Credit swings cause earnings rethink

The impact of credit spreads on US bank earnings has become so volatile that it is causing a rethink of derivatives valuations. Last month’s earnings releases revealed such sharp swings from Q3 to Q4 and on a year-on-year basis that banks either reported some of their worst earnings results or they managed to hold their own, depending on which accounting numbers are used.

Bank risk managers are still having a hard time grasping credit valuation adjustment (CVA), which discounts the value of derivatives positions to account for the expected loss due to counterparty defaults, let alone debt valuation adjustment (DVA), which is the amount added back to the derivatives position to account for the expected gain from a firm’s own default.

Banks are now discussing a way to price liquidity risk that would take the difference between DVA calculated with credit default swap spreads and DVA calculated with bond spreads, according to Dmitry Pugachevsky, director of research at software and analytics provider Quantifi. Liquidity valuation adjustment is considered a more accurate measure of pricing liquidity risk.

LVA could present its own “asymmetric pricing problem”, added Pugachevsky, but the valuation could also offset some of the recent widening in the bond-CDS basis.  

The concept is new, but market participants are warming to alternative pricing methods since bank earnings have swung so dramatically lately when incorporating CVA and DVA calculations.   

Citigroup CFO John Gerspach reported on its conference call last month that “CVA and DVA were a negative US$40m in the fourth quarter of 2011 compared to a positive US$1.9bn last quarter [Q3 2011] and a negative US$1.1bn in the fourth quarter of last year [2010]”.

Results for Morgan Stanley were equally choppy due to credit spread movement. The firm had net revenues for 2011 of US$32.4bn, but US$3.7bn of that can be attributed to changes in Morgan Stanley’s debt-related credit spreads and DVA, which increased dramatically from negative revenue of US$873m during 2010.  

“We cannot control the accounting noise of DVA, the movement of counterparty spreads,” said James P Gorman, chairman and CEO of Morgan Stanley on his conference call.

He is not the only one. Aside from the wild swings in valuation between individual bank earning periods, some banks use a kind of CVA/DVA calculation that is not comparable with what other banks are doing, according to Frank Mueller, senior manager at KPMG.

It remains uncertain whether alternative valuation methods will become more widespread, but if current practices continue to be used, there are likely to be huge swings in earnings

One difference in bank valuations comes from the interest rate environment, he said. For some banks, “their internal ratings systems don’t show the level of volatility in terms of credit spread movements”, which, he notes, creates differences among the calculations.

LVA, noted Mueller, can also be seen as a measure for the differences between refinancing costs for collateralised and non-collateralised transactions. “As a proxy, you can look at the difference between using OIS [Overnight Indexed Swap] and Libor or Euribor,” he said.

Banks, he noted, were having problems with OIS discounting since many banks did not have up-to-date systems to run it. “There is a need to create a proxy all-in credit spread curve, which will then be used for CVA/DVA,” he added.  

Accounting rules require that CVA be used in mark-to-market reporting, which has brought the acronym to the forefront of bank operations. Basel II and III have also helped to make the term more mainstream since they offer capital relief when hedging with credit default swaps (see “CVA desks: risk-reducers become risk-takers,” IFR 1901). Banks do not have to use the DVA valuation, but it is accepted under accounting rules.

But having no common or best practice for pricing and hedging is a problem, said Pugachevsky. Morgan Stanley, for one, bought back its own debt to hedge DVA but a variety of other hedging methods exist. Since DVA goes up when credit spreads widen, “it is equivalent to the bank being short its own debt”, he noted.

If banks cannot manage their CVA, however, it is likely to be costly under Basel III. Banks that have more active CVA desks will be able to hedge this more easily than those banks without a separate CVA desk, according to market participants.

Putting quick hedges in place, though, will be expensive, they say, compared with working out hedges over a few years, since derivatives valuation is typically a longer process.

It remains uncertain whether alternative valuation methods will become more widespread, but if current practices continue to be used, there are likely to be huge swings in earnings. Although DVA losses were relatively small during Q4, heavy losses could still occur in the future, which has the potential to offset earnings, added Pugachevsky.  

Most banks turned in large DVA gains during Q3 2011 due to wide credit spreads.