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Quantifi Whitepaper - CVA DVA and Q4 Bank Earnings

Quantifi Whitepaper - CVA DVA and Q4 Bank Earnings

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Published by Quantifi
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
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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Categories:Types, Research
Published by: Quantifi on Mar 16, 2012
Copyright:Attribution Non-commercial

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03/16/2012

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Credit Vae Adjstment (CVA) is te amont sbtractedrom te mark-to-market (MTM) vae o derivativepositions to accont or te expected oss de toconterpart deats. Debt Vae Adjstment (DVA)is basica CVA rom te conterpart’s perspective. Ione part incrs a CVA oss, te oter part records acorresponding DVA gain.
DVA is the amount added back to the MTM value toaccount or the expected gain rom an institution’s owndeault. Including DVA (in addition to CVA) is intuitivelypleasing because both parties theoretically report thesame credit-adjusted MTM value. DVA is also controversialbecause institutions record gains when their credit qualitydeteriorates, creating perverse incentives, and the gainscan only be realised on deault
.
Accounting rules mandate the inclusion o CVA in MTMreporting, which means bank earnings are subject toCVA volatility. DVA is also accepted under the accountingrules and banks that include it, and by doing so mustcontinue to include it going orward, add their own creditspread as a source o earnings volatility. To mitigate CVAvolatility, as well as hedge deault risk, many banks buyCDS protection on their counterparties. Hedging DVA isnot as straightorward. Since DVA increases as the bank’scredit spread widens, it is equivalent to the bank beingshort its own debt. Thereore, hedging involves buyingthe bank’s own bonds or selling protection on highlycorrelated institutions, i.e., other banks, since they can’t sellprotection on themselves.DVA became a hot topic when banks announced 2011Q3 earnings, due to the magnitude and direction o theamounts. Ironically, where large DVA gains substantiallyimpacted earnings, the bank’s outlook improved,thereby tightening its credit spread and generating DVAlosses. This article is a sequel to a previous reportentitled ‘CVA, DVA and Bank Earnings’, which attemptedto dissect the Q3 DVA results and make some predictionsabout Q4. Here, we will analyze the recently reported Q4DVA results.
Q3 DVA Review
Most banks reported large DVA gains or the third quarterdue to signicantly wider credit spreads. The ollowingtable displays Q3 DVA results reported by the ve largestU.S. banks:
BankJn CDS(bps)Sep CDSCDSDVA Gain(bn)BAC
1584262681.700
C
1373191821.888
GS
1373301930.450
JPM
79163841.900
MS
1624923303.400
Q4 DVA Rests
We used the reported Q3 DVA results above to estimate Q4DVAs. These estimates, along with the actual change in CDSspreads during Q4 are provided in the ollowing table:
BankSep CDSDec CDSCDSEst. DVAGain (mm)BAC
426413-13(82)
C
319285-34(353)
GS
33033225
JPM
163147-16(339)
MS
492421-71(732)
DAVID KElly, 
Drector o Credt ad
DMITRy PuGAChEVSKy,
 Drector o Reearch, at Quatf
CVA, DVA AnD Q4BAnk EARnings

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