time to back up the truck, page-20

Ctindale/Ocker

I hope you don’t mind my intrusion, however I think the representation of the CDS scenario’s and implications here is not entirely accurate. Very slow day at work, so I’ll set the scene for everyone here, give a bit more background to the whole CDS world.

All banks of course lend money as a normal part of their business. Lending can be in form of tradeable financial instruments (e.g. bonds) or in a non tradeable form specific to the borrower. In accounting terms, all bank lending (tradeable and non tradable) is represented as an asset on their respective balance sheets. At the outset of a loan, the value of the loan asset on the balance sheet (B/S) is essentially what is owed (there are some exceptions relating to transaction costs, however they are not material so I won’t go into it).
From here the value of a loan asset held on the B/S depends on the nature of the loan. The accounting treatment for a loan asset varies depending on the applicable category in the accounting standard AASB 139. There are four categories, each with a different accounting treatment. The applicable category is designated at the inception of the loan. A listed bond might be designated as ‘FVTPL’ (Fair Value Through Profit & Loss) where fair and market value are considered the same, movements in these are reflected in the P&L on a regular basis (potentially daily). An overdraft facility would be designated in ‘Loan & Receivables’, valuation for the B/S is via a methodology called Amortised Cost, movements in this are also reflected in the P&L. Amortised Cost does not reflect credit risk effects on fair value, therefore ‘Loans & Receivables’ are subject to impairment testing (at least annually).

Now, all loans are of course subject to credit risk (i.e. will we get out money back), banks wear and manage this risk as a normal part of their business. However there are times when a bank may wish to reduce their credit risk exposure in relation to a particular borrower or instrument. As per Ctindale’s comments, a bank can buy a CDS to insure against credit default. Common reasons why a bank would buy a CDS include:
- close a sold position in relation market making or trading activity
- reduce bank wide credit risk exposure to a particular entity below pre-determined limits to enable further lending to this entity
- structured deals where the intention is to earn transaction fee revenue, not hold a lingering credit risk exposure

Financial instruments like CDS’ are subject to the same accounting valuation shenanigans I’ve described above.

Enough of the background, now to the points on bank CDS positions and their potential implications for the B/S and P&L.

Ctindale re “if the these monoline insurers do become insolvent, then ANZ would have to immediately make provision for billions and billions of new debt” That’s not true, I’ll explain why. Also note I’m assuming that most bought CDS positions have a positive life to date valuation, a reasonable assumption in the current credit environment. This life to date P&L is held as an asset on the bank B/S. The CDS valuation is adjusted for counterparty credit risk via a Credit Valuation Adjustment (CVA) for CDS positions held at FVTPL. The update from ANZ in July suggests than the majority of ANZ’s CDS portfolio is valued at FVTPL (reflecting changes in CDS CVA is the giveaway).
Even if a dud bought CDS is part of a hedging relationship (possible for the 3rd scenario above), separate accounting is maintained for the CDS and the related loan. In the event of a bought CDS becoming worthless due to counterparty failure, the only impact on the bank P&L is the effect of the elimination of the life to date value previously held on the B/S. The underlying loan remains as an asset on the bank B/S valued separately as per my previous comments. The only time a bank will provision for the full (or at least a significant portion) of a loan is if the loan itself is considered impaired (i.e. less/not likely to be repaid). The provisions related to Centro, Lafayette etc are examples of this.

Ocker re “Does the fact ANZ (or others) have in place credit insurance enable them to take the asset off the balance sheet and treat the exposure as a "contingent" item?” As per my comments, a definite no. Even with Bills, the only way the asset and liability can be offset on the B/S is if the requirements of AASB 132 are met, these include a legally enforceable right to offset and settle on a net basis. To offset, the corresponding deals really need to be with the same counterparty, otherwise the asset and liability must be reflected separately.

Ctindale re “to the second part IMO yes that’s why they have to make provisions and bring it onto the books when a counterparties credit rating falls below a certain level” Sorry but your O is incorrect. Surely accounting rules are a matter of fact, not opinion anyway? The amounts ANZ has announced in relation to CDS this year are not technically provisions at all; they reflect the reduced MTM value of their bought CDS portfolio. The accounting entry would be debit profit and credit B/S (eliminating the CDS asset value), no liability, no provision. The primary driver of the decreased MTM value has been the impact of reduced counterparty credit ratings on the CVA.

Finally Ctindale, re “Credit Default Swaps are easy to understand” maybe, in practice few people really understand CDS’, let alone you accounting for them.