CVA, DVA AnD Q4BAnk EARningsDAVID KElly, Director of Credit andDMITRy PuGAChEVSKy,Director of Research, at QuantifiCredit ...
CommentaryThe estimated DVA in the last column is based on a simple       Using bond spreads instead of CDS would seem tor...
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Quantifi whitepaper CVA, DVA and Q4 Bank Earnings

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The paper provides an overview of DVA and highlights some of the results reported by larger banks, along with potential implications going forward. The paper addresses the following:

The meaning of DVA and how it relates to CVA
Q4 DVA results for the five largest U.S banks, along with the increases in their respective CDS spreads that drove these gains
How some banks hedge DVA in order to reduce earnings volatility

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Quantifi whitepaper CVA, DVA and Q4 Bank Earnings

  1. 1. CVA, DVA AnD Q4BAnk EARningsDAVID KElly, Director of Credit andDMITRy PuGAChEVSKy,Director of Research, at QuantifiCredit Value Adjustment (CVA) is the amount subtracted entitled ‘CVA, DVA and Bank Earnings’, which attemptedfrom the mark-to-market (MTM) value of derivative to dissect the Q3 DVA results and make some predictionspositions to account for the expected loss due to about Q4. Here, we will analyze the recently reported Q4counterparty defaults. Debt Value Adjustment (DVA) DVA results.is basically CVA from the counterparty’s perspective. Ifone party incurs a CVA loss, the other party records a Q3 DVA Reviewcorresponding DVA gain. Most banks reported large DVA gains for the third quarter due to significantly wider credit spreads. The followingDVA is the amount added back to the MTM value to table displays Q3 DVA results reported by the five largestaccount for the expected gain from an institution’s own U.S. banks:default. Including DVA (in addition to CVA) is intuitivelypleasing because both parties theoretically report the Jun CDS DVA Gainsame credit-adjusted MTM value. DVA is also controversial Bank (bps) Sep CDS ∆ CDS (bln)because institutions record gains when their credit qualitydeteriorates, creating perverse incentives, and the gains BAC 158 426 268 1.700can only be realised on default. C 137 319 182 1.888Accounting rules mandate the inclusion of CVA in MTM GS 137 330 193 0.450reporting, which means bank earnings are subject toCVA volatility. DVA is also accepted under the accounting JPM 79 163 84 1.900rules and banks that include it, and by doing so must MS 162 492 330 3.400continue to include it going forward, add their own creditspread as a source of earnings volatility. To mitigate CVAvolatility, as well as hedge default risk, many banks buy Q4 DVA ResultsCDS protection on their counterparties. Hedging DVA is We used the reported Q3 DVA results above to estimate Q4not as straightforward. Since DVA increases as the bank’s DVAs. These estimates, along with the actual change in CDScredit spread widens, it is equivalent to the bank being spreads during Q4 are provided in the following table:short its own debt. Therefore, hedging involves buyingthe bank’s own bonds or selling protection on highly Est. DVAcorrelated institutions, i.e., other banks, since they can’t sell  Bank Sep CDS Dec CDS ∆ CDS Gain (mm)protection on themselves. BAC 426 413 -13 (82)DVA became a hot topic when banks announced 2011 C 319 285 -34 (353)Q3 earnings, due to the magnitude and direction of theamounts. Ironically, where large DVA gains substantially GS 330 332 2 5impacted earnings, the bank’s outlook improved, JPM 163 147 -16 (339)thereby tightening its credit spread and generating DVAlosses. This article is a sequel to a previous report MS 492 421 -71 (732)
  2. 2. CommentaryThe estimated DVA in the last column is based on a simple Using bond spreads instead of CDS would seem toratio of the change in CDS spread for Q4 divided by the compromise a key benefit of including DVA in the valuationchange in CDS spread for Q3 times Q3 DVA. For example, of derivative positions. Including DVA along with CVA, alsoBank of America’s $1.7bln DVA gain in Q3 came from its called ‘Bilateral CVA’, results in both parties reporting thecredit spread widening 268bps, so 13bps tightening in same credit-adjusted value for the position. Using bondQ4 should roughly equate to a $82.5mln loss (13/268 * spreads compromises that because each party typically1.7bln). Of course, these crude estimates ignore changes uses the other party’s CDS spread, not the bond spread,in portfolio composition and changes in risk factors other to price CVA. The reason is that CDS is a more effectivethan the bank’s CDS spread, such as interest rates, FX, means to ‘replicate’ (hedge) credit risk. On the flip side,commodity & equity prices, volatilities DVA is more efficiently replicated by buying the firm’s ownand correlations. bonds since the firm cannot sell protection on itself. In fact, Morgan Stanley reported that they did buy back someSince the CDS spreads for all banks except Goldman Sachs debt during Q4 on their earnings call.tightened, we would expect to see DVA losses for thequarter. The next table shows actual DVA results reported To compound the problem, the basis between bond andby the banks and differences from the above estimates: CDS spreads, generally wide at the end of Q3, dramatically widened for Citigroup and Morgan Stanley during Q4. The bond-CDS basis is a measure of liquidity risk, as reflected Est. DVA Gain Actual DVA Bank  Difference in the diverging bid-offer spreads for bank-issued bonds (mm) Gain during Q4. Due to the widening basis, there has been BAC (82) (474) 392 increased interest in pricing liquidity risk through a Liquidity Valuation Adjustment (LVA). Roughly speaking, C (353) (40) (313) LVA is the difference between DVA calculated with CDS GS 5 – 5 spreads and DVA calculated with bond spreads. JPM (339) (567) 228 Even with LVA, the asymmetric pricing problem persists unless LVAs for both parties are exactly the same. There MS (732) 216 (948) is also research challenging the efficacy of buying one’s bonds to hedge DVA. The bottom line is that a standardAside from JPMorgan, the estimated DVAs appear or ‘best practice’ for pricing and hedging DVA has not yetsignificantly off, although the differences are less than 4% been established and we should continue to see swings inof implied expected exposure for each bank. Certainly, this component of bank earnings.simplifying assumptions about constant portfolios andstatic underlying market risk factors are responsible for Although Q4 DVA results were relatively small, there couldsome of the differences but the choice of using CDS be substantial losses in the future given the relatively highspreads, as opposed to bond prices, as the key input to spreads. For example, if the increases in spreads thatthe DVA calculation is a critical issue. occurred during Q3 of 2011 were reversed, those large DVA gains would turn into roughly equivalent losses.In reality, banks use credit spreads derived from their In a tougher regulatory environment it is reasonable tobonds (or some combination of bonds and CDS) to expect that bank earnings will remain constrained andcalculate DVA. The table below shows recalculated DVA it is possible that future DVA losses could entirely offsetestimates using the change in 5-year credit spreads earnings even as credit quality improves.implied from bonds. Est. DVA Sep 5yr Dec 5yr Gain Bank Bond Bond ∆ Bond (mm) About Quantifi BAC 495 480 -15 (95) Quantifi is a leading provider of analytics, trading and risk management software for the global capital markets. C 305 310 5 52 Top-tier financial institutions in over 15 countries trust Quantifi to provide integrated pre and post-trade GS 330 330 0 – solutions that better value, trade and risk manage their JPM 233 220 -13 (294) exposures, allowing them to respond more effectively to changing market conditions. MS 485 505 20 206 london + 44 (0) 20 7397 8788The DVA estimates using bond spreads are generally New york + 1 (212) 784 6815much closer. Notice that there is significant basis between Sydney + 61 (02) 9221 0133the bond and CDS spreads in most cases. We will outlinewhy banks use bond spreads and implications of the enquire@quantifisolutions.combond-CDS basis next. www.quantifisolutions.com

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