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Citigroup (NYSE:C) crushed earnings expectations earlier today with reported earnings of $1.23/share on $20.8 billion of revenue, way above expectations. At a casual glance, these numbers look pretty good. Today’s release suggests that maybe things aren’t as bad at Citi as one might think, and that perhaps the market is panicking too soon on the company.

But what's driving the crazy earnings numbers? Head over to the actual earnings release on Yahoo Finance and start reading.

The first paragraph should be pretty easy to understand. The firm’s earnings were $1.23 per share, 74% higher than Q3 last year and 13% above the second quarter. Got it. Now move on to the second paragraph.

“Third quarter revenues included $1.9 billion of credit valuation adjustment (CVA) reflecting the widening of Citi’s credit spreads during the third quarter. Excluding CVA, third quarter 2011 revenues were $18.9 billion, 8% below the prior year period and 8% below the second quarter 2011. CVA increased reported third quarter earnings by $0.39 per share. “

So $0.39/share of the $1.23 per share and most of the revenue gains came from credit valuation adjustment, a term most people (myself included), aren’t familiar with. Yet, it’s a term that has been popping up in a lot of financial earnings statements lately, notably that of J.P. Morgan (NYSE:JPM) last week.

So what is credit valuation adjustment? Simply put, a credit valuation adjustment is a way to put a number on the risk of a loss due to counterparty risk, the risk that the other guy won’t make good on his bet. If you bet against untrustworthy people, you might win the bet, but if the other guy doesn’t make good on his end you can still lose money. Institutions calculate CVA when they trade to account for the risk that another institution that makes too many bad bets might go bankrupt and not fully pay out.

The basic concept of the equation for CVA is this:

CVA = Discount Expected Exposure x Default Probability x Loss in Event of a Default

The equation gets much more complicated when additional risks and time factors are added in, but at its core the three main factors are the amount of money at stake, the likelihood of a default, and how much of the money would be lost in the event of a default. When the likelihood of default increases (usually measured by the spread of credit default swaps on a company’s bonds), the credit value adjustment increases. Modern accounting practice allows a company to book changes in CVA as current revenues.

We’ve established that CVA is a method for determining risk on a trade, but how do you record income from it?

The answer is a complicated and somewhat controversial method of institutions estimating their own risk of default, then hedging against their own default, as well as the default of their counterparties. In effect, the bank is making bets against its own survival. When the survival of the bank becomes less likely, those bets on its own default actually increase in value. When bets against the survival of the whole banking industry gain value, the bank books a pretty gain from CVA. It is likely that at least some of the $1.9 billion Citi made this quarter from CVA came from the increased risk that it, and other financial institutions, will go bankrupt.

1YR chart of Citi 5YR CDS. Chart sourced from bloomberg.com
J.P. Morgan (JPM) reported a similar $1.9 billion gain in DVA (the hedging side of CVA) in its earnings statement last week, but added a caveat, “The DVA gain reflects an adjustment for the widening of the Firm's credit spreads which could reverse in future periods and does not relate to the underlying operations of the company.” In short, these gains, which are perfectly legal, might be distorting the current earnings picture. Would anyone like to bet that Goldman Sachs (NYSE:GS) will also have its earnings inflated by CVA when it reports?

I find that one of the fundamental rules for surviving in the investing world is stepping back and using common sense. When a significant portion of a company’s revenue is derived from an increased risk of the company going out of business, it might be time to reconsider what kind of value that company represents to the common shareholder. Before investing in any of the major financial institutions, be sure to look at the fundamentals underlying the company, not just the latest flashy earnings release. But, as always, don’t take my word for it, do your own research and see what you come up with.

I wrote this article to present the results of my limited research into CVA in terms that can be understood by the average investor. I understand that the financial system is much more intricate than described here, if you have any insight to add you are more than welcome to do so. I am by no means a financial expert, so please do not take my writing as a recommendation to trade any equities listed. I welcome everyone’s insight into unraveling the complex financial instruments at play.

Source: Here's How The Banks Are Crushing Earnings Estimates