Trekking to Stamford for the FASB Slugfest? Take two Prozac and bring these articles along in your briefcase.

Bankers, Fasten Your Seat Belts: Volatility Pockets Ahead

By Lang Gibson

The FASB proposals will dramatically alter bank accounting for derivatives and force them to live with yo-yoing disclosed earnings. The new rules will also encourage a greater emphasis on co-variance, give rise to market versus book value biases and, what is worse perhaps, treat different instruments differently even where their economic logic may be the same. Despite these drawbacks derivatives will remain financial institutions' hedge instrument of choice. And in the long run, as the focus of risk management shifts from book to market value, bank shareholders may be better served.

The FASB draft ideas represent a compromise between book and market value accounting. The Big Six accounting firms have objected to this approach, saying that FASB should either stick with traditional book value accounting or go full throttle towards mark-to-market accounting without compromising the two approaches.

Nevertheless the proposals do make a giant leap towards mark-to-market accounting, which has witnessed a rising popularity among the major entities that set international accounting standards. For bank treasurers the proposals may have the effect of further outdating the traditional interest rate gap repricing and GAAP Earnings-at-Risk (GEAR) models of accounting value in favor of Value-at-Risk (VAR) and similar simulation models of true economic value.

Till now FASB and the SEC have endorsed the segregation of derivatives into mark-to-market categories while the underlying exposure is carried at book value. The new "four category" hedge accounting proposal goes one very important step further than the "two category" approach. It requires banks to mark to market on balance sheets both the derivative and the underlying exposure.

The new proposal calls for the required hedge accounting treatment to depend on the intended use of the derivative and its resulting designation. The chart below explains the "four category" approach.

Under the new proposals the effect on earnings and capital value will depend more on the market price volatility of the derivative and hedged items, and the correlations between them. Amortized cost accounting, which is currently used by banks for futures and options, and accrual accounting, which is used for swaps, will become obsolete. So if a bank treasurer wishes to minimize periodic net income and equity volatility, it will be important for him to measure and monitor the future co-variances between the derivative and the hedged exposure to estimate the effect on net income.

Such micro hedge accounting begs the question-will there be any room for macro, or portfolio, hedging? The answer is yes, but bank treasurers must still book a paper trail at the micro level, since on an enterprise-wide basis actions to reduce market value risk generally exacerbate cash flow risk.

FASB believes that assessment of enterprise risk would require a single, and thus far too restrictive, definition of risk for the whole entity. The flip side, of course, is that it may now be tougher for investors to determine which risks a bank feels are most important to its balance sheet: earnings, equity or economic risk.

Bank risk management will be particularly affected by the proposals. Bank balance sheets are highly leveraged and are consequently more susceptible to earnings swings from discrepancies between book and market value accounting. For instance, the requirement to mark to market only the derivative in a forecasted transaction promises to pump up the volatility of bank earnings and equity. Why? Because FASB has defined floating rate instruments as a series of forecasted transactions. Consequently derivative hedging gains and losses are deferred to equity and comprehensive income, while the floating rate instrument is recorded at book value.

FASB also fails to account for the economic value of unhedged exposures. Accordingly there is an inconsistency here because only hedging and trading activity is marked to market. Furthermore, accounting rules do not encourage firmwide risk management, because they take no account of total portfolio correlations, that is, those between hedge instruments or between underlying exposures.

Furious lobbies

Bankers are busy lobbying to stop the FASB proposals, and not the least of their complaints is that demand deposits do not qualify as a hedgeable liability because, FASB asserts, they have no price risk. In reality, of course, bank models such as option, turnover, regression and simulation forecast significant duration for demand deposits and passbook savings. In fact, the Hutchison­Pennacchi "economic rents" model used by the Federal Reserve Board of Chicago forecasts a median duration for all banks of 6.7 years, which clearly represents significant price risk. Although expected rollovers of demand deposits would qualify as forecasted cash flows, the inherent fluctuation in earnings and equity would again be an agony to bankers.

As in the previous rules, debt securities classified as "held to maturity" may not be designated as hedged items. Thus this classification of debt will always be carried at book value, resulting in different treatment for them and those items that are marked to market. Meanwhile hedging is allowed for loans which are often intended to be held to maturity.

For banks the choice between swaps and futures strip hedging becomes more complicated by the fact that swaps will no longer command preferential treatment as they did before. Under the proposed rules, larger banks will probably increase their usage of futures strips versus swaps due to the former's lower bid/ask spreads, since both will now be on-balance-sheet items. The case may be different for smaller regional banks without the critical mass to support sophisticated treasury departments or large banks whose treasury operations do not share the dealing unit's technology. For these banks, swaps may continue to be the preferred instrument, because they are transparent and require less know-how than futures strip trading.

The new "comprehensive income" slot will require a number of items currently recognized only in capital accounts (that is, unrealized securities gains and losses, pension liability and translation adjustments) to be displayed with equal prominence next to net income. Following on the heels of FAS 115, which resulted in banks' preference for shorter-duration bonds to minimize the size of earnings volatility, banks may now have a further incentive to buy short-term fixed income securities. Why? Because gains and losses in the "held for sale" account would be reflected not only in capital but in comprehensive income as well. An additional likely effect is that higher comprehensive income volatility may outweigh the advantages of using securities as a parking place for funds when loan demand is poor.

Derivatives will continue to be the instrument of choice for hedging interest rate gaps, because securities do not qualify for hedge accounting. Derivatives used to hedge balance sheet items and firm commitments can result in a lower cost to the bank in the form of less volatility to both the capital and the earnings accounts.

Despite some shortfalls in FASB's transition towards true market value accounting, FASB has made significant strides with the new proposals. The new emphasis on partial economic value is important enough to warrant that bank treasurers rely more heavily on VAR and simulation, or at least modify their interest rate gap repricing and GEAR models.

Friction decrease

Since investors and analysts will increasingly focus more on true economic value, the friction between accounting and economic models will be decreased. Consequently, a bank treasurer will have less explaining to do about why accounting earnings volatility is high despite an economically fully hedged balance sheet. Furthermore, there may be less of a tendency for banks to assume substantial interest rate risk to create high net interest margins.

In determining the appropriate risk management strategy, banks must consider shareholder preference. Shareholders are concerned about appreciation in long-term market value, which indicates how future interest rate volatility may affect net income. Appropriately, the new accounting rules give banks more reason to measure, monitor and forecast long-term market value via VAR and simulation to suit their shareholders.

Bondholders also prefer banks with stable and wide net interest margins and low exposure to interest rate risk. That's why banks with consumer franchises are attractive investments-they capture the wide net interest margin between interest-free funding and high-yielding consumer loans. Accounting models will still be needed to track net interest margins, which represent 63 percent of U.S. banking revenues. Adapting these models to the new rules on comprehensive income and hedge accounting will likely be a major chore for the average bank treasurer over the next year.

Lang Gibson is a risk management advisor for Ferrell Capital Management.

The futures industry hopes to change FASB's mind.

Judging from the amount and ubiquity of opposition to the FASB proposals, the mid-November public hearings might end up looking like a scene out of Spartacus. If so, one of the chief gladiators will be the futures industry-probably the biggest likely loser from the new rules-which has retaliated by recruiting a working group that is girding for battle. "We're putting together a broad-based user group," enthuses Bruce Domash, manager of the audit department at the Chicago Board of Trade. And it is indeed broad, consisting of members of the Big Six accounting firms (Andersen reportedly has a blistering 30-page commentary/attack), financial institutions, the CBOT and the Merc. "We're hoping that a broader industry group will have more of an impact," he says. In the same breath, however, Domash admits he-like others-is highly skeptical that anything said at this juncture will have an effect on the final standard. "It's unfortunate," says Domash. "But we hope we're going to be heard."

The futures industry's main beef has been FASB's ban on rollover strategies. Under the proposed standard, end-users cannot roll over futures as cash flow hedges (that is, hedges of anticipated transactions) since the Board requires that the duration of the hedge of an anticipated cash flow match the timing of the expected transaction.

But that's not all that worries futures pros. Another concern involves hedging anticipated bond deals with bond futures. Under the proposed standard, such hedges qualify as cash flow hedges. Hence gains/losses on the hedge stay in comprehensive income until the expected date of issuance, when they move out into the P&L.

What happens at that juncture is the subject of misgivings. Under the proposed standard, the cumulative gain/loss will effectively adjust the interest payments on the debt issue. However, since the hedge was intended to protect the price of the debt, some industry specialists would prefer that the adjustment be made to the price of the debt itself-not the interest expense or the future cash flow resulting from the debt deal. "You end up recognizing all of the gain/loss in a single period, instead of accrual accounting, which in effect spreads the gains/losses on the hedge over the life of the issue," explains one futures pro. "The remedy is easy," he says. "Make price adjustments to the debt."

Cash flow conundrum

Another clash is likely over what happens when current hedges are used to protect future cash flows. FASB requires that changes largely offset each other in order for the hedge instrument to qualify. Often, however, because of duration differences, hedgers will have to hedge smaller notional amounts to match the future expected cash flows on a net present value basis. A dealer may want to hedge a variable rate exposure that will generate an extra $100 per every basis point change 10 years from now. The hedger's goal is to create a hedge that will generate the net present value of $100 in 10 years. That may be $50 today. Futures people worry that FASB will disqualify such hedges since the notional amounts are not equivalent.

There is probably a hundred-to-one chance that the futures industry will prevail, but then these are traders who are used to long shots. "I've had a couple of FASB conversations, and I think they clearly want to do the right thing," says one exchange official. "Maybe I am going to look like a naive fool, but I'd like to think that if we explain things in a straightforward way they'll be more receptive."

Who's Afraid of Comprehensive Income?

Like a magician with a top hat and rabbit, FASB has created this animal especially for derivatives. Henceforth comprehensive income will serve as a new, more detailed and more visible disclosure vehicle for hedging activity, which has prompted some derivative users to fear that it will 1) draw undue attention to a firm's hedging activity and 2) mislead market analysts, most of whom are either unaware or thoroughly uneducated in the complex implications of the new accounting rule.

Such anxieties are silly, according to Ethan Heisler, director of corporate bond research at Salomon Brothers. "My opinion is that the usefulness of this information varies inversely with its volume," says Heisler. He points out that most of the information that will now be slotted into comprehensive income was previously disclosed in other parts of the financial statement, hence no new insights are likely. What's more, he opines, such assumption-intensive information is so firm-specific that it's a very shaky base for analysts to make any comparative value determinations. "There's very little additional information companies can provide that will be highly usable," says Heisler. "The bottom line is that analysts will simply desegregate the information and retain the focus on core earnings, no matter how they're presented."

Conclusion: more marginal information will be printed in annual reports. Snaps Heisler: "If only half the time spent on derivative disclosure would be dedicated to better disclosure of credit risk, we would be much better off."

Will Swaps Lose Out To Mortgage-Backed Securities?

Does the recent FASB derivatives initiative mean a catastrophe in the making for the swaps market? That's the conclusion of the mid-August issue of the PaineWebber Mortgage Strategist, which predicts that under the proposed Financial Accounting Standards Board rules, banks and insurance companies will be motivated to take interest rate risk on their balance sheets, thus helping mortgaged-backed securities at the expense of swaps.

The nub of this argument is that under the new FASB rules, swaps must be carried on their balance sheets and marked to market-not held at amortized cost-and the same goes for all assets and liabilities. Even more distress has arisen because FASB rules contain no grandfathering provisions, so current transactions with a term greater than two years may fall under the rules, scheduled for adoption in December 1997.

Also hard hit are cash flow or anticipatory hedges-that is, selling a futures contract today in anticipation of issuing fixed debt three months hence. "Hedging an anticipated transaction under the proposed standard would be much more difficult than under current practice, as some of the more commonly used hedging vehicles such as futures would be difficult to apply," the report observes. In theory, "Investors would be able to find customized vehicles that allow for the desired effect on income, but the transaction cost could be far greater than using a futures contract or a vanilla swap."

Kaboom to swaps

According to PaineWebber, FASB delivers a particularly deadly blow to index amortizing rate swaps, widely used by banks to hedge anticipated loan demand. These, like all swaps with embedded options, would not be treated as hedges. "Denying hedge accounting treatment to instruments with embedded options or net written options could severely hamper the flexibility currently enjoyed by government-sponsored enterprises and others that fund with callable debt, then enter into swaps to transform the debt into LIBOR securities at sub-LIBOR financing rates," the report notes, adding that "under the new rules the swaps would be marked to market but could not be paired with the callable debt."

Now for the biggest market impact predicted by Paine Webber: FASB's rules would motivate the taking of interest rate risk on balance sheet, whereas heretofore FAS 115 has encouraged off-balance-sheet treatment. Then, too, changes in the market value of securities available for sale-that is, mortgage-backed securities-would not yo-yo up and down in the income statement but be melded (and presumably forgotten) into "comprehensive income," a category within book value. Changes in value of derivatives with embedded options, however, would be market to market in income. "This should boost demand for mortgage-backed securities at the expense of swaps with embedded options and structured notes," the report concludes.