The Fair Value Option: Practitioners Views IACPM General Meeting Swiss Re Centre for Global Dialogue Zurich, Switzerland June 15, 2007
IAS Fair Value Option IAS 39, which details the fair value option, became effective January 1, 2005. At the insistence of bank regulators, IAS 39 was amended in June 2005 to add FVO eligibility criteria. The FVO may be applied if either: a) It eliminates or significantly reduces an accounting mismatch or b) The fair valued instruments are managed on and performance measured on a fair value basis according to a documented strategy. The FVO must be adopted at the origination date of the instrument and the entire instrument (as opposed to a pro-rata portion) must be fair valued. Once adopted, the decision to use the FVO is irrevocable. 2
IAS Fair Value Option - Disclosure Must disclose the amount that any offsetting credit derivatives mitigate exposure of FV assets to credit risk and the change in fair value of those credit derivatives. Must disclose the amount of change in Fair Value of assets that is due to credit risk (as opposed to market risk) and the method used to determine this. 3
FAS Fair Value Option FAS 159, which details the US Fair Value option, was published in February 2007. It is effective for fiscal years beginning after Nov. 15, 2007 but it may be early adopted. Unlike IAS 39, there are no eligibility criteria. Like IAS 39, the FVO must be adopted at origination of the instrument and the entire instrument must be fair valued. Once adopted, the decision to use the FVO is irrevocable. FAS 159 is intended to be an interim step until FASB addresses Fair Value accounting for all financial instruments comprehensively. 4
FAS Fair Value Option - Disclosure Must disclose management reasons for adopting FVO. Must disclose why any similar items are not fair valued. Must disclose information (specifically about non-performing loans) that would have been reported had the FVO not been used. Annually, must disclose methods and significant assumptions used to estimate fair values. 5
Using IAS39-FVO to Reduce the Accounting Mismatch in Credit Portfolio Management Gene D. Guill IACPM General Meeting Swiss Re Centre for Global Dialogue Zurich, Switzerland June 14-15, 2007
Loan Exposure Mgt. Group (LEMG): Fair value book To eliminate or significantly reduce an accounting mismatch LEMG selected condition #2 to set up the fair value loan book proposal was approved by the DB Group Finance Committee in December 2005 Between Q2 of 2003 and Q4 of 2004, LEMG recorded PnL gains/losses between + 40.3n and - 117.0mn from the use of derivatives to hedge the loan portfolio Gains/Losses from Derivatives to Hedge Loans/Commitments ( millions) Millions of Euro 60.0 40.0 20.0 0.0 (20.0) (40.0) (60.0) (80.0) (100.0) (120.0) (140.0) 1Q-02 2Q 3Q 4Q 1Q-03 2Q 3Q 4Q 1Q-04 2Q 3Q 4Q 1Q-05 2Q 3Q 4Q 1Q- 2Q 3Q 4Q M-t-M gains/losses plus premiums paid 7
LEMG fair value book: Day-one assignment LEMG set up a fair value loan book on January 1, 20 to establish starting balances as of January 1, 2007 Loans were selected for the fair value book based on credit spread sensitivity to minimize PnL volatility associated with the accounting mismatch Credit spread sensitivity was measured with Relative (Credit) Spread Tightening RST = Change in the fair value of a position, or book of positions, given a one percent increase in credit spreads * RST provides a reasonable approximation of systematic changes in credit spreads over a credit cycle for entities with different absolute spread levels Example: IBM 5 year CDS spread = 18 bps > RST = 18 *1.01 = 18.18 bps GM 5 year CDS spread = 405 bps > RST = 405 *1.01 = 409.05 bps For a 100mn CDS position with a 5 year maturity, the RST sensitivities are: 1 Basis Point RST IBM 39,401 7,8 GM 35,033 141,908 * Credit spreads are the primary variables that impact valuation of CDS and loans/commitments 8
LEMG fair value book: Day-one assignment Under a portfolio interpretation of the accounting mismatch, the notional size of the fair value loan book is determined by the notional size and sensitivity of the derivative hedge book Total CDS Portfolio FV Book FV Book Total Loan Portfolio Derivative Hedges Against Loans XX.Xbn RST of FV Loans - x.xxmn RST of Derivative Hedges + x.xxmn Fair Value Loans XX.Xbn Historical Cost Loans RST Off-set 100.0% 9
LEMG fair value book: Day-two and beyond New loans are reviewed at origination; selections for the fair value book based on the same criteria as the day-one assignment Shadow fair value book shows significantly less volatility than mark-to-market positions under non-fvo practices Mark-to-Market of Banking Book CDS, Fair Value Loans, and Net Positions Millions of EUR MtM CDS MtM Loans Net Jan- Feb- Mar- Apr- May- Jun- Jul- Aug- Sep- Oct- Nov- Dec- Jan- 07 Feb- 07 Mar- 07 Apr- 07 April 2007 included significant MtM losses for loans resulting from announced LBOs 10
LEMG fair value book: Sensitivity analysis Sensitivity analysis of the LEMG fair value book involve scenarios with credit spreads widening/tightening and credit curves steepening/ flattening LEMG prepares approximately 20 credit spread scenarios each month Most troublesome PnL scenario involves further spread tightening of 50% and results in a PnL loss of less than EUR 20mn Largest Loss Scenarios ID Description 6M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 6 Parallel Shift Tighter -50% -50% -50% -50% -50% -50% -50% -50% -50% -50% -50% 10 Bullish Steepener -50% -50% -43% -35% -28% -20% -20% -20% -20% -20% -20% 16 Bullish Flattener -30% -30% -28% -25% -23% -20% -20% -20% -20% -20% -20% Sensitivity Analysis and PnL Performance of the LEMG Fair Value Book Δ MtM Loans Δ MtM CDS Net Δ MtM Millions of EUR 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 11
Using IAS39-FVO to Reduce the Accounting Mismatch in Credit Portfolio Management Gene D. Guill IACPM General Meeting Swiss Re Centre for Global Dialogue Zurich, Switzerland June 14-15, 2007 12
The Fair Value Option: Bank of America Vipin Ramani Bank of America IACPM General Meeting Swiss Re Centre for Global Dialogue Zurich, Switzerland June 15, 2007
FVO Fair Value Option Summary Background: The Fair Value Option (SFAS 159) is an accounting change, which allows financial institutions the option to mark certain financial assets and liabilities to market, with changes in fair value to be recognized in earnings as those changes occur. Utilizes mark-to-market (MTM) accounting on certain large corporate loan and loan commitments, which is more consistent with management s view of the economics and the manner with which they are managed. It also reduces the accounting asymmetry that would otherwise be result from carrying loans at historical cost and hedges at fair value. Other Loan Accounting Options include Historical Cost and Lower Of Cost Or Market (LOCOM) Accounting: Fair Value Option (FVO) - Some Highlights Option to adopt either January 1, 2007 or January 1, 2008. Bank of America along with some other banks adopted 1/1/07. Adoption of FVO is linked to the adoption of Fair Value Measurement (SFAS 157) which requires disclosures based on transparency / observability of inputs used in the valuation approach. A one time election to move existing assets into MTM is available at adoption of FVO, with any cumulative unrealized gains and losses on existing contracts recorded as an adjustment to retained earnings. Implementation is prospective and will not require financial restatements for prior periods. Subsequently, irrevocable FVO election must be made at origination, with the associated mark impacting current P&L. FVO assets and associated hedges will also be managed on a market risk basis (issuer limits, DE@R, etc.). We will continue to require a bank risk rating and capital would continue to be ascertained on a credit risk basis. Summary: Under the new accounting guidelines, we will have the option to elect Accrual, LOCOM or Mark-to-Market (MTM) accounting at the inception of each loan transaction allowing us to more effectively manage our loan portfolio. 14
FVO Client Impact: Flexibility No change in Portfolio Management Capacity Creation: Loans will be marked to market. More options for managing credit through the cycles Respond to market conditions Cost: Day 1 portfolio mark flows through equity Subsequent marks through P&L Align Loan and CDS MTM / Carry Key Benefits Market Facing Discipline: Economic transparency Market Risk management 15
The Fair Value Option: Dresdner Kleinwort Stefan Gotthardt Dresdner Kleinwort Credit Asset Management Analytics IACPM General Meeting Swiss Re Centre for Global Dialogue Zurich, Switzerland June 15, 2007 16
Dresdner Kleinwort Credit Asset Management (CAM) Profit Centre since 2001 Asset Owner Transfer Pricing Active Management Part of Dresdner Kleinwort's Global Banking Business Line Main Activities Credit Portfolio Management Loan Asset Management (Bilateral and Syndicated Loans) Leveraged Loans Counterparty Risk Proprietary Credit Trading Structured Assets Investment and Management Group Core loan book > 2,500 clients 80 bn commitments and drawings thereof ~ 40 % liquid by name (liquid CDS quotes for name or parent company) 17
Dresdner Kleinwort Application of Fair Value Option Aspired Start Date: January 1, 2008 Reasons to choose FVO Avoiding of accounting mismatch Economic transparency of portfolio situation More active and closer portfolio management Facilitates joint management with other asset classes Eligible Portfolio Bilateral and Syndicated Loans Commitments and Cash Drawings Availability of CDS quotes Relevant Accounting Principles Dresdner Bank AG: IFRS Allianz SE: US GAAP 18
Dresdner Kleinwort Valuation Methodology Current Valuation Methodology Daily mtm valuation of the entire book already for more than five years Hitherto for internal reporting and management purposes Waterfall approach CDS Generic bond sector curves E2C (Equity to Credit model, based on MKMV CreditEdge for German SME loans) Calculation of "simple duration" Use of Par Spreads Option handling Prepayment Drawing Extension Potential Extensions of Valuation Methodology Cash Flow Modelling Use of Zero Spreads Lattice Model for option handling 19