Krugman’s latest post… what does this mean?

April 22, 2009

I’ve simply cut an paste the entire post since  I don’t understand a word of it.

So the accounting rules say that a decline in the market value of a bank’s debt thanks to increased credit default swap spreads — that is, because investors think you’re more likely to fail — counts as a a profit. On the other hand, if your bank looks stronger, the spreads fall, and you book a loss.

FT Alphaville has the story. Citigroup reported

A net $2.5 billion positive CVA on derivative positions, excluding monolines, mainly due to the widening of Citi’s CDS spreads

while Morgan Stanley reported

Morgan Stanley would have been profitable this quarter if not for the dramatic improvement in our credit spreads – which is a significant positive development, but had a near-term negative impact on our revenues.

So Citigroup is profitable because investors think it’s failing, while Morgan Stanley is losing money because investors think it will survive. I am not making this up.

3 Responses to “Krugman’s latest post… what does this mean?”

  1. jck Says:

    If you were to buy insurance from a highly rated counter-party, you would normally pay more than if you bought it from a low rated counter-party.
    CVA, credit value adjustment, is the market value of that counter-party credit risk.
    So if Citi credit quality degrades as evidenced by credit default swaps on its own paper, it is entitled to book as profit (mark-to-market, not cash), certain liabilities, and vice-versa, if credit quality improves as for Mrgan Stanley , it will have to book a loss ( again mark-to-market, not cash).
    This is logical, if assets have to be marked-to-market, it’s common sense that liabilitiers have too, for consistency.

  2. mk Says:

    So what does that tell us regarding the wisdom of mark-to-market?

  3. jck Says:

    Mark-to-market is fine for a pure trading book, where there is a market. It’s not fine otherwise. Good to remember that the losses taken by banks are not cash losses, they have zero incidence on the banks’ ability to pay their bills, something that’s misunderstood by the majority of investors.


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