The risk of a debt default looks to be much lower than it was three months ago for Citigroup Inc., Bank of America Corp. and other large financial institutions. That is the good news.

It also is the bad news, because it means a peculiar aspect of mark-to-market accounting — the part that lets companies value certain liabilities based on their worth in the marketplace, as opposed to the amount the companies actually are on the hook for — probably worked against the big banking firms last quarter, after providing a windfall to the bottom line in the first quarter.

"When a bank's credit quality goes down, the market value of the bonds that it issues goes down, because those IOUs are worth less, and if it's worth less to you, then it's a lower liability to me," said Darrell Duffie, a finance professor at Stanford University's Graduate School of Business. "But it's a two-sided sword," meaning that as a bank's creditworthiness improves, so does the value of its IOUs and, by extension, its liabilities.

It is one of the more confusing aspects of mark-to-market accounting, made all the more complex because its use is entirely optional, and because there is no standard way of disclosing its effect on a financial statement. So-called credit-valuation adjustments, or CVAs, can be applied to bonds that a company has issued, or to derivatives trades in which its creditworthiness as a counterparty to the firm on the other side of the trade can affect the value of the contract itself.

Companies have had the option to use CVAs for the past two years, under the Financial Accounting Standards Board's FAS 159 rule. But the practice has come under increased scrutiny since last quarter, partly because investors are taking a closer look at bank accounting methods in general, and partly because this type of accounting allowed some banks to post outsized gains in the first quarter even as their financial health appeared to fade.

For example, as escalating concerns about Citi's future pumped up the risk premium, or spread, on credit-default swaps providing a protection against a bond default by the company, Citi's fixed-income markets division was able to take a net $2.5 billion CVA gain on its derivatives positions and a $30 million gain on the fair value of its liabilities. CVAs supplied an additional $383 million benefit to the firm's equity markets revenue.

Bank of America, meanwhile, recorded a $2.2 billion fair-value option gain on structured notes it inherited from Merrill Lynch, and Chief Financial Officer Joe Price disclosed on the company's first-quarter conference call that it had another $1.5 billion or so in other CVA gains across its global markets businesses. And at JPMorgan Chase & Co., revaluations of structured notes and derivatives based on changes in the company's own credit spread had a first-quarter earnings impact of more than $1 billion.

The banks' first-quarter adjustments came as the average spread on five-year credit-default swaps covering 14 major global banks widened from about 165 basis points at the start of the period to nearly 263 basis points at the end of it, according to data from Credit Derivatives Research LLC in New York. That means increasingly wary investors were willing to pay an average $263,000 to insure $10 million of bonds for five years as of March 31, up from $165,000 three months earlier.

But spreads snapped back during the second quarter, to an average 158 basis points as of June 30. The shrunken risk premium should indicate improved values for swaps and other trading positions in which valuations depend on counterparty creditworthiness. And that means that bank liabilities that got marked down based on spread levels in the first quarter will most likely get marked up, at least part of the way, based on spreads in the second quarter.

The accounting treatment, while seemingly counterintuitive, is perfectly legal. And some accounting experts argue that if companies are going to use mark-to-market accounting methods to value their assets, it makes sense for them to do the same on the liabilities side of the ledger. Not everyone agrees.

"Your debts are fixed, and the only scenario in which banks could justify marking down their debt is if theoretically they would go back into the open market and buy their bonds at a discount. But that theory doesn't apply when their capital is too low" to embark on a strategy like that, said Martin Weiss, president of Weiss Research in Jupiter, Fla. "It's fundamentally unconscionable and fundamentally incorrect to devalue or adjust for falling prices of your own bonds, when the reason your bonds are falling is precisely because you're in trouble."

Of course, the mark-to-market rules are likely to have the reverse effect this quarter. Spreads on credit derivatives offering five years of default protection on Citi's bonds, for example, got as narrow as 331 basis points on June 1, compared with their March 9 peak of 630 basis points, according to Dave Klein, a senior analyst with Credit Derivatives Research.

Analysts are certain to comb through the footnotes and supplements to banks' second-quarter financial statements for signs of CVA effects — there is no specific line item for them, though most of the big banks tend to include them in the trading results for their investment banking businesses — but the information will not make it any easier for investors or regulators to determine the overall health of the institutions.

"Decisions about these accounting matters have nothing to do with the actual solvency or economics of these firms," Duffie said. "What you need to do is look at the promises they've made to pay, not how much those promises are worth in the market."

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