Matt Levine’s Article on Derivatives Accounting Explained in Plain English.

Matt Levine of Bloomberg wrote 2500 word article the other day describing, in detail, some new tricks banks are beginning to use to evaluate their derivatives contracts. It’s a great read for someone who’s exposed to that world but indecipherable to a regular. I wanted to translate this article into plain English.

Back in the day, before the crisis, Libor rate was a gold standard for many things: interbank lending, funding, discounting future cashflows of derivatives contracts. Fresh-faced analysts used to plug in that risk-free rate into their Excel spreadsheets valuations models and worry about other things. Well, those days are gone. Matt Levine in his Bloomberg article explains how it is being dealt with today, at least in JP Morgan, although others may follow suit too.

You see, before, doing valuations on your derivatives contracts you used tools called CVA (credit valuation adjustment) and DVA (debit valuation adjustment). But ignore these fancy words for a moment. In plain English CVA means an adjustment for a risk that a counterparty won’t pay you. DVA means an adjustment for a risk that your own credit deteriorates. To describe DVA concept in extreme but understandable terms, imagine that you owe $100K to Russian mobsters, but you die of a heart attack (it’s a metaphor for your credit worsening), so you (or your estate) book a gain on your DVA. Mobsters book a loss on their CVA. Matt Levine is correct for using the word “creepy” to describe DVA: why would you care if your own credit deteriorates, isn’t it the other guy’s problem? Well, it is, but as a bank you have to reflect such deterioration in your books. But CVA and DVA are not offsetting each other, so from what I can discern from the article Jamie Dimon wasn’t too happy about having to explain these counterintuitive discrepancies on earnings calls. In fact it does sound kinda weird: “Our credit deteriorated so we booked a gain, and the next month when our credit spreads improved, we booked a loss.” I know, weird, isn’t it? But that’s how it works in the banking realm.

But what if you didn’t die, but your business has suffered some temporary setbacks? You book a little gain on your books, on the money that you owe the mobsters and go out and find someone who will lend you the money at some interest rate. That’s where the new concept of FVA (Funding valuation adjustment) comes in. You don’t fund yourself with risk-free rate anymore. Libor-shmibor! Everyone knows you’re in some kind of trouble, so they will charge you extra. These days 3-mo Libor is not considered a risk-free rate it once was.

If Libor is not risk-free rate then what do you use? You use some kind of spread over Libor. JPMorgan apparently uses its own 50 bps CDS spread as a funding valuation. That means when they calculate how much it costs them to fund they add 0.5% (50bps) to a 3mo Libor rate. Note that if their credit worsens that 50bps will become, say, 70 or 80 which would make their funding more expensive and will be reflected in the books as a loss, offsetting the accounting gain on a credit deterioration. But this way Jamie Dimon or Marianne Lake won’t have to explain, again and again, how they booked a gain if their credit worsened. Yeah, it’s worsened, but it also became more expensive for us to borrow. FVA in some sense offsets DVA. So it’s a wash. You can be dead or in trouble but your books are perfectly balanced!

Nothing scandalous here, just a neat new concept of accounting tricks explained.

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