Profitable bulemia

The scenario of banks downgrading each other's balance sheets due to opaque accounting of toxic assets is understandable--they are competitors after all. If misery loves company, one could argue perhaps they should be cheering each other on in their attempts to restore their balance sheets to solvency.

But there's an interesting twist in this game of mutual cannibalism: not only are they throwing stones at each other's glass houses, they are also betting on their own demise. Let me repeat: banks are profiting from bets against their own solvency.

Here's an excerpt from The Daily Reckoning:

But something magic happened in the fixed income trading group for Citi. This is pure gold if you like arcane financial statements packed with fictional earnings. If you dig into the quarterly report, you'll learn than fixed income trading revenues were boosted by a "net $2.5 billion positive CVA on derivative positions, excluding monoclines, mainly due to the widening of Citi's CDS spread.

That takes some sorting out. A CVA is a "credit value adjustment." As you can learn here, it's the credit risk premium of a derivative contract. Once you sort it out, you learn that Citi "made" $2.5 billion on a derivatives position designed to profit when the companies own credit default swaps spreads widen.

Or, in plain English, Citi profited because it made a bet that the cost of insuring itself against a default would go up. The credit default swap market is the place where you can bet on the credit worthiness of a firm, or, essentially, the chance that a firm might default on its bonds. Citi appears to have reported a $2.5 billion trading gain in the fourth quarter precisely because the market thought the company stood a good chance of failing (hence the widening CDS spread).

As far as we can tell, if you use this kind of perverted logic, the closer Citi gets to bankruptcy, the more money it would "make" on its derivatives. That shows you how bogus the quarterly number was. The company reported declining revenues in its core banking and lending activities. But thanks to fixed income and this handy $2.5 billion CVA, the company was able to report $1.5 billion in net income.

The financial bazaar has truly turned bizarre.