Debt valuation adjustments, otherwise known as the bane of every bank reporter, analyst and investor relations’ team existence, are finally being phased out.
I don’t have much new to add so here, other than I wonder whether we’ll see any impact from the withdrawal of fake and flimsy – but countercyclical – capital).
In the meantime, and in memorium, here’s an old thing from 2012 that I wrote on the subject.
Banks face profits hit as fog descends
It’s the attack of the accounting quirk.
One day into bank earnings season on Wall Street and we have already seen the dreaded “debt valuation adjustment”, or DVA, wallop JPMorgan , knocking $211m off the supersized bank’s $5.7bn of third-quarter profits.
DVA is the flipside of the recent rally in bank debt. While investors have been clamouring for the extra yield on offer from banks’ bonds, pushing up prices, they are now experiencing the counter-factual of narrowing bank debt spreads.
That’s because the accounting option known as DVA effectively gives banks the ability to book profits when the value of their bonds decreases, but also requires them to record losses if the value of their debt increases.
The motivation behind the option, the US accounting standards board says, was “to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently”.
The ultimate effect of the standard, issued in 2007, was the exact opposite. When the value of banks’ own bonds fell precipitously during the financial crisis, banks used the accounting option to record significant profits. Lehman Brothers, for instance, posted a more than $1bn DVA gain just days before it filed for bankruptcy.
In early 2009, when banks were publishing results from the dark days of the 2008 fourth-quarter, DVA reached new heights of absurdity as financials, en masse, reported stellar profits based on the plummeting value of their bonds. Between 2007 and the first quarter of 2009, US banks posted DVA that averaged 10-20 per cent of their pre-tax earnings, but reached as much as 200 per cent, according to research by specialists at UBS.
When the value of their bonds recovered in later years, they were compelled to post losses. Now, with the price of the bonds having surged in recent months, the accounting quirk is about to eat into banks’ third-quarter results once again.
It’s an impressively counter-cyclical accounting standard, but one that does nothing to shine a light on the already impenetrable thicket that is bank earnings.
There is an added complexity in that some banks have not been content with the weird and wacky world of DVA. To help hedge – or offset – the profit and loss swings caused by the value of their own debt, some have taken to selling credit protection on correlating banks. In late 2008, for example, some banks were said to have sold protection on Lehman as a hedge against their own DVA gains.
This creates another baffling dynamic; banks may record losses as the value of their own bonds increases, but not to the extent that they have hedged that loss and profited from the rising value of credit protection written on other banks…
More here, here, here and here.