Tuesday 18 January 2011

Credit Value Adjustment and the boomerang effect of FAS 159 accounting rules on Banks Earnings - Citigroup latest results

Citigroup's latest results clearly show the impact of tightening CDS spreads on earnings.

Credit valuation adjustment (CVA) refer to the fair value of liabilities which in the case of Citigroup equates to a 1.1 billion USD hit on its earnings. The company incurs a negative revenue mark when the value of the debt/liabilities increases.

In my post "Statement 159 - Debt Valuation Adjustments - Déjà Vu 2008", published in July 2010, we studied the impact on earnings with FAS 157 and FAS 159.

For more on FAS 157 and FAS 159 please check the link below to the American Academy of Actuaries paper on the subject:

http://www.actuary.org/pdf/life/fas157_0209.pdf

Citigroup's hit on earnings is linked to a tightening in its CDS 5 year spread. The more the CDS 5 year spread tightens in 2011, the more pressure Citigroup will face on its earnings.


In April last year Citigroup had the following positive results thanks to CVA in its Quarter 1 results:

http://www.businesswire.com/portal/site/home/permalink/?ndmViewId=news_view&newsId=20090417005227&newsLang=en

"Fixed income markets revenues of $4.7 billion reflected strong trading performance, as high volatility and wider spreads in many products created favorable trading opportunities. Interest rates and currencies and credit products had strong revenue growth. Revenues also included (all reflected in Schedule B):
o A net $2.5 billion positive CVA on derivative positions, excluding monolines, mainly due to the widening of Citi’s CDS spreads
o A net $30 million positive CVA of Citi’s liabilities at fair value option
"


There you have it, the boomerang always come back, in that case FAS 159...

For more on Citigroup's past CVA:

Monoline Insurers Credit Valuation Adjustment (CVA)

During the first quarter of 2009, Citigroup recorded a pretax loss on CVA of $1.090 billion on its exposure to monoline insurers. CVA is calculated by applying forward default probabilities, which are derived using the counterparty's current credit spread, to the expected exposure profile. The majority of the exposure relates to hedges on super senior subprime exposures that were executed with various monoline insurance companies. See "Direct Exposure to Monolines" for a further discussion.

This excerpt taken from the C 10-Q filed May 11, 2009.

Monoline Insurers Credit Valuation Adjustment (CVA)

During 2008, Citigroup recorded a pretax loss on CVA of $5.736 billion on its exposure to monoline insurers. CVA is calculated by applying forward default probabilities, which are derived using the counterparty’s current credit spread, to the expected exposure profile. In 2007, the Company recorded pretax losses of $967 million. The majority of the exposure relates to hedges on super senior positions that were executed with various monoline insurance companies. See “Direct Exposure to Monolines” on page 70 for a further discussion.

These excerpts taken from the C 10-K filed Feb 27, 2009.

2 comments:

  1. See this paper for calculating CVA correctly
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2267508

    ReplyDelete
    Replies
    1. Thanks looks interesting, I will definitely take a look "Anonymous"! Best, Martin

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