Trading and risk management firm Quantifi has released a whitepaper to explain why large banks, such as Morgan Stanley, Bank of America and Citigroup, include credit valuation adjustments (CVA) and debt or debit valuation adjustments (DVA) into their top-line results.
“DVA has caused a lot of confusion because banks are allowed to record gains as their credit quality deteriorates,” says David Kelly, director of credit products at Quantifi. “While there are pros and cons to including DVA in earnings, most people see it as accounting gimmickry that doesn’t reflect any true economic value. We hope this paper will shed some light on the issue.”
In the third quarter this year, the market saw major banks add CVA and DVA results into their earnings, which, in some cases, dramatically changed their top-line results. While experts say banks have been transparent in terms of using these accounting methods, this has confused some market participants as it essentially reveals the deterioration of the firms’ credit worthiness.
CVA is the market value of counterparty credit risk, meaning that it is the differential between the risk-free portfolio and the true portfolio value. DVA is another accounting valuation method related to how a company handles changes in its issued fixed income securities and to the credit adjustment on a negative derivative exposure.
Structured liabilities are traditionally used to help corporations manage their risks, which are in effect securities of any asset class that are restructured to facilitate some form of risk transfer.
In October, Citigroup published a jump in net income, and securities and banking revenues. However, once you delve into the results, it is clear CVA and DVA accounting methods dramatically boosted numbers.
Citigroup posted a 20% year-on-year increase in securities and banking revenues in the third quarter, rising to $6.7 billion. However, third-quarter results for this unit included $1.9 billion of positive CVA from a widening of Citigroup's credit spreads. If this had been excluded, its revenues here would have been down 12%, to $4.8 billion.
Similarly, Citigroup's net income increased 74% to $3.8 billion, compared with Q3 2010, reflecting the impact of CVA and a $2.6 billion improvement in the cost of credit, which was partially offset by an 8% – or $940 million – increase in operating expenses from the prior year period.
“DVA is not only driven by the bank’s credit spread but also by the underlying market risk factors of the portfolio,” says Dmitry Pugachevsky, director of research at Quantifi. “The volatilities of the individual risk factors contribute substantially to the volatility of DVA. We expect more banks to look more closely at hedging DVA to mitigate earnings volatility.”
In a similar move, Morgan Stanley stated that results for the third quarter included positive revenue of $3.4 billion, or $1.12 per diluted share, compared with negative revenue of $731 million a year ago relating to changes in Morgan Stanley's DVA, which somewhat charts the decline in the bank’s credit worthiness.
“This ratio was affected by DVA, which increased net revenues in the current period,” says the bank in a statement. “Non-compensation expenses of $2.5 billion reflected higher levels of business activity and costs associated with the UK bank levy. For the current quarter, net income applicable to Morgan Stanley, including discontinued operations, was $1.15 per diluted share, compared with a net loss of $0.07 per diluted share in the third quarter of 2010.”
Bank of America also employed similar methodsby revealing that there were a number of items that affected results in both periods.
“The most recent quarter included, among other things, $4.5 billion (pre-tax) in positive fair value adjustments on structured liabilities, a pre-tax gain of $3.6 billion from the sale of shares of China Construction Bank (CCB), $1.7 billion pre-tax gain in trading DVA, and a pre-tax loss of $2.2 billion related to private equity and strategic investments, excluding CCB,” says the bank in a statement.
Check out the November issue of Euromoney, as we will analyze how continued pressure from the withdrawal of investors in the funding market impacts upon banks’ margins and is prompting radical changes to their business models.