Interesting article from WSJ about valuation of Crdit-default swaps…How Radian turned a profit… From WSJ “When a Loss is a Gain” “…Here is how it plays out. Say a company holds a bond and insures against the bond’s default by buying a credit-default swap from an insurer. If the bond falls 10%, the value of the swap would increase, say, by the same amount. The bond is considered riskier, so insurance on the bond is more valuable. In the past, a bondholder would have booked offsetting gains and losses as the bond fell in value and the insurance rose in value. But the new accounting rule on measuring market values says companies also have to consider how much something would fetch if sold today. If the market has doubts about the financial health of the insurer that issued the credit-default swap, that swap might not fetch the full 10% premium. While the bond it insures is riskier, the insurer that issued it is riskier, too. Maybe it could be sold for only a 5% gain. In that case, the initial 10% moves in both the bond and swap wouldn’t cancel each other out and the bondholder would record a loss of 5%. For the insurer issuing the swap, though, this works in reverse. When bonds that Radian insured fell in value, the increase in the value of the swap, or liability, would be taken as a charge. The new rule added a wrinkle – they could no longer assume that the only driver of the swap’s value was the bond it insured. Instead, the insurers had to figure in the impact of their own perceived credit-worthiness and how that would affect the swap’s value in a sale. Radian’s perceived credit-worthiness plummeted in the first quarter as billions of dollars of mortgages it insured fell in value. With Radian’s credit-worthiness in question, the value of the credit-default swaps it issued fell in value. That led to a big decline in the value it ascribed to swaps. Because the bonds it insured had been falling in value for a while, the swaps’ values had been increasing, leading to charges in previous quarters. In the first quarter, a big chunk of that was reversed. That turned a loss into profit. In theory, the logic of the new accounting approach holds up. But that doesn’t change the fact that for investors, the real-world outcome is perverse.”
I don’t understand why the world says “Liars, damn liars, and statisticians” and leaves accountants off the list. It’s not fair.
Anyway - I like the plan of recording the liability without credit risk and then setting up the “Accumulated credit unworthiness” contra account. At least we could see what was going on then.