Credit value adjustment
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Warning: ramblings of an untutored maniac here.
Credit value adjustments
A credit value adjustment — to its friends CVA — is a calculation made by financial reporting types to financial instruments one holds to account for changes in the creditworthiness of the issuer of those instruments since their issue. For a liquid instrument, the CVA ought really to be baked into the mark-to-market value of the instrument. For a collateralised one, it ought to be more or less zero. As far as this bear of little brain can see, the credit value adjustment ought really to be the difference between the present value of the remaining expected cashflows due on that instrument (assuming it does not default) and the price at which that instrument is presently trading.
The theory is that since you strike the spread on your debt instrument when it is issued, and the spread doesn’t change, it reflects your creditworthiness at that moment. Should your fortunes then improve, the value of your indebtedness should rise, because the interest it pays reflects a higher risk than the one you now present. And vice versa.
Debt value adjustments — snake oil alert
- “DVA has caused a lot of confusion because banks are allowed to record gains as their credit quality deteriorates. While there are pros and cons to including DVA in earnings, most people see it as accounting gimmickry that doesn’t reflect any true economic value.”
- —David Kelly, Quantifi, 2009, quoted in Euromoney
The imposition of CVA adjustments during the global financial crisis — it was a Basel requirement — where counterparties had, effectively, to discount the value of their claims under derivative contracts due to deterioration in their counterparties’ creditworthiness, led resourceful types to wonder whether they shouldn’t also be able to discount the book value of their liabilities under the same contracts due to a deterioration in their own creditworthiness.
There is a neat logic to this — if I consider out-of-the-money exposures to be my term indebtedness, then if my prospects have worsened, I would be able to buy this indebtedness back at less than its face value for exactly the same reason, so why shouldn’t I mark my liability down in the same way?
So the investment banks did, and in size. Let the low-quality earnings klaxons blare. They called these “debt value adjustments”, and while it was a thing, it didn’t fare so well and these days there aren’t as many Investopedia articles about it. But, around 2011, it was the talk of the smoky salons where credit traders would gather to complain to each other about the prevailing squeeze on their own credit. Strangely, as the credit squeeze alleviated, they grew less enthusiastic about having to pay to hedge away the cost of their own improving fortunes with credit derivatives: now these were showing up as losses it became obvious what a silly it had been in the first place. And so was born the idea of “motivated irrationality”.
Seriously?
Now you would not be alone if you felt something tugging at the strings of your bullshit apron: if this seems a bit snake oil-y, that’s because it is.
If you think your own credit deterioration is grounds for you to book a profit, then, not to put too fine a point on it, you should get your coat. Just because, as you lurch towards insolvency, the value to your creditors of your liabilities tends to zero, it doesn’t mean their cost to you tends to zero. You are still fully liable for that indebtedness, come what may. That you should have collapsed into ignominious torpor of bankruptcy before being able to honour it does not mean your obligation doesn’t exist, and it certainly shouldn’t go towards your pnl.
“But,” I hear you cry, “I could buy that indebtedness back in the market at that discounted va —”
WITH WHAT, DEAR LIZA? The theory is your business is swan-diving into the side of a hill. If you had free cash available to buy out all your debts, said hill would not be filling up your entire field of vision. You don’t have any goddamn money to buy your debts back. That is your exact problem.
“But I could borrow some mo —” and here, dear reader, follows a pause. “Oh, hang on. I think I see the problem here.”
Right. You don’t have any money, so you would have to borrow it. Even if you could find someone prepared to lend to a shortly-to-be-bankrupt company (look, it does happen), it would lend to you at your current state of indebtedness. So you would be extinguishing your apparently “cheap” indebtedness and replacing it with more expensive indebtedness.
Thus: credit value adjustments: nonsense on stilts.