DVA's Bring the Bank Earnings Noise

While it's hard to determine exactly what assets and liabilities banks currently fair value on a quarterly basis, DVA gains and losses are mostly created from the marking the trading prices of a bank's outstanding debt. Presently, banks use the prices of credit default swaps the cost to insure their debt as a means of deriving those debt costs. If swaps are rising in price, accounting rules imply that a bank's ability to repay its liabilities is lower, diminishing their worth. That logic also says that the decline in liabilities is a positive for bank shareholders, leading to an earnings gain.

At the most basic level, the biggest question is whether the practice even makes sense?

Had Lehman Brothers not gone bankrupt in September 2008, it would likely have booked a big earnings gain on the skyrocketing cost to insure the firms debts as its trading counterparts ran for the hills. However, in its bankruptcy, those prospective gains evaporated into thin air. Meanwhile, for a firm facing insolvency, calculating its earnings gain if it were to buy back all of its debt seems to be an exercise that borders on the absurd.

"It's when the wheels are falling off of the bus that the credit spreads widen out, so no bank generally is going to take advantage of that situation," says Michael Wong an equity analyst with Morningstar who covers investment banks and institutional brokerages. Wong says most analysts first began to understand DVA's in early 2008 when the crisis was picking up and see little use in accounting for the fair value bank's liabilities - discarding their impact on earnings.

Tchir of TF Market Advisors began working with credit default swaps as a trader with Bankers Trust in the mid 1990s and doesn't see why CDS prices would be used to impute earnings based on the fluctuating value of a firms debt. While he questions the practicality of fair valuing liabilities and DVAs, Tchir makes the point that by using Troubled Asset Relief Program funds and other aid during the crisis, some banks did create real gains by repurchasing their debt at a discount. With the European Central Bank currently providing long-term refinancing, he adds that some European banks may also create real DVA earnings.

Still, a key question is whether the press, analysts and or even bank CEO's treat DVA gains and losses the same as they swing quarterly earnings by over $3 billion, in some cases.