BAC released its 1Q12 financial report on 04/19. Here are its earnings: Net Income of $653 million, or $0.03 Per Diluted Share…
Most headline news highlight the earnings of $0.03 Per Diluted Share which is way below the concurrent earnings estimation of $0.12/share. So by only look at the headlines, the investors of BAC will surely be in a panic mode – BAC has very little earning power!
However, the earnings reported are just half of the story. The earning results Include Negative Valuation Adjustments of $4.8 Billion Pretax, or $0.28 Per Share, From the Narrowing of the Company’s Credit Spreads.
First of all, what is Credit Valuation Adjustments (CVA) and why do we need it?
According to the International Swap and Derivative Association (ISDA), the notional amount outstanding in over-the-counter (OTC) derivative trades, in the seven year period, between 2000 and 2007, has grown seven times. Such an exponential growth in contractual commitments among financial entities demands a solid understanding and the proper evaluation of counterparty risk of the trading book.
Once two counterparties enter into a trade, besides market risk, they also take credit risk against each other. The risk of financial loss due to default of trading counterparties is referred to as counterparty credit default risk. In most cases, this risk is not considered in direct evaluation of the trades and, therefore, needs to be adjusted appropriately to reflect the risk should either of the counterparties default on their commitments. The adjustment to the value of a default free trading book is what is usually referred to as credit (or counterparty) valuation adjustment (CVA).
Therefore, we need CVA because we live in an increasingly risky world including
- Bank failures.
- Global recession.
- Libor rates far from the “risk free” rate
Before 2009, swaps traded without counterparty risk being taken into account. Started in 2010, the counterparty risk needs to be included in the equation.
Secondly, when did financial bank start to implement CVA in accounting?
Since there is much demand for managing counterparty risk, the accounting standards changed,
- Accounting standards — FASB 157 (now “Topic 820, Section 10”) and IAS 39 — credit risk must be taken into account.
- Regulators.
- Risk managers
The IASB even issued a request for comment on counterparty risk calculation methodologies.
Lastly, how does CVA affect financial banks’ income?
The debt securities of BAC have implemented CVA. CVA is applied as “liability benefit” – a payable that does not need to be paid unless BAC defaults. Since BAC continues to build up impressive capital and liquidity, its credit rate drives up significantly, the credit spread keeps on narrowing, then the debt price ramps up … all these are good, except … the “liability benefit” also increases, thus “payable” increases, and revenue and net income gets negatively impacted – this is how come BAC needs to take Negative Valuation Adjustments of $4.8 Billion Pretax!! Remember that CVA is only designed for catastrophic scenario. If bank runs under normal condition, it is way too conservative for BAC to take this artificial hit on earnings!
If the price of their debt increases (reduces), BAC must report an unrealized loss (gain) in their structured notes or debt businesses. Structured notes are debt instruments embedded with derivatives. The underlying reasoning is that as creditworthiness of bank improves (deteriorates), it is more (less) likely to perform on those financial obligations. That results in an unrealized loss (gain) on a company’s books. So it is essentially a non-cash charge! Under normal condition, the price of BAC’s debt does not move as much as it did the last two quarters in 2011 so these adjustments were small. Due to the large market valotility (including EU financial flare up) in the last two quarters last year, the debt movement of BAC was significant in 1Q12, then BAC has to report significant unrealized loss (CVA) in 1Q12. Remember again, this is non-cash charge.
By excluding this artificial negative CVA to NI, BAC earns $0.31 per share, which is way above the estimated earnings ($0.12/share). It is such a blow-out earnings. Shouldn’t we be very excited about its superior earning power?
Disclosure: I long BAC and BAC.WS.A.
About Timeless Investor
My name is Samual Lau. I am a long-term value investor and a zealous disciple of Ben Graham. And I am a MBA graduated in May 2010 from Carnegie Mellon University. My concentrations are Finance, Strategy and Marketing.
TimelessInvestor
A closer look at Earnings of Bank of America 1Q12 report
BAC released its 1Q12 financial report on 04/19. Here are its earnings: Net Income of $653 million, or $0.03 Per Diluted Share…
Most headline news highlight the earnings of $0.03 Per Diluted Share which is way below the concurrent earnings estimation of $0.12/share. So by only look at the headlines, the investors of BAC will surely be in a panic mode – BAC has very little earning power!
However, the earnings reported are just half of the story. The earning results Include Negative Valuation Adjustments of $4.8 Billion Pretax, or $0.28 Per Share, From the Narrowing of the Company’s Credit Spreads.
First of all, what is Credit Valuation Adjustments (CVA) and why do we need it?
According to the International Swap and Derivative Association (ISDA), the notional amount outstanding in over-the-counter (OTC) derivative trades, in the seven year period, between 2000 and 2007, has grown seven times. Such an exponential growth in contractual commitments among financial entities demands a solid understanding and the proper evaluation of counterparty risk of the trading book.
Once two counterparties enter into a trade, besides market risk, they also take credit risk against each other. The risk of financial loss due to default of trading counterparties is referred to as counterparty credit default risk. In most cases, this risk is not considered in direct evaluation of the trades and, therefore, needs to be adjusted appropriately to reflect the risk should either of the counterparties default on their commitments. The adjustment to the value of a default free trading book is what is usually referred to as credit (or counterparty) valuation adjustment (CVA).
Therefore, we need CVA because we live in an increasingly risky world including
Before 2009, swaps traded without counterparty risk being taken into account. Started in 2010, the counterparty risk needs to be included in the equation.
Secondly, when did financial bank start to implement CVA in accounting?
Since there is much demand for managing counterparty risk, the accounting standards changed,
The IASB even issued a request for comment on counterparty risk calculation methodologies.
Lastly, how does CVA affect financial banks’ income?
The debt securities of BAC have implemented CVA. CVA is applied as “liability benefit” – a payable that does not need to be paid unless BAC defaults. Since BAC continues to build up impressive capital and liquidity, its credit rate drives up significantly, the credit spread keeps on narrowing, then the debt price ramps up … all these are good, except … the “liability benefit” also increases, thus “payable” increases, and revenue and net income gets negatively impacted – this is how come BAC needs to take Negative Valuation Adjustments of $4.8 Billion Pretax!! Remember that CVA is only designed for catastrophic scenario. If bank runs under normal condition, it is way too conservative for BAC to take this artificial hit on earnings!
If the price of their debt increases (reduces), BAC must report an unrealized loss (gain) in their structured notes or debt businesses. Structured notes are debt instruments embedded with derivatives. The underlying reasoning is that as creditworthiness of bank improves (deteriorates), it is more (less) likely to perform on those financial obligations. That results in an unrealized loss (gain) on a company’s books. So it is essentially a non-cash charge! Under normal condition, the price of BAC’s debt does not move as much as it did the last two quarters in 2011 so these adjustments were small. Due to the large market valotility (including EU financial flare up) in the last two quarters last year, the debt movement of BAC was significant in 1Q12, then BAC has to report significant unrealized loss (CVA) in 1Q12. Remember again, this is non-cash charge.
By excluding this artificial negative CVA to NI, BAC earns $0.31 per share, which is way above the estimated earnings ($0.12/share). It is such a blow-out earnings. Shouldn’t we be very excited about its superior earning power?
Disclosure: I long BAC and BAC.WS.A.
About Timeless Investor
My name is Samual Lau. I am a long-term value investor and a zealous disciple of Ben Graham. And I am a MBA graduated in May 2010 from Carnegie Mellon University. My concentrations are Finance, Strategy and Marketing.