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Credit Suisse Q1FY12: Why Bank Published Profits are totally Useless

April 26, 2012

At the risk of boring you dear readers, we state for the zillionth time, big bank published results are useless if you don’t look at the caveats and subjunctives behind the published numbers .  That is predominantly because of the way the banks value illiquid securities and derivative contracts.

Sample the following paragraphs from Credit Suisse’s 1Q2012 results:

Our results are impacted by the risk of counterparty defaults and the potential for changes in counterparty credit spreads related to our derivative trading activities. In 1Q12, we entered into the 2011 Partner Asset Facility transaction (PAF2 transaction) to hedge the counterparty credit risk of a referenced portfolio of derivatives and their credit spread volatility. The hedge covers approximately USD 12 billion notional amount of expected positive exposure from our counterparties, and is addressed in three layers: (i) first loss (USD 0.5 billion), (ii) mezzanine (USD 0.8 billion) and (iii) senior (USD 11 billion). The first loss element is retained by us and actively managed through normal credit procedures. The mezzanine layer was hedged by transferring the risk of default and counterparty credit spread movements to eligible employees in the form of PAF2 awards, as part of their deferred compensation granted in the annual compensation process.

We have purchased protection on the senior layer to hedge against the potential for future counterparty credit spread volatility. This was executed through a CDS, accounted for at fair value, with a third-party entity. We also have a credit support facility with this entity that requires us to provide funding to it in certain circumstances. Under the facility, we may be required to fund payments or costs related to amounts due by the entity under the CDS, and any funded amount may be settled by the assignment of the rights and obligations of the CDS to us. The credit support facility is accounted for on an accrual basis. The transaction overall is a four-year transaction, but can be extended to nine years. We have the right to terminate the third-party transaction for certain reasons, including certain regulatory developments.

 In plain English, in the second paragraph, Credit Suisse is stating that it had entered into a hedging transaction with a counterparty, but will fund the counterparty should it encounter losses on the transaction.  If this is the definition of hedging in the year of the Lord 2012, God help the creditors and shareholders of the big banks.  And this is just one of the thousands of transactions these institutions  indulge in to mislead investors.  It fortifies the silliness of bank stocks jumping up on the back  of a quarterly “earnings beat”.

Little wonder that long-term investors, such as the Singapore government on the UBS share purchase transaction of 2008, pay a very heavy price for failing to do a thorough investment appraisal before taking the plunge.


From → Credit Analysis

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