J.P. Morgan s Response to GASB Statement No. 53, Accounting and Financial Reporting for Derivative Instruments TABLE OF CONTENTS 1. Summary...2 2. GASB53 Disclosures...4 3. What You Can Expect from J.P. Morgan...7 4. Frequently Asked Questions...7 Appendix A: GASB 53 Report Guide and Report Sample Appendix B: J.P. Morgan Derivative Descriptions This memorandum describes J.P. Morgan s response and methodology regarding GASB Statement No. 53 Accounting and Financial Reporting for Derivative Instruments J.P. Morgan Response to GASB 53 1
I. SUMMARY In June 2008, The Government Accounting Standards Board issued Statement No. 53, Accounting and Financial Reporting for Derivative Instruments. The objective of this Statement, which supersedes a number of previously adopted Statements and Technical Bulletins, is to enhance the usefulness and comparability of derivative instrument information reported by state and local governments. The new disclosure guidance applies to the annual reporting period for which a statement of financial position (e.g., balance sheet) and statement of financial performance (e.g., income statement) are presented. Some of the more significant disclosure requirements include the following: The location and fair value amounts of derivative instruments, hedged items, and related gains and losses in the balance sheet and income statement, presented in a tabular format The level of an entity's derivative activity (e.g., total notional amount of contracts outstanding at the end of the reporting period) Footnote disclosure of risks (e.g. credit, interest rate, foreign currency) associated with derivatives that could give rise to financial loss The existence and nature of credit-risk-related contingent features and the circumstances in which those features could be triggered in derivative instruments that are in a net liability position at the end of the reporting period SCOPE Derivatives in scope of the Statement are defined by GASB as a financial instrument of other contract that has all of the following characteristics: a. Settlement factors. It has (1) or more reference rates and (2) one or more notional amounts or payment provisions or both. Those terms determine the amount of the settlement and, in some cases, whether or not a settlement is required. b. Leverage. It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes to market factors. c. Net Settlement. It terms require or permit net settlement, it can readily be settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from a net settlement. 1 1 Settlement factors, leverage and net settlement are more fully defined in paragraphs 9-13 of the GASB 53 Implementation Guide. J.P. Morgan Response to GASB 53 2
Financial Instruments not included in the scope of the Statement include: 1. Normal purchases and normal sales contracts 2. Insurance contracts 3. Certain financial guarantee contracts 4. Certain contracts that are not exchange-traded 5. Loan commitments The disclosure requirements of GASB 53 distinguish between derivatives which are accounted for using hedge accounting rules and derivatives that are used for investment only. For derivative instruments designated as hedging instruments, the descriptions in the disclosure are required to distinguish between those derivative instruments designated as fair value hedges and/or cash flow hedges. The largest section of the Statement describes the general circumstances under which a derivative is considered a hedging derivative instrument, items that may be hedged and the specific methods for evaluating whether a potential hedging derivative instrument is effective. The public entities for which J.P. Morgan provides accounting services value their derivatives at fair value and recognize changes in fair value through the statement of operations; they do not qualify for hedge accounting. Accordingly, even though an entity s investments in derivatives may represent economic hedges, they are considered investment derivative instruments and are considered to be non-hedge transactions for purposes of GASB53 disclosure. The remainder of this paper, and the J.P. Morgan reporting solution, assumes that derivatives are not accounted for as hedges. EFFECTIVE DATE The requirements of Statement 53 are effective for financial statements for periods beginning after June 15, 2009. Please note that this document has been prepared for J.P. Morgan's clients for informational purposes only and is subject to change. It is not intended to provide, and should not be relied on for accounting, investment, tax or legal advice. J.P. Morgan clients should consult their own accountants, lawyers or other experts for specific advice. J.P. Morgan Response to GASB 53 3
II. GASB 53 DISCLOSURES Summary Information GASB requires governments to provide a summary of their derivative instrument activity during the reporting period and at the end of the reporting period. The information disclosed should be organized by governmental activities, business-type activities, and fiduciary funds. The information should then be divided into the following categories hedging derivative instruments and investment derivative instruments. Within each category, derivative instruments should be aggregated by type (e.g. swaps, swaptions, rate caps, futures contracts). Information in the summary should include: a. Notional amount b. Changes in fair value during the reporting period and the classification in the financial statements where those fair values are reported. c. Fair values as of the end of the reporting period and the classification in the financial statements where those fair values are reported. If derivative instrument fair values are based on other than quoted market prices, the methods and significant assumptions used to estimate those fair values should be disclosed. d. Fair values of derivative instruments reclassified from a hedging derivative instrument to an investment derivative instrument. There also should be disclosure of the deferral amount that was reported within investment revenue upon the reclassification. Disclosure of this information may be in a table, narrative form, or a combination of both. J.P. Morgan Response to GASB 53 4
GASB Illustrative Example of Summary Disclosure Additional Notes to Financials 1) Risk Disclosures For derivatives held at the end of the reporting period, governments must disclose their exposure to the following risks that could give rise to financial loss: a) Credit risk. This credit risk disclosure does not include exchange-traded derivatives. The government should include the following: i) The credit quality ratings of counterparties ii) The maximum amount of loss due to credit risk that the government would incur if the counterparties to the hedging derivative instrument failed to perform according to the terms of the contract (without regard to collateral or netting arrangements) iii) The government s policy of requiring collateral or other security to support derivatives subject to credit risk, a summary description and the aggregate amount of the collateral and information about the government s access to that collateral. J.P. Morgan Response to GASB 53 5
iv) The government s policy of entering into master netting arrangements, including a summary description and the aggregate amount of liabilities included in those arrangements. v) The aggregate fair value of hedging derivative instruments in asset positions net of collateral pledged posted by the counterparty and the effect of master netting arrangements. vi) Significant concentrations of net exposure to credit risk. b) Interest rate risk. The government should disclose this exposure consistent with the disclosures required by Statement 40, paragraphs 14 and 15. c) Foreign currency risk. The government should disclose this exposure consistent with the disclosures required by Statement 40, paragraph 17. 2) Disclosure of Existence and Nature of Contingent Features GASB 53 requires entities to disclose information about the existence and nature of credit-risk-related contingent features (e.g., a material adverse change clause or payment acceleration clause) in derivative instruments for every annual and interim reporting period in which a balance sheet is presented. These disclosures include the following: 1. The existence and nature of credit-risk-related contingent features and the circumstances in which the features could be triggered in derivative instruments that are in a net liability position at the end of the reporting period 2. The aggregate fair value amounts of derivative instruments that contain credit-risk-related contingent features that are in a net liability position at the end of the reporting period 3. The aggregate fair value of assets that are already posted as collateral at the end of the reporting period and the aggregate fair value of additional assets that would be required to be posted as collateral and/or the aggregate fair value of assets needed to settle the instrument immediately, if the contingent features were triggered The disclosure is intended to provide information about the timing and likelihood of those contingencies occurring, and the magnitude of the impact that credit-risk-related contingency features could have on an entity s financial position, results of operations, and cash flows, particularly on an entity s liquidity. Derivative instruments often contain credit-risk-related contingent features that could result in an immediate payment to the counterparty. For example, a material adverse change clause could provide the counterparty with the right to early terminate the derivative agreement. Alternatively, it could provide a basis for renegotiating the agreement if specific events occur, such as a downgrade of the entity s credit rating below investment grade. These provisions may include an obligation to post additional collateral in instances where the credit-risk contingent feature is triggered or the counterparty is provided the right to terminate the agreement early. J.P. Morgan Response to GASB 53 6
III. WHAT YOU CAN EXPECT FROM J.P. MORGAN To assist you in compiling the required summary disclosure, J.P. Morgan has created a report designed to provide complete detail-level and summary-level investment derivative information as required by the Statement. GASB 53 Report Guide Please see Appendix: GASB 53 Report Guide for a detailed overview of the report available through the J.P. Morgan ACCESS Web portal. IV. Q&A What values are disclosed in the J.P. Morgan report for each type of derivative? The summary-level reporting level reporting discloses the following: Security/Financial Instrument Type Futures Contracts Option Written/Purchased Swaps Forward Currency Contracts TBAs Disclosure Value Total Unrealized Gain-Loss Market Value Total Unrealized Gain-Loss Total Unrealized Gain-Loss Market Value Why is the Total Unrealized Gain/Loss disclosed for futures and swaps? Won t this presentation differ from other balance sheet disclosure for those assets? Based on J.P. Morgan s understanding of industry best practices, the recommended disclosure value for futures should be the total unrealized gain/loss (as opposed to unsettled variation margin) and for swaps it should also be the total unrealized gain/loss (as opposed to market value based on notional amount). J.P. Morgan clients should consult their own accountants, lawyers or other experts for specific advice. GASB 53 financial statement preparers to disregard the effect of netting agreements and collateral positions. In the development of our reporting solution, J.P. Morgan did consult with the GASB Staff and received affirmation on the values listed above that should be disclosed for the various derivative instrument types. J.P. Morgan Response to GASB 53 7
Will J.P. Morgan be able to support the additional footnote disclosures for contingent features in derivatives and counterparty credit risk? J.P. Morgan does not receive or maintain the source data required to assist clients with the disclosures of contingent features or counterparty credit risk. Clients may wish to consult their asset managers for support of this disclosure requirement. What is the expectation on the level of detail required for derivative type in the GASB53 tabular disclosure? The illustrative example provided by GASB includes derivative descriptions such as receivefixed interest rate swap, pay-fixed interest rate swaps, and forward currency forward. J.P. Morgan inquired with the GASB Staff regarding the requirement for the level of detail that should be disclosed. The Staff confirmed that the illustrative example was only a sample and was not prescriptive. Reporting entities will need to determine the level of detail to disclose that best describes their derivative holdings. J.P. Morgan will report the most detailed derivative descriptions that are maintained in the accounting system. Appendix B: Derivative Descriptions contains the complete list of descriptions that will be used in the disclosure reporting. Currency Forward Contracts will be reported at the currency level. Are currency spot contracts as well as forward contracts required to be disclosed? Based on J.P. Morgan s understanding of industry best practice and based on discussions with the GASB Staff, J.P. Morgan does not believe that spot currency contracts are required to be disclosed in GASB 53 reporting. Spot currency contracts are used primarily for trade settlement and currency repatriation and are valued at spot (traded) currency rates. Forward currency contracts are valued at interpolated forward rates and are generally used to hedge currency risk for changes in value associated with foreign holdings, payables and/or receivables. These contracts should be considered investment derivatives for purposes of GASB 53 reporting. J.P. Morgan clients should consult their own accountants, lawyers or other experts for specific advice How do I obtain access to the GASB 53 reports? Clients with access to J.P. Morgan s Views Portfolio Reporting system (available through the J.P. Morgan ACCESS SM Web portal) will receive entitlement to the GASB 53 disclosure report. If you do not have access to the system or do not have entitlement to these reports, please contact your Relationship Manager or Client Service Representative. How long after the fiscal year-end period will these reports and data for these reports be available? The reports and the data for the reports can be available as early as the business day following your fiscal-year-end accounting close. J.P. Morgan Response to GASB 53 8
GASB53 Derivative Instruments Appendix A: GASB 53 Report Guide and Report Sample Governmental Accounting Standards Board (GASB) Statement No. 53, Accounting and Financial Reporting for Derivative Instruments, requires that the fair value of derivative instruments be reported in the financial statements of state and local governments. This report supports the requirements for disclosure of the change in fair value of derivatives for the period selected and the fair value of derivatives at the selected period end date reported in the statement of financial position. Key Features Both the Detail and Summary reports include Futures, Options, Swaptions, Swaps, To-Be-Announced Securities (TBAs), and Forward Currency Contracts. Both reports exclude spot currency contracts. Spot contracts are valued at a spot rate, unlike Forward Contracts that are valued at interpolated forward rates. Spot contracts are presumed to be used for trade settlement and/or currency repatriation rather than to hedge currency risk. In the detail and summary reports, Futures, Swaps, and Forward Currency Contracts are reported at their Total Unrealized Appreciation/Depreciation (Unrealized Gain or Loss) and Options, Swaptions, and TBAs are reported at their Market Value. This reporting election is based on industry best practices. Clients should consult their own accountants, auditors or other experts for specific advice. The XLS report includes one detail and one summary reports. The detail report lists all derivatives held at the beginning of the period, held at the end of the period, or both. The summary report is designed to produce, as closely as is possible, the final disclosure-ready report which shows derivative change in fair value for the selected period and the fair value at the selected period end date. The PDF report includes one detail and one summary report. The detail report includes the following three sections per account for derivatives held at the beginning of the period, held at the end of the period, or both: 1. Futures, options, swaps, and TBAs 2. Forward currency contracts 3. Subtotals by account The summary report is designed to produce, as closely as is possible, the final disclosure-ready report which shows derivative change in fair value for the selected period and the fair value at the selected period end date. Optional Report Parameters Format: Both the Detail and Summary reports can be run to XLS or PDF format. Swaps Only: The Summary report default parameter excludes swap income from fair value. The Summary report may be run to include swap income in the fair value of the derivative. The Detail report includes swap income. The XLS summary report displays Yes or No in the Report Includes Swap Income field to indicate if the default (No excludes swap income) or the optional report parameter (Yes includes swap income) was selected. The PDF summary report displays Report Includes Swap Income if the optional report parameter was selected. Warnings Account Analysis If no Futures, Options, Swaps, TBAs are held on the account selected, the report will display the account number and a warning message No Derivatives Held on account P XXXXX. J.P. Morgan Response to GASB 53
Appendix A: GASB 53 Report Guide and Report Sample If no Forward Currency Contracts are held on the account selected, the report will display the account number and a warning message No Forward Currency Contracts Held on account P XXXXX. If neither derivatives nor forward currency contracts are held on all accounts selected, the above two warning messages will display asking the user to Please use the 'View Parameters' button to view the complete list of accounts selected. Detail Data Elements Trade Date: The date on which a transaction was executed in the marketplace. (displays for forward currency contracts only) Contractual Settlement Date: The date on which a transaction is due to settle (displays for forward currency contracts only) Memo Number: Unique JPM accounting system transaction number (displays for forward currency contracts only) Security Number: The primary security identifier Security Description / Pay Currency: A brief description of the security or name of the currency sold Pay Currency Code: ISO code for the currency sold (displays for forward currency contracts only) SharePar / Pay Amount (Local): The number of shares/par/contracts held as-of the report date or the local amount of the currency sold Begin Period Market Value (Base): The market value (in the fund s base currency) of a derivative held at the beginning of the period (displays for options, swaptions, and TBAs only) End Period Market Value (Base): The market value (in the fund s base currency) of a derivative held at the end of the period (displays for options, swaptions, and TBAs only) Change in Market Value (Base): End of period market value minus beginning period market value (displays for options, swaptions, and TBAs only) Begin Period Unrealized G/L (Base): The total unrealized gain/loss (in the fund s base currency) of a derivative or pay currency held at the beginning of the period (displays for futures, swaps, and forward currency contracts only) J.P. Morgan Response to GASB 53 Receive Currency: Name of the currency bought (displays for forward currency contracts only) Receive Currency Code: ISO code for the currency bought (displays for forward currency contracts only) Receive Currency Amount: The local amount of the currency bought Begin Period Unrealized G/L (Base) Rec Curr: The total unrealized gain/loss (in the fund s base currency) of the receive currency held at the beginning of the period (displays for forward currency contracts only) End Period Unrealized G/L (Base) Rec Curr: The total unrealized gain/loss (in the fund s base currency) of the receive currency held at the end of the period (displays for forward currency contracts only) Change in Unrealized G/L (Base) Rec Curr: End of period total unrealized gain/loss minus beginning period total unrealized gain/loss (displays for forward currency contracts only) Begin Period Accrued Swap Income (Base): The amount of accrued swap income (in the fund s base currency) of on a swap held at the beginning of the period (displays for swaps only) End Period Accrued Swap Income (Base): The amount of accrued swap income (in the fund s base currency) of on a swap held at the end of the period (displays for swaps only) Change in Accrued Swap Income (Base): End of period accrued swap income minus beginning period accrued swap income (displays for swaps only) Begin Period Acc Swap Inc + UGL (Base): Summation of Begin Period Acc Swap Inc + Swap UGL (Base) (displays for swaps only) End Period Acc Swap Inc + UGL (Base): Summation of End Period Acc Swap Inc + Swap UGL (Base) (displays for swaps only)
Appendix A: GASB 53 Report Guide and Report Sample End Period Unrealized G/L (Base): The total unrealized gain/loss (in the fund s base currency) of a derivative or pay currency held at the end of the period (displays for futures, swaps, and forward currency contracts only) Change in Unrealized G/L (Base): End of period total unrealized gain/loss minus beginning period total unrealized gain/loss (displays for futures, swaps, and forward currency contracts only) Change in Period Acc Swap Inc + UGL (Base): (End Period Acc Swap Inc + Swap UGL) minus (Begin Period Acc Swap Inc + Swap UGL). Value will be used on the summary report if the swaps only optional parameter is selected (displays for swaps only) Segment Sector Category Industry: Detailed asset classification Summary Disclosure The summary report is designed to produce, as closely as is possible,the final disclosure-ready report which shows derivative change in fair value for the selected period and the fair value at the selected period end date. It is broken out into the sections by derivative Sector: futures, options, swaps, TBAs, and forward currency contracts, then by Category (i.e. bond index futures, credit default swap, GMNA II TBA, etc). Forward currency contracts are listed by currency name (i.e. Canadian Dollar), then by pay or receive amounts. Change in Fair Value Amount This is the change in fair value for derivatives held at the beginning of the period, held at the end of the period, or both displayed in the fund s base currency. Fair Value Amount at End Date This is the fair value for derivatives held at the end of the period displayed in the fund s base currency. Notional at End Date This is the number of shares/par/contracts for derivatives held at the end of the period. Specifically: Futures Notional = Contract Number Options Notional = Contract Number Swaptions Notional = Contract Number TBAs Notional = Shares/Par Swap Notional is intentionally left blank. Swap processing in the accounting system is driven by a number of factors including the manner in which a swap is valued. These factors will determine if the swap is processed on one leg or on two legs. If the swap is processed on one leg the shares associated with the swap equal notional and the detail report can be easily used to sum the swap notional. If the swap is processed on two legs, the notional will be used on each leg of the swap. Additional report review will be necessary to sum the correct swap notional. Forward Currency Contract Notional = Local Currency Amount J.P. Morgan Response to GASB 53
GASB53 Derivative Instruments - Summary Disclosure Page 1 of 1 From: 31-Dec-2008 To: 31-Dec-2009 Institutional Accounting GASB53 Derivative Instruments Investment Derivative Instruments Futures Options Swaps To-be-announced securities (TBAs) Forwards Currency Contracts Change in Fair Value Amount (Base) Fair Value at Amount (Base) 31-Dec-2009 Notional BOND INDEX FUTURES (6,581,895) (94,278) 94 INTEREST RATE FUTURES (2,568,485) 1,936,142 919 FUTURE INTEREST RATE CALL OPTION (1,500) (1,500) (4) FUTURE INTEREST RATE PUT OPTION (4,375) (4,375) (6) INTEREST RATE CALL OPTION (1,141,697) (63,044) (48,000,000) INTEREST RATE PUT OPTION (1,044,251) (1,264,549) (85,600,000) CREDIT DEFAULT SWAPS (CDS) (1,201,526) 360,541 FORWARD RATE AGREEMENTS (FRA) 1,415,391 0 INTEREST RATE SWAPS (IRS) 28,350,136 293,110 FHLMC GOLD TBA 13,750 13,750 (2,000,000) FNMA TBA 1,994,727 249,946 (38,000,000) GNMA I TBA (208,140) 925 (1,000,000) Pay/Receive AUSTRALIAN DOLLAR Receive (66,583) 0 0 BRAZILIAN REAL Pay 14 14 (88,482) BRAZILIAN REAL Receive 317,519 (857) 0 CANADIAN DOLLAR Pay 18,692 (243) (347,259) CANADIAN DOLLAR Receive (1,298) 0 0 EURO Pay 2,551,007 853,700 (29,641,352) EURO Receive (199,227) 10,597 35,392 JAPANESE YEN Pay (17,186) 0 0 JAPANESE YEN Receive 65,474 0 0 MEXICAN PESO Pay (79,091) 0 0 POUND STERLING Pay (119,892) 64,769 (3,056,000) POUND STERLING Receive 6,546 6,251 0 SWISS FRANC Pay 204,166 0 0 SWISS FRANC Receive (4,243) 0 0 US DOLLAR Pay 0 0 (12,209,898) US DOLLAR Receive 0 0 48,705,092 D-022-579-875 22-Apr-2010 15:06:40
Appendix B: J.P. Morgan Derivative Descriptions FUTURES BOND INDEX FUTURES EQUITY INDEX FUTURES COMMODITY FUTURES INTEREST RATE FUTURES CURRENCY FUTURES OPTIONS BOND INDEX CALL OPTION EQUITY PUT OPTION BOND INDEX PUT OPTION FOREIGN CURRENCY INDEX CALL OPTION COMMODITY CALL OPTION FOREIGN CURRENCY INDEX PUT OPTION COMMODITY INDEX CALL OPTION FUTURE COMMODITY CALL OPTION COMMODITY INDEX PUT OPTION FUTURE COMMODITY PUT OPTION COMMODITY PUT OPTION FUTURE CURRENCY CALL OPTION CREDIT INDEX CALL OPTION FUTURE CURRENCY PUT OPTION CREDIT INDEX PUT OPTION FUTURE EQUITY INDEX CALL OPTION CURRENCY CALL OPTION FUTURE EQUITY INDEX PUT OPTION CURRENCY PUT OPTION FUTURE INTEREST RATE CALL OPTION EQUITY CALL OPTION FUTURE INTEREST RATE PUT OPTION EQUITY INDEX CALL OPTION INTEREST RATE CALL OPTION EQUITY INDEX PUT OPTION INTEREST RATE PUT OPTION SWAPTIONS BOND INDEX SWAPTION CURRENCY SWAPTION COMMODITY INDEX SWAPTION EQUITY INDEX SWAPTION CREDIT DEFAULT SWAPTION FOREIGN CURRENCY INDEX SWAPTION CREDIT INDEX SWAPTION INTEREST RATE SWAPTION SWAPS BOND INDEX SWAP FORWARD RATE AGREEMENTS (FRA) BOND INDEX TRS INFLATION LINKED SWAPS (ILS) COMMODITY INDEX SWAP INTEREST RATE SWAPS (IRS) COMMODITY INDEX TRS PRICE LOCK SWAPS (PLS) CONSTANT MATURITY SWAPS (CMS) SPREAD LOCK SWAPS (SPS) CREDIT DEFAULT SWAPS (CDS) VARIABLE RATE SWAP (VRS) CREDIT INDEX SWAP VARIANCE COMMODITY INDEX SWAP CREDIT INDEX TRS VARIANCE EQUITY INDEX SWAP CURRENCY SWAPS (CS) VARIANCE BOND INDEX SWAP EQUITY DEFAULT SWAPS (EDS) VARIANCE FORWARD CURRENCY SWAP EQUITY INDEX SWAP VOLATILITY COMMODITY INDEX SWAP EQUITY INDEX TRS VOLATILITY EQUITY INDEX SWAP EQUITY SWAPS (ES) VOLATILITY BOND INDEX SWAP FOREIGN CURRENCY INDEX SWAP VOLATLITY FORWARD CURRENCY SWAP FOREIGN CURRENCY INDEX TRS ZERO COUPON SWAPS (ZCS) TBAs FNMA TBA GNMA TBA FNMA TBA ARM GNMA I TBA FHLMC GOLD TBA GNMA I TBA ARM FHLMC GOLD TBA ARM GNMA II TBA FHLMC TBA GNMA II TBA ARM FHLMC TBA ARM J.P. Morgan Response to GASB 53