DVA shift a net positive for structured notes

Over the years, debit valuation adjustment (DVA) has gone from being a garland to a millstone in the structured products community.

DVA was initially applied to structured notes as a way to better manage the instruments' accounting. Bonds are usually valued using accrual accounting, but banks pushed for the ability to mark the bond portion of their structured notes at fair value, where changes in value driven by movements in their own credit spread hit the profit and loss (P&L) statement as DVA. This allowed them to recognise the difference between the sale price and fair value of the notes as profit on day one.

But the yo-yoing of bank creditworthiness in recent years has meant this figure has been subject to wild swings. In 2013 for example, Credit Suisse's structured note DVA swung from a SFr41 million ($41.3 million) loss in the first quarter to a SFr79 million gain the following quarter, then back to a SFr99 million loss in the third quarter.

The industry viewed the DVA fluctuations of structured notes and other liabilities tied to banks' own credit as irrelevant to the underlying performance of the banks, and stripped them out of the final profit numbers. Even so, forcing the chief executive to explain away DVA gains or losses on quarterly earnings calls is unlikely to endear a structured note business to upper management.

The move by accounting standard setters to shift DVA out of P&L will therefore probably be welcomed by many structured note issuers. They can continue marking the products to market and recognising profit on day one, but the fair value changes don't cause undue earnings volatility. In fact, some banks such as Credit Suisse and Bank of America Merrill Lynch (BAML) adopted the change early.

The move by accounting standard setters to shift DVA out of P&L will probably be welcomed by many structured note issuers. They can continue marking the products to market and recognising profit on day one, but the fair value changes don’t cause undue earnings volatility

"We believe this change makes our earnings comparison more meaningful and easier to understand, therefore we adopted early," said Paul Donofrio, chief financial officer at BAML, during the bank's fourth-quarter earnings call in January.

Except, that is, for those banks that decided to hedge the DVA from their structured notes holdings with negatively correlated bonds or credit default swaps (CDSs) referencing peer institutions. While currently the two offset each other, moving the DVA out of P&L means the hedge sits alone, altering the earnings statement once again.

Dealers claim it's not a common practice, but some bankers believe it could trigger significant unwinds as the hedges are taken off. That could have a real impact in the single-name CDS market, where liquidity has already fallen dramatically in the post-crisis years.

A possible exemption has been identified for non-US banks reporting under International Financial Reporting Standards that allows the structured note DVA to remain in P&L alongside the hedges, and firms large and small are lobbying the big four auditors for this to happen - to little obvious success so far.

But for most structured note businesses, the great DVA shift will likely be met with open arms - particularly if the banks' creditworthiness starts to improve and dealers start recording DVA losses once again.