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Funny Money

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by Ryan Avent
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Apr 22 2009 11:00am EDT

Funny Money

Remember how Citigroup booked a $2.5 billion gain because its CDS spreads deteriorated? That is, the sole reason Citi turned a profit was because people thought it was more likely to default? Here, let me let one of Justin Fox's commenters explain:

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.
Neat, right? Well, the same trick wound up biting Morgan Stanley in the earnings report. Because its CDS spreads tightened, indicating that the firm was a better risk, it ended up booking a quarterly loss. Isn't finance fun?

Also, Morgan Stanley had an orphan month.

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