Citigroup makes some money, sort of

"In somewhat dumbed-down but still utterly flummoxing language: credit-default swap (CDS) spreads represent the cost of insuring against Citi's default. That cost went up in the quarter as investors fretted about Citi's solvency, so Citi was able to book $2.5 billion in gains. Got that? "
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No, I didn't. Did anybody?

Basically this is the side of mark to market accounting that nobody talks about. FAS 157 (the accounting term for mark to market accounting) applies to both assets and liabilities. So for Citigroup and other banks, they have to mark their liabilities to fair value, and in the case of their own debt (or in this case liabilities on derivative positions), they have to consider their own default potential as a component of fair value. So the more likely it becomes that Citi will default on their debt/swaps, the less those instruments are worth to the investors that hold them. Therefore the accounting guidance says that Citi should reduce the value of the liabilities on their books, and they book this reduction as a gain through the income statement. As an auditor I find the guidance to be ridiculous, but its the rule so companies are following it - Justin - it'd be interesting to see how much of the other banks "earnings" are really due to these ghost profits on their own default potential.

There's a great passage in Jamie Dimon's letter to shareholders on this practice, "The theory is interesting, but, in practice, it is absurd. Taken to the extreme, if a company is on its way to bankruptcy, it will be booking huge profits on its own outstanding debt, right up until it actually declares bankruptcy–at which point it doesn't matter."

sulliclm,
Thank you. Who makes up these guidances? Orwell? Kafka?

As far as I know Orwell or Kafka are not members of the FASB, but I can't be sure. It is a ridiculous piece of regulation, that basically violates the cardinal rule of accounting - conservatism. Just goes to show you that the debate about mark to market accounting is far more nuanced than idiots like schwarzman and gingrich would like the public to think.

Bank of America's earnings release this morning - $4.2B in profit for Q1 2009. But read this section of the press release:

"Noninterest income included $2.2 billion in gains related to mark-to-market adjustments on certain Merrill Lynch structured notes as a result of credit spreads widening."

FAS 157 strikes again! Couple that with a $1.9B gain on the sale of some of their shares of CCB, and essentially their entire quarterly profit was due to either accounting nonsense or a one time transaction.

Haha thanks for the shout out Justin!

Sulliclm:

When you say "the accounting guidance says that Citi should reduce the value of the liabilities on their books, and they book this reduction as a gain through the income statement" I am at lost to the intuition behind this policy. I am a little rusty on my accounting, but it seems to me that a reduction in the liabilites would be reflected on the balance sheet, not the income statement. Why is the reduction in libilities recorded on the income statement?

Thanks,
David