Accounting for Interest Rate Derivatives FAS ASC 815

Transcription

1 Accounting for Interest Rate Derivatives FAS ASC 815 Presented by Wilary Winn Douglas Winn, President September 27,

2 Douglas Winn President Today s Presenter Mr. Winn co-founded Wilary Winn in the summer of 2003 and his primary responsibility is to set the firm's strategic direction. Mr. Winn is a nationally recognized expert in financial institution accounting and regulatory reporting and has led seminars on the subject for many of the country's largest public accounting firms, the AICPA, the FDIC, and the NCUA. Mr. Winn began his career as a practicing CPA for Arthur Young & Company now Ernst & Young. Mr. Winn co-founded Wilary Winn in the summer of 2003 and his primary responsibility is to set the firm's strategic 2 direction.

3 Topics Covered Accounting for a long-term swap designed to hedge against rising rates on rollovers of FHLB advances Economic purpose Example of cash flow hedge using the change in variable cash flows method Practical application of the hedging rules 3

4 Other Items to Consider Derivatives are complex and volatile Permitted use is therefore limited including quantitative tests Must be considered in the context of ALM profile and risks Proper ALM software Consider alternatives o Floating rate assets o Longer duration liabilities Not all credit unions are eligible Federal over $250 mm in total assets, CAMEL 3 or better (2 or better management) 4

5 Other Items to Consider Only a few types are permitted vanilla Interest rate swaps, caps and floors, basis swaps, treasury note futures Exchange traded versus over the counter Requires prior regulatory approval Need to consider counterparties, collateral and margining Requires policies, internal controls and qualified personnel Audited financials 2 years of internal controls testing 5

6 1. Fair value hedge Two Types of Hedge Accounting Change in fair value of the hedging instrument runs through the income statement, along with the change in the fair value of the item being hedged used for existing financial assets and liabilities 2. Cash flow hedge Effective portion of the hedge is reported in Other Comprehensive Income, while the ineffective portion is reported in current earnings used for forecasted transactions or variable payments on existing financial assets and liabilities 6

7 Formal Designation and Documentation Required at Inception The CU s objective and strategy for the hedge must include ( b 2): The hedging instrument the derivative interest rate swap The hedged item or transaction the asset or liability being hedged the risk of increasing interest rates on FHLB advances The nature of the risk being hedged interest rate risk The method that will be used to retrospectively and prospectively measure the hedge s effectiveness 7

8 The method that will be used to measure hedge ineffectiveness Benchmark interest rate being hedged eligible benchmark rates ( A): Treasury rates Federal funds effective swap rate LIBOR In addition, for cash flow hedges the following information about forecasted transactions must be provided: Date on which transaction will occur Specific nature of asset or liability Quantity of the forecasted transaction 8

9 To qualify for hedge accounting, the hedging relationship (both at inception of the hedge and on an ongoing basis), shall be expected to be highly effective in offsetting cash flows attributable to the hedged risk during the term of the hedge - a cash flow hedge ( ) 9

10 Hedge Effectiveness Can be Measured in Two Ways: 1. Dollar-offset approach ( a) Compares changes in fair value or cash flow of the hedged item and the derivative Can be applied period by period (cannot be less than 3 months) or cumulatively Most believe a dollar offset range of 80%-125% would be considered highly effective 2. Statistical methodologies May permit a CU to continue to use hedge accounting for the current period even though the dollar-offset approach appears ineffective Complex to implement and requires multiple observation periods 10

11 Statistical Approaches Regression Analysis Minimum of 30 observations Must consider changes in the value of the derivative and the hedged item Time horizon must coincide or be less than the time horizon of the hedge relationship Must consider whether to regress value changes or value levels Must review distribution of error terms EY Derivatives and Hedging, October

12 Statistical Approaches Regression Analysis Continued R-squared result must exceed a pre-specified level (e.g. 0.80) Hedge relationship must correspond to beta (the slope of the regression line) Standard error must be used to calculate the reliability using the t statistic T-test must be passed at a 95% confidence level Must consider y-intercept Must compare results to dollar offset results EY Derivatives and Hedging, October

13 R-squared Analysis Hedged item floating dividend rate on money market shares 1 Mo LIBOR Line Fit Plot Dividend Rate Div. Rate Predicted Div. Rate Mo LIBOR 13

14 A credit union shall consider hedge effectiveness in two different ways: 1. Prospective Considerations 2. Retrospective Evaluations 14

15 Prospective Considerations ( a) Can be based on regression or other statistical analysis of past changes in fair values or cash flows as well as on other relevant information Shall consider all reasonably possible changes in fair value (if a fair value hedge) or in fair value or cash flows (if a cash flow hedge) of the derivative instrument and the hedged items for the period used to assess whether the requirement for expectation of highly effective offset is satisfied Not be limited only to the likely or expected changes in fair value (if a fair value hedge) or in fair value or cash flow (if a cash flow hedge) Generally involves a probability-weighted analysis consistent with FASB Concepts Statement No. 7 15

16 Retrospective Considerations ( a) An assessment of effectiveness shall be performed whenever financial statements or earnings are reported, and at least every three months Can be based on dollar offset or statistical approaches Dollar-offset measurement can be for period or cumulative Statistical methods must be similar period to period (e.g. same number of data points) 16

17 Entities can assume no ineffectiveness in an interest rate swap in two instances: 1. A private company that enters into a pay fixed, receive floating interest rate swap (this exemption does not apply to credit unions) ( B) 2. A swap can be examined to determine if it can be accounted for under the Short-Cut Method (this applies to all companies, including financial institutions) 17

18 To conclude no hedge ineffectiveness in a hedge with an interest rate swap, all of the following conditions must be met for both fair value and cash flow hedges ( ): a. Notional amount of swap matches principal amount of item being hedged b. Fair value of the swap is zero at inception (can ignore bid/ask spread, commissions and other transaction costs) c. Formula for computing net settlements remains the same throughout the swap i. Fixed rate remains the same ii. Variable rate index does not change d. Interest bearing asset or liability is not pre-payable i. Unless the prepayment is due to an embedded call (put) option and the swap has a mirror option call (put) option - options must match exactly ii. Because the NCUA does not allow a credit union to enter into a swap with this feature, we believe a swap involving loans that can be prepaid will not qualify for the short-cut method e. Index on which the variable rate leg is based matches the benchmark interest rate designated as the interest rate being hedged Note: For the purposed of determining zero: can ignore bid/ask spread at inception, commissions, and other transaction costs 18

19 WW Risk Management does not recommend the short-cut method, because if you fail, you cannot reassess Another alternative generally used for cash flow hedges is the critical terms match notional amount, interest rate, and maturity We recommend that a credit union account for the swap using the long-haul method, recognizing that swaps that would qualify for the short-cut or critical terms method will easily pass the effectiveness testing 19

20 What if the Hedge is Not or No Longer Effective? The hedge accounting is discontinued prospectively, resulting in potential income statement volatility as the derivative is marked to market with no offset to the hedged item (cash flow hedge ) Cash flow hedge - the net gain or loss remains in AOCI unless it is probable that the forecasted transaction will not occur by the end of the originally specified time period plus a 2 month extension ( ) 20

21 A credit union may designate a derivative instrument as hedging the exposure to variability in expected future cash flows that is attributable to a particular risk. That exposure may be associated with either of the following ( ): Payments on an existing recognized asset or liability (such as all or certain future interest payments on variable-rate debt or variable rate liabilities FHLB advance) A forecasted transaction (such as a forecasted purchase or sale) 21

22 A forecasted transaction is eligible for designation as a hedged transaction in a cash flow hedge if all of the following criteria are met ( ): A forecasted transaction is specifically identified as either: a. A single transaction b. A group of individual transactions that share the same risk exposure for which they are designated as being hedged. A forecasted purchase and a forecasted sale shall not both be included in the same group of individual transactions that constitute the hedged transaction. 22

23 The occurrence of the forecasted transaction is probable The forecasted transactions meets both of the following conditions: o It is a transaction with a party external to the reporting entity o It presents an exposure to variations in cash flows for the hedged risk that could affect reported earnings The forecasted transaction is not the acquisition of an asset or incurrence of a liability that will subsequently be re-measured with changes in fair value attributable to the hedged risk reported currently in earnings If the forecasted transaction relates to a recognized asset or liability, the asset or liability is not re-measured with changes in fair value attributable to the hedged risk reported currently in earnings 23

24 If the hedged transaction is the variable cash inflow or outflow of an existing financial asset or liability, the designated risk being hedged is any of the following: o The risk of overall changes in the hedged cash flows related to the asset or liability, such as those relating to all changes in the purchase price or sales price o The risk of changes in its cash flows attributable to changes in the designated benchmark interest rate (referred to as interest rate risk) o The risk of changes in its cash flows attributable to all of the following (referred to as credit risk): i. Default ii. Changes in the obligor s creditworthiness iii. Changes in the spread over the benchmark interest rate with respect to the related financial asset s or liability s credit sector at inception of the hedge. 24

25 Hedge Ineffectiveness for Income Statement is Measured by the Dollar-offset Method Cash Flow Hedge: Ineffectiveness must be separately measured and recorded on the income statement. If the fair value of the derivative changes by more than the present value of hedged cash flows, the difference is the ineffective amount. If the fair value of the hedged cash flows changes by more than the change in the fair value of the derivative then no ineffectiveness and no journal entry is necessary ( c) 25

26 Ineffectiveness testing for a cash flow hedge involving an interest rate swap can be done using one of three methods: Change in variable cash flows method ( through 24) Hypothetical derivative method ( through 30) Change in fair value method ( through 32) 26

27 Non-performance Risk for Cash Flow Hedges Using Interest Rate Swaps The discount rate used for the change in variable cash flows method and the hypothetical derivative method is the rate applicable to determining the fair value of the swap ( ).This means that the non-performance risk of the swap counterparty would be applied to the swap and the hedged item cash flows so it would not in itself result in effectiveness. Issue arises if default of counterparty is probable Non-performance risk can result in effectiveness using the change in fair value method ( ) 27

28 Accounting for cash flows AOCI reclassified into earnings in the same period in which the forecasted transaction affects earnings 28

29 Hedge Accounting Examples Rollover of FHLB Advances Hypothetical derivatives Change in variable cash flows 29

30 Economic Example and Summary of Terms FHLB Pricing 4 year swap rate = 1.41% 4 year FHLB advance rate = 1.70% 1 year FHLB advance rate = 3 month LIBOR + 7 basis points Alternative 1: 4 year FHLB advance 1.70% Alternative 2: 1 year LIBOR based advance & 4 year interest rate swap which results in a fixed rate of 1.48% Benefit: 22 basis points a year for 4 years assuming annual renewal of spread to LIBOR remains constant 30

31 Critical Terms Notional amount of the swap and FHLB advance match at $50 MM Fixed rate on the swap is the same throughout the term and the variable rate equals LIBOR Index on the swap s variable interest rate leg matches the benchmark interest rate designated as the risk being hedged (three month LIBOR) No interest payments beyond the term of the swap are designated as hedged Swap and borrowings re-price on the same day FHLB advance contains a floor and the swap does not include a cap Determination that the it is probable that the swap counterparty will not default on its obligations 31

32 Example 4 year swap with 3 years remaining A $50 MM 4-year pay fixed, receive floating interest rate swap is used to hedge against the risk of increase in interest rate related cash flows on rollovers of a credit union s FHLB advances. Fair Value of the Swap Fair Value of the FHLB Advance (hypothetical derivative) Pay Receive Net Present Pay Receive Net Present Qtr Days Fixed Floating Payments Value Qtr Days Fixed Floating Payments Value 5 90 (178,208) 105,338 (72,871) (72,717) ,208 (105,338) 72,871 72, (176,250) 120,695 (55,555) (55,304) ,250 (120,695) 55,555 55, (180,167) 125,352 (54,814) (54,430) ,167 (125,352) 54,814 54, (180,167) 130,635 (49,532) (49,057) ,167 (130,635) 49,532 49, (178,208) 134,130 (44,078) (43,539) ,208 (134,130) 44,078 43, (176,250) 137,791 (38,459) (37,884) ,250 (137,791) 38,459 37, (180,167) 145,296 (34,871) (34,250) ,167 (145,296) 34,871 34, (180,167) 150,089 (30,077) (29,453) ,167 (150,089) 30,077 29, (178,208) 148,489 (29,720) (29,017) ,208 (148,489) 29,720 29, (176,250) 150,329 (25,921) (25,232) ,250 (150,329) 25,921 25, (180,167) 157,414 (22,752) (22,078) ,167 (157,414) 22,752 22, (178,208) 159,384 (18,824) (18,234) ,208 (159,384) 18,824 18,234 Total (2,142,417) 1,664,941 (477,475) (471,193) Total 32 2,142,417 (1,664,941) 477, ,193

33 Example 4 year swap with 3 years remaining A $50 MM 4-year pay fixed, receive floating interest rate swap is used to hedge against the risk of increase in interest rate related cash flows on rollovers of a credit union s FHLB advances. Fair value of the interest rate swap Fixed leg Gross cash flow (2,142,417) Discounted cash flow (2,106,437) Variable leg Gross cash flow 1,664,941 Discounted cash flow 1,635,244 Swap fair value (471,193) Fair value of the FHLB advance (hypothetical derivative) Fixed leg Gross cash flow 2,142,417 Discounted cash flow 2,106,437 Variable leg Gross cash flow (1,664,941) Discounted cash flow (1,635,244) Swap fair value 471,193 Effectiveness 100% 33

34 Credit Union Must Perform Effectiveness Testing Effectiveness testing will be based on the changes in LIBOR only as a benchmark interest rate Ineffectiveness will measured using the change in variable cash flows method 34

35 Hedge Ineffectiveness is Based on a Comparison of: Variable leg of the interest rate swap Hedged variable-rate cash flows on FHLB advance Based on the premise that only the floating-rate component of the interest rate swap provides the cash flow hedge The interest rate swap is recorded at fair value on the balance sheet. The calculation of ineffectiveness involves a comparison of the following amounts: o The present value of the cumulative change in the expected future cash flows on the variable leg of the interest rate swap o The present value of the cumulative change in the expected future interest cash flows on the FHLB advances 35

36 Hedge ineffectiveness results when the present value of the cumulative cash flows on the swap exceed the present value of the cumulative cash flows of the designated FHLB advances. Conversely, there is no ineffectiveness if the PV of the designated FHLB advances exceed the PV of the swap (FAS ASC (b)) 36

37 A $50 MM 4-year pay fixed, receive floating interest rate swap was entered into on August 31, Fair Value of the Swap Pay Receive Net Present Qtr Days Fixed Floating Payments Value 5 90 (178,208) 105,338 (72,871) (72,717) 6 88 (176,250) 120,695 (55,555) (55,304) 7 90 (180,167) 125,352 (54,814) (54,430) 8 90 (180,167) 130,635 (49,532) (49,057) 9 90 (178,208) 134,130 (44,078) (43,539) (176,250) 137,791 (38,459) (37,884) (180,167) 145,296 (34,871) (34,250) (180,167) 150,089 (30,077) (29,453) (178,208) 148,489 (29,720) (29,017) (176,250) 150,329 (25,921) (25,232) (180,167) 157,414 (22,752) (22,078) (178,208) 159,384 (18,824) (18,234) Total (2,142,417) 1,664,941 (477,475) (471,193) At inception hedge value is $0. LIBOR rates have decreased since inception. Value is as of August 31,

38 A $50 MM 4-year pay fixed, receive floating interest rate swap was entered into on August 31, Change in Cash Flows on the Variable Leg of the Swap Change in Cash Flows on the Hedged Item Projected Updated Increase Discount Present Projected Updated Increase Discount Present at Inception Projection (Decrease) Factor Value at Inception Projection (Decrease) Factor Value 117, ,338 (11,992) (11,967) 114, ,449 (8,381) (8,364) 139, ,695 (18,381) (18,298) 135, ,806 (14,603) (14,537) 161, ,352 (36,213) (35,959) 156, ,363 (31,202) (30,983) 181, ,635 (50,887) (50,398) 177, ,746 (46,026) (45,584) 194, ,130 (60,718) (59,974) 188, ,241 (54,357) (53,691) 207, ,791 (70,158) (69,109) 204, ,824 (66,459) (65,464) 230, ,296 (85,445) (83,923) 225, ,407 (79,334) (77,921) 248, ,089 (98,654) (96,607) 242, ,200 (92,293) (90,378) 250, ,489 (102,058) (99,643) 246, ,500 (98,297) (95,971) 258, ,329 (108,473) (105,589) 250, ,440 (98,806) (96,180) 279, ,414 (121,949) (118,335) 276, ,636 (119,227) (115,694) 293, ,384 (134,464) (130,064) 291, ,406 (131,942) (127,624) 2,564,332 1,664,941 (887,399) (879,866) 2,510,944 1,670,017 (832,545) (822,391) $822,391 is the effective portion of the hedge. $57,475 is ineffective. 38

39 Record Fair Value of the Swap and the Ineffective Portion OCI $ 413,718 Interest Expense $ 57,475 Derivative Liability $ 471,193 39

40 Benchmark interest rate Summary of Changes* Cash flow hedge variable rate financial instruments any contractually specified rate Fair value hedge of fixed rate interest rate risk SIFMA added Fair value hedges of interest rate risk Permits partial term hedges Can consider how changes in benchmark interest rates affect the decision to prepay a pre-payable financial instrument Permits the change in fair value to be based on a benchmark interest rate vs. full contractual cash flows permitted only when the market yield exceeds benchmark interest rate Critical terms match Forecasted transactions and hedge maturity within 31 days * Exposure draft issued September 8 th comments due November 22 nd 40

41 Hedge Ineffectiveness No longer separately measured and reported Effectiveness Assessments Quantitative continues to be required at inception Qualitative testing thereafter unless a change in the hedging relationship In failure of shortcut method can move to long haul Designation Documentation Quantitative testing can be completed at the end of the quarter rather than at inception Disclosure Changes References to ineffectiveness discontinued Additional disclosure required 41

42 For those considering the use of interest rate derivatives we can: Identify the optimal derivative(s) to be used given your credit union's ALM profile Work with you to amend your ALM policies to allow for the use of derivatives Work with you to draft derivatives policies and procedures that ensure you have the proper internal controls in place and that you meet all of the NCUA requirements regarding the use of derivatives Provide estimates of ongoing fair value for loans, investments, and liabilities which you have elected to account for at fair value. We can also help you with the initial selection of the items 42

43 For those electing hedge accounting we can: Develop the appropriate interest rate hedge and hedging item(s) to be used given your credit union's ALM profile Work with you to identify the item(s) to be hedged and the nature of the risk being hedged Ensure you are able to achieve hedge accounting - including prospective and retrospective effectiveness testing on a dollar offset or statistical basis Provide you with the journal entries needed to report hedging activities 43

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45 Asset Liability Management, Capital Stress Testing, Concentration Risk Analyses, and CECL Matt Erickson Mergers and Acquisitions, ASC , Goodwill Impairment Testing, and TDRs: Brenda Lidke Servicing Rights and Mortgage Banking Derivatives: Eric Nokken Non-agency MBS: Amin Mohomed 45

46 Contact Information Wilary Winn LLC First National Bank Building 332 Minnesota Street, Suite 1750W Saint Paul, MN