Mark-to-market's strange accounting benefits for Citi and BofA

On Friday I noted that Citigroup wouldn't have reported a profit if it hadn't been for a $2.5 billion derivatives valuation adjustment "mainly due to the widening of Citi's CDS spreads." Citi's CDS spreads widen when traders think Citi is more likely to default. So basically, Citi was able to report a profit because fears grew that it would go under. Weird, huh?

Today, Alea notes, Bank of America joined in the weirdness with "$2.2 billion in gains related to mark-to-market adjustments on certain Merrill Lynch structured notes as a result of credit spreads widening." This didn't make the different between profit and loss—BofA reported net income of $4.2 billion. But it does point out again that bank earnings reports have become very strange things. As commenter sulliclm explained, with reference to Citi's earnings:

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 ...

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."

In fact, Lehman Brothers booked repeated debt valuation gains as it went down last year—although they weren't big enough to offset its other losses. And it seems clear that there really is something screwy about mark-to-market accounting that goes beyond the simple fact that markets are volatile.