# CVA/CDVA - Worsened Credit Quality implies profit?

In the book Counterparty Credit Risk, Collateral and Funding by Brigo et al I found the following:

• credit quality of investor WORSENS $\Rightarrow$ books POSITIVE MARK TO MKT
• credit quality of investor IMPROVES $\Rightarrow$ books NEGATIVE MARK TO MKT

# Balance sheet Example

Imagine the balance sheet of OTC Subsidiary with rating A:

Assets                    | Liabilities
----------------------------------------------------
OTC derivative + CVA   100| Total Liabilities    100


Now OTC Subsidiary gets downgraded to rating B increasing the CVA by 10:

Assets                    | Liabilities
----------------------------------------------------
OTC derivative + CVA   110| Total Liabilities    100


A balance should balance and liabilities haven't changed (extra collateral wouldn't leave the balance sheet). Hence something should be added on the right side. I believe that how you want to name this quantitiy is mostly an accounting matter but one can choose to put this into the P/L. Putting it in the P/L might not be a really nice solution but it's what often used. Two discussions on this topic I found interesting can be found in Tracy Alloway in Banks face profits hit as fog and OTC Derivatives, Bilateral Trading and Central Clearing by David Murphy, Chapter 3.

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Having read the FT article I am still not sure why "DVA effectively gives banks the ability to book profits when the value of their bonds decreases". This seems peculiar to me and I am still not why this is the case. – Tom Aug 24 '14 at 23:24
I'll try to add some stuff later today. – Bob Jansen Aug 25 '14 at 8:34

The rules relating to mark-to-market accounting have always been, in my opinion, ridiculous.

Citigroup have to mark their liabilities to a fair value, and in this case, where it is their own debt, part of the pricing require that they consider the potential of their own default. The more likely it becomes, that the bank defaults the less the banks swaps is worth to the investors who hold them. The mark-to-market guidelines says Citigroup then should reduce the value of the liabilities on their books, they are allowed to book this difference as a gain/profit.

It is ridiculous because a bank spinning out of control and heading directly into bankruptcy are able to book huge paper profits while it at the same time is melting down.

I do not think you are missing something, except knowing about this one specific mark-to-market accounting practice/guideline.

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I don't think that's the problem here because Citi's press release explicitly mentions CVA as the cause. – Bob Jansen Aug 26 '14 at 6:25
@BobJansen But it is also mentioned that the profits are "mainly due to the widening of Citi’s CDS spreads". So maybe CVA from the perspective of any counterparty is meant, or maybe they just wrote CVA for the sake of simplicity. – Tom Aug 26 '14 at 7:55