So earlier in the week when Citi announced to everyone’s utter shock that the company had actually shown a profit for Q1, some expressed a polite skepticism that this was in any way reflective of the company’s performance. Then yesterday when Morgan Stanley announced a quarterly loss, well, that just sounds like shenanigans and tomfoolery! Surely the House of Mack is in a much better position than the House That Fail Built. And it actually is, but for a wacky accounting rule that temporarily put C in the black and MS in the red. I have spent literally hours since I saw this yesterday trying to understand just what, exactly, happened here.
I know it involves some wacky thing called a Credit Value Adjustment, or a CVA. I know a CVA is the difference between the best-case value of a thing and how much that thing is actually worth in the event of a default. I know that the CVA is tied to the price of a CDS on that company, and as that cost rises (as it does when the company is perceived to be doing more poorly) the company gets to book more CVA-related profit, and vice versa. What I am still failing to understand is why. Why, when a company is failing as hard as Citi does it get to report profits that do not exist, never existed, and will not exist, but when Morgan Stanley is doing well it has to take losses that belong to no one. In fact, these pretend losses are why MS reported a small loss for Q1, per the company’s press release (page 3):
Morgan Stanley would have been profitable this quarter if not for the dramatic improvement in our credit spreads – which is a significant positive development, but had a near-term negative impact on our revenues.
So when you lose, you win. When you win, you lose. It befuddles me, and it befuddles Paul Krugman. The only way I can kind of understand it is by looking at it like writing off stock market losses on your income taxes. I am to understand that this is somehow related to paying interest on its debt, of which it would have to pay much less in the event of a default, so maybe it isn’t an actual profit so much as a lowering of future payouts, which would mean more money stays at Citi? Maybe, but it really sounds like another clever way to obfuscate a company’s actual financial position.
alyx // Apr 23, 2009 at 11:25 am
Oh hell yes! I can book a huge profit on my own debt!
…right before I go bankrupt.
Best explanation I have seen thusfar is at http://holdingtoaccount.blogspot.com/2009/04/cvas-or-magic-of-your-own-credit-on.html, because it uses examples, and I like those.
Jason // Apr 23, 2009 at 11:39 am
Fuck Reagan, this is the real voodoo economics.
Tony // Apr 23, 2009 at 11:58 am
And true to American form, there will be much sound and fury over this, signifying nothing. The laws governing this garbage were paid for by the people they benefit, using money from the last time they did something crazy with laws to benefit themselves. I’m wondering if maybe once a year we could get everyone in America to chip in $2 and we could buy one law ourselves… or better yet, pick one of their new laws to veto.
bb // Apr 23, 2009 at 12:15 pm
Jason,
not sure if it was you who made the perfect comparison to this CVA nonsense: it is identical to an owner of a mortgaged home to report higher income just becuase the value of his home (the collateral) has plummeted, all the while his loan dues do not change substantially.
in reality, C is still on the hook for the face value of its bonds. just because the cds is pricing high default risk, it does not mean the company can call its issues at anything but market price. it has a contractual obligation to pay the face value at a call. they can buy some bonds at market prices, but this does not mean the whole issue has to be marked to market (another nonsense). no intelligible bond holder will sell to the issuer his bonds at market price which is inferior to the call price of the issue.
there are quite a few things wrong with the accounting standards and banks seem positioned best to exploit them.
Mr.Sparkle // Apr 23, 2009 at 12:59 pm
That was a pretty good link alyx.
What I would also be interested to find out is the relative values on each of the companies books in real life. The example of GS buying C debt is a nicely illustrative hypothetical. But what of this scenario?
Entity #1 holds $1M par of C 10 years.
C has sold $1M par.
C fails, fails, and fails some more and pretty soon the debt is trading at 0.70/$1.
C realizes a magic profit of 0.30/$1. But… in real life what is Entity #1 booking at? Par? 0.85/$1? If the rules regarding how to mark an asset vs a liability are so vastly different, I’d say there is a serious problem. It seems impossible to me (I don’t even play an accountant on TV) to reconcile how one company might be carrying this debt at par and the issuing entity realizing a 30% profit becuase the value fell.
Any accountants out there that can clue me in and help reconcile this?
Greg // Apr 23, 2009 at 9:29 pm
Alyx, thanks that site was super helpful. I too have been struggling to understand how this accounting works. It is truly preposterous…