With the recent financial turmoil of 2009 (which I hope is behind us), a new regulatory fad that has caught on in wall street is the CVA or Credit valuation adjustment. If you are not a financial junkie and a main streeter - which in otherwords means a good person :), CVA is just a fancy term to recongnize the fact that whatever assets (of the financial kind, that cannot be touched, felt or used for personal gratification outside of adrenalin kicks and missed hearbeats as it goes up and down in value) you own is worth anything only if the party that you purchased it from is going to honor its committment to pay. Hence the asset value should be reflected on the books at a discount to its current market value to reflect the fact that when the moment of truth arrives and your payment is due the other party ain't broke. Now all this seems like a step in the right direction.
However the funny part is that increasingly the same principle is being applied to liabilities as well. The rationale being offered is that if I owe you something and I know I am going broke - well, I probably don't owe you anything. This is being touted as bi-directional CVA. I believe this is just egregious to say the least and another shenanigan that's almost surely goign to land us in trouble and feed into an accounting P&L bubble. For the uninitiated, asset price changes over a year less liability price changes over a year = P&L for that year. If liabilities decrease, your P&L will increase. However using the fact that you may go broke and not honor your commitments to increase your P&L is just plain wrong (ethically and otherwise) as it challenges the viability of the firm as a "going concern".
Now there is an element of truth to the fact that there is a good chance that you may go broke before the other party does, in which case the other party's default has little or no consequence to you. My take on this is that, this fact can be reflected by adding a small premium to the discounting effects of the CVA adjustments to the assets only (not liabilities) by using a CVA adjustment based on a conditional probability of default. ie. counterparty probability of default conditioned on your survival. This will be identical to the implied default probabilities reflected in credit default swap spreads, where a third party purchases a credit default swap (CDS) from you where you are the protection seller and the issuer is your counterpart from whom you have purchased assets (This is a theoretical equivalence). The liabilities, I opine, should be valued at their full price.
This is a much more realistic and conservative approach than the one that is currently being touted. Some might argue that you can hedge away your liability risk - which might let one think there is some credence to the claim of bi-directional CVA. However this is, as many risk practitioners know, a moral hazard. Think of this as buying a put option on your liabilities. No sane counterpart should or would allow you to hedge away your liability risk.
Hope the SEC is watching ...
