalk up earnings gains, which are typically reported as Credit Valuation Adjustments (CVAs) or Debit Valuation Adjustments (DVAs).

S&P is not impressed with this chicanery and in a report released Friday, the rating agency recommends banks end the practice. Or rather, they wish that it never happened in the first place, since banks aren’t allowed to switch from fair value accounting to amortised costs accounting, like one is going out of fashion, of course. These ain’t the short suit, after all.

This is what’s made S&P cranky — a table showing how important CVA or DVA adjustments were to 3Q earnings:

The credit deterioration of both Bank of America, for example, was responsible for the entirety of its reported net income. For JPMorgan Chase and Citigroup, it provided a profit boost. (And don’t think we haven’t spotted little SunTrust, either.) For Goldman Sachs and Morgan Stanley it offset further losses. All in all, a nice cushion.

Metaglossian accounting is absurd, of course, and we hope new proposals from the Financial Accounting Standards Board (FASB) and the International Accounting Standards Boards (IASB) will assign it to the scrapheap. But S&P does a decent job at explaining why we’ve reached this situation in the first place:

Many financial institutions, particularly U.S. and European banks, prefer to use the fair value option on certain financial assets and liabilities when such accounting will better reflect how those assets and liabilities are managed. In addition, companies may view the fair value option as simpler to use than applying more complex hedge accounting standards. Both accounting practices achieve similar reported, and arguably economic, results in most circumstances. From a theoretical accounting standpoint, the fair value option helps mitigate reporting mismatches between certain financial assets and liabilities. For example, as the fair value of debt declines because of factors related to worsening market conditions, assets or equity that banks could use to absorb those asset declines likely will deteriorate also.

The rating agency, unsurprisingly, isn’t casting blame but it makes two important points for why this accounting technique should be avoided, which go beyond the simple “accounting scam” narrative. In short, it varies from bank to bank, and doesn’t provide the best way of assessing the amount the bank will actually need to pay to settle its debts.

We favor elections for fair value measurement that are based on a desire to mitigate a financial statement mismatch and therefore better represent the underlying economics of asset-liability management. The accounting treatment of debt under the fair value option may create a more symmetrical accounting framework that, we believe, is insightful for analysis. Nevertheless, we have long held that amortized cost is the most relevant way for companies to account for long-term debt in financial statements. We believe it best reflects the amount a going-concern company ultimately needs to pay or settle on a liability. Moreover, companies seldom settle their liabilities at the theoretical values (i.e., they may not have the ability or capacity to buy back debt prior to maturity at fair value prices).

We generally adjust reported profitability measures to remove the gains and losses arising from valuing financial liabilities–including debt–at fair value that result from changes in a company’s own credit standing. We also recognize that own-debt fair value fluctuations may include other factors (such as liquidity) that depend on internal company methodologies and that may be difficult to identify from financial statement disclosures alone. Therefore, for practical purposes, we typically remove the entire fair value change of an issuer’s debt related to its credit standing from earnings (see “Bank Capital Methodology And Assumptions”).

Add to that the trouble hedging DVA and CVA, perhaps it’s best we just banned this altogether and had one less source of earnings confusion?

Related links:
How one bank’s default is the same bank’s gain – FT Alphaville
Comment by “Perny” on the above post – “Perny”
Comment by RiskyKP on the above post – “RiskyKP”
The truth behind CVA – Euromoney