How CITI made money shorting itself

Interesting article from Daily Reckoning:

But something magic happened in the fixed income trading group for Citi. This is pure gold if you like arcane financial statements packed with fictional earnings. If you dig into the quarterly report, you'll learn than fixed income trading revenues were boosted by a "net $2.5 billion positive CVA on derivative positions, excluding monoclines, mainly due to the widening of Citi's CDS spread.

That takes some sorting out. A CVA is a "credit value adjustment." As you can learn here, it's the credit risk premium of a derivative contract. Once you sort it out, you learn that Citi "made" $2.5 billion on a derivatives position designed to profit when the companies own credit default swaps spreads widen.

Or, in plain English, Citi profited because it made a bet that the cost of insuring itself against a default would go up. The credit default swap market is the place where you can bet on the credit worthiness of a firm, or, essentially, the chance that a firm might default on its bonds. Citi appears to have reported a $2.5 billion trading gain in the fourth quarter precisely because the market thought the company stood a good chance of failing (hence the widening CDS spread).

As far as we can tell, if you use this kind of perverted logic, the closer Citi gets to bankruptcy, the more money it would "make" on its derivatives. That shows you how bogus the quarterly number was. The company reported declining revenues in its core banking and lending activities. But thanks to fixed income and this handy $2.5 billion CVA, the company was able to report $1.5 billion in net income.

Also, don't forget that all of the banks benefitted from what financial sector analyst Meredith Whitney called "back door financing." Whitney described what amounts to Fed-sanctioned front-running of the fixed income market by the banks. The Fed publicly telegraphed its intention to buy $750 billion mortgage backed securities from Fannie Mae and Freddie Mac and $300 billion in U.S. Treasury bonds. And that was AFTER it announced in late November of last year it would be wading in as a buyer for all agency bonds to support the U.S. mortgage market.

Since the financial statements of the banks don't break trading revenues out a line item basis, it's hard to say how much money each bank may have made by front running the Fed's actions in the bond market. And of course, there was nothing really illegal about it that we can gather.

But from the looks of it, what we have here is a kind of back door subsidy to bank profitability provided by the Fed. First quarter earnings were strongly boosted by an increase in the valuations of mortgage backed securities that went up with Fed buying. Before you get all excited about the recovery in financial stocks, you may want to keep that in mind.