Portfolio (Macro) Hedge Accounting in SFAS 133 and IAS 39
Bob Jensen at Trinity University
Bob Jensen's SFAS 133 and IAS 39 Glossary
SFAS 133 Paragraph 21
The Hedged Item
21. An asset or a liability is eligible for designation as a hedged item in a fair value hedge if all of the following criteria are met:
a. The hedged item is specifically identified as either all or a specific portion of a recognized asset or liability or of an unrecognized firm commitment. \8/ The hedged item is a single asset or liability (or a specific portion thereof) or is a portfolio of similar assets or a portfolio of similar liabilities (or a specific portion thereof).
1) If similar assets or similar liabilities are aggregated and hedged as a portfolio, the individual assets or individual liabilities must share the risk exposure for which they are designated as being hedged. The change in fair value attributable to the hedged risk for each individual item in a hedged portfolio must be expected to respond in a generally proportionate manner to the overall change in fair value of the aggregate portfolio attributable to the hedged risk. That is, if the change in fair value of a hedged portfolio attributable to the hedged risk was 10 percent during a reporting period, the change in the fair values attributable to the hedged risk for each item constituting the portfolio should be expected to be within a fairly narrow range, such as 9 percent to 11 percent. In contrast, an expectation that the change in fair value attributable to the hedged risk for individual items in the portfolio would range from 7 percent to 13 percent would be inconsistent with this provision. In aggregating loans in a portfolio to be hedged, an entity may choose to consider some of the following characteristics, as appropriate: loan type, loan size, nature and location of collateral, interest rate type (fixed or variable) and the coupon interest rate (if fixed), scheduled maturity, prepayment history of the loans (if seasoned), and expected prepayment performance in varying interest rate scenarios.
Footnote 9
\9/ Mortgage bankers and other servicers of financial assets that designate a hedged portfolio by aggregating servicing rights within one or more risk strata used under SFAS 133 Paragraph 37(g) of Statement 125 would not necessarily comply with the requirement in this SFAS 133 Paragraph for portfolios of similar assets. The risk stratum under SFAS 133 Paragraph 37(g) of Statement 125 can be based on any predominant risk characteristic, including date of origination or geographic location.
SFAS 133 Paragraph 56
56. At the date of initial application, mortgage bankers and other servicers of financial assets may choose to restratify their servicing rights pursuant to SFAS 133 Paragraph 37(g) of Statement 125 in a manner that would enable individual strata to comply with the requirements of this Statement regarding what constitutes "a portfolio of similar assets." As noted in footnote 9 of this Statement, mortgage bankers and other servicers of financial assets that designate a hedged portfolio by aggregating servicing rights within one or more risk strata used under SFAS 133 Paragraph 37(g) of Statement 125 would not necessarily comply with the requirement in SFAS 133 Paragraph 21(a) of this Statement for portfolios of similar assets, since the risk stratum under SFAS 133 Paragraph 37(g) of Statement 125 can be based on any predominant risk characteristic, including date of origination or geographic location. The restratification of servicing rights is a change in the application of an accounting principle, and the effect of that change as of the initial application of this Statement shall be reported as part of the cumulative-effect-type adjustment for the transition adjustments.
SFAS 133 Paragraphs 241 and 242
241. The Board believes that accounting requirements should be neutral and should not encourage or discourage the use of particular types of contracts. That desire for neutrality must be balanced with the need to reflect substantive economic differences between different instruments. This Statement is the product of a series of many compromises made by the Board to improve financial reporting for derivatives and hedging activities while giving consideration to cost-benefit issues, as well as current practice. The Board believes that most hedging strategies for which hedge accounting is available in current practice have been reasonably accommodated. The Board recognizes that this Statement does not provide special accounting that accommodates some risk management strategies that certain entities wish to use, such as hedging a portfolio of dissimilar items. However, this Statement clarifies and accommodates hedge accounting for more types of derivatives and different views of risk, and provides more consistent accounting for hedges of forecasted transactions than did the limited guidance that existed before this Statement.
242. Some constituents have said that the requirements of this Statement are more complex than existing guidance. The Board disagrees. It believes that compliance with previous guidance was more complex because the lack of a single, comprehensive framework forced entities to analogize to different and often conflicting sources of guidance. The Board also believes that some constituents' assertions about increased complexity may have been influenced by some entities' relatively lax compliance with previous guidance. For example, the Board understands that not all entities complied with Statement 80's entity-wide risk reduction criterion to qualify for hedge accounting, and that also may have been true for requirements for hedging a portfolio of dissimilar items. The Board also notes that some of the more complex requirements of this Statement, such as reporting the gain or loss on a cash flow hedge in earnings in the periods in which the hedged transaction affects earnings, are a direct result of the Board's efforts to accommodate respondents' wishes.
SFAS 133 Paragraph 317
Valuation of Deposit Liabilities
317. The guidance in Statement 107 precludes an entity from reflecting a long-term relationship with depositors, commonly known as a core deposit intangible, in determining the fair value of a deposit liability. SFAS 133 Paragraph 12 of Statement 107 states, in part:
In estimating the fair value of deposit liabilities, a financial entity shall not take into account the value of its long-term relationships with depositors, commonly known as core deposit intangibles, which are separate intangible assets, not financial instruments. For deposit liabilities with no defined maturities, the fair value to be disclosed under this Statement is the amount payable on demand at the reporting date.
Some respondents to the Exposure Draft requested that this Statement permit the fair value of deposit liabilities to reflect the effect of the core deposit intangible. The Board decided to make no change to the guidance in Statement 107 on that issue because it will be addressed as part of the Board's current project on measuring financial instruments at fair value. Issues of whether the fair values of certain liabilities (or assets) should reflect their values as if they were settled immediately or whether they should be based on their expected settlement dates, as well as issues of whether or when it would be appropriate to measure portfolios of assets or liabilities rather than individual items in those portfolios, are central to that project.
SFAS 133 Paragraphs 432-436
Additional Qualifying Criteria for Fair Value Hedges Specific Identification
432. This Statement requires specific identification of the hedged item. The hedged item must be (a) an entire recognized asset or liability, or an unrecognized firm commitment, (b) a portfolio of similar assets or similar liabilities, or (c) a specific portion of a recognized asset or liability, unrecognized firm commitment, or portfolio of similar items. If an entity hedges a specified portion of a portfolio of similar assets or similar liabilities, that portion should relate to every item in the portfolio. If an entity wishes to hedge only certain similar items in a portfolio, it should first identify a smaller portfolio of only the items to be hedged.
433. The Exposure Draft would not have permitted designation of a portion of an asset or a liability as a hedged item. Under the Exposure Draft, those items could only have been hedged in their entirety or on a percentage basis. Some respondents to the Exposure Draft objected to that limitation because it precluded identification of only selected contractual cash flows as the item being hedged (referred to as partial-term hedging for a debt security). For example, it would have prohibited identification of the interest payments for the first two years of a four-year fixed-rate debt instrument as the hedged item and, therefore, would have precluded hedge accounting for a hedge of that debt with a two-year interest rate swap.
434. The Board was reluctant to permit identification of a selected portion (rather than proportion) of an asset or liability as the hedged item because it believes that, in many cases, partial-term hedge transactions would fail to meet the offset requirement. For example, the changes in the fair value of a two-year interest rate swap cannot be expected to offset the changes in fair value attributable to changes in market interest rates of a four-year fixed-rate debt instrument. For offset to be expected, a principal repayment on the debt (equal to the notional amount on the swap) would need to be expected at the end of year two. The Board decided to remove the prohibition against partial-term hedging and other designations of a portion of an asset or liability to be consistent with the modification to the Exposure Draft to require an entity to define how the expectation of offsetting changes in fair value or cash flows would be assessed. However, removal of that criterion does not necessarily result in qualification for hedge accounting for partial-term or other hedges of part of an asset or a liability.
435. The criterion in SFAS 133 Paragraph 21(a) that permits a hedged item in a fair value hedge to be a designated portion of an asset or liability (or a portfolio of similar assets or similar liabilities) makes the following eligible for designation as a hedged item:
a. A percentage of the entire asset or liability (or of the entire portfolio)
b. One or more selected contractual cash flows (such as the asset or liability representing the interest payments in the first two years of a four-year debt instrument) \32/
c. A put option, a call option, an interest rate cap, or an interest rate floor embedded in an existing asset or liability that is not an embedded derivative accounted for separately under this Statement
d. The residual value in a lessor's net investment in a direct-financing or sales-type lease.
If the entire asset or liability is a variable-rate instrument, the hedged item cannot be a fixed-to-variable interest rate swap (or similar instrument) perceived to be embedded in a fixed-rate host contract. The Board does not intend for an entity to be able to use the provision that a hedged item may be a portion of an asset or liability to justify hedging a contractual provision that creates variability in future cash flows as a fair value hedge rather than as a cash flow hedge. In addition, all other criteria, including the criterion that requires a hedge to be expected to be highly effective at achieving offset, must still be met for items such as the above to be designated and to qualify for hedge accounting.
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\32/ However, as noted in SFAS 133 Paragraph 434, it will likely be difficult to find a derivative that will be effective as a fair value hedge of selected cash flows.
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436. As discussed in SFAS 133 Paragraphs 414 and 415, in designating a hedge of a component of an asset or liability, an entity must consider the effect of any derivatives embedded in that asset or liability related to the same risk class. To disregard the effects of an embedded derivative related to the same risk class could result in a designated hedge that is not effective at achieving offsetting changes in fair value or cash flows. The same unacceptable result would occur if a freestanding derivative that was accounted for as hedging a particular item was ignored in considering whether another derivative would qualify as a hedge of the same risk in that item.
SFAS 133 Paragraphs 443-450
443. This Statement retains the provision from the Exposure Draft that prohibits a portfolio of dissimilar items from being designated as a hedged item. Many respondents said that hedge accounting should be extended to hedges of portfolios of dissimilar items (often called macro hedges) because macro hedging is an effective and efficient way to manage risk. To qualify for designation as a hedged item on an aggregate rather than individual basis, the Exposure Draft would have required that individual items in a portfolio of similar assets or liabilities be expected to respond to changes in a market variable in an equivalent way. The Exposure Draft also included a list of specific characteristics to be considered in determining whether items were sufficiently similar to qualify for hedging as a portfolio. Respondents said that, taken together, the list of characteristics and the "equivalent way" requirement would have meant that individual items could qualify as "similar" only if they were virtually identical.
444. To deal with the concerns of respondents, the Board modified the Exposure Draft in two ways. First, the Board deleted the requirement that the value of all items in a portfolio respond in an equivalent way to changes in a market variable. Instead, this Statement requires that the items in a portfolio share the risk exposure for which they are designated as being hedged and that the fair values of individual items attributable to the hedged risk be expected to respond proportionately to the total change in fair value of the hedged portfolio. The Board intends proportionately to be interpreted strictly, but the term does not mean identically. For example, a group of assets would not be considered to respond proportionately to a change in interest rates if a 100-basis-point increase in interest rates is expected to result in percentage decreases in the fair values of the individual items ranging from 7 percent to 13 percent. However, percentage decreases within a range of 9 percent to 11 percent could be considered proportionate if that change in interest rates reduced the fair value of the portfolio by 10 percent.
445. The second way in which the Board modified the Exposure Draft was to delete the requirement to consider all specified risk characteristics of the items in a portfolio. The Board considered completely deleting the list of risk characteristics included in the Exposure Draft, and the Task Force Draft did not include that list. However, respondents to that draft asked for additional guidance on how to determine whether individual assets or liabilities qualify as "similar." In response to those requests, the Board decided to reinstate the list of characteristics from the Exposure Draft. The Board intends the list to be only an indication of factors that an entity may find helpful.
446. Those two changes are consistent with other changes to the Exposure Draft to focus on the risk being hedged and to rely on management to define how effectiveness will be assessed. It is the responsibility of management to appropriately assess the similarity of hedged items and to determine whether the derivative and a group of hedged items will be highly effective at achieving offset. Those changes to the Exposure Draft do not, however, permit aggregation of dissimilar items. Although the Board recognizes that certain entities are increasingly disposed toward managing specific risks within portfolios of assets and liabilities, it decided to retain the prohibition of hedge accounting for a hedge of a portfolio of dissimilar items for the reasons discussed in the following SFAS 133 Paragraphs.
447. Hedge accounting adjustments that result from application of this Statement must be allocated to individual items in a hedged portfolio to determine the carrying amount of an individual item in various circumstances, including (a) upon sale or settlement of the item (to compute the gain or loss), (b) upon discontinuance of a hedging relationship (to determine the new carrying amount that will be the basis for subsequent accounting), and (c) when other generally accepted accounting principles require assessing that item for impairment. The Board decided that a hedge accounting approach that adjusts the basis of the hedged item could not accommodate a portfolio of dissimilar items (macro hedging) because of the difficulties of allocating hedge accounting adjustments to dissimilar hedged items. It would be difficult, if not impossible, to allocate derivative gains and losses to a group of items if their values respond differently (both in direction and in amount) to a change in the risk being hedged, such as market interest rate risk. For example, some components of a portfolio of dissimilar items may increase in value while other components decrease in value as a result of a given price change. Those allocation difficulties are exacerbated if the items to be hedged represent different exposures, that is, a fair value risk and a cash flow risk, because a single exposure to risk must be chosen to provide a basis on which to allocate a net amount to multiple hedged items.
448. The Board considered alternative approaches that would require amortizing the hedge accounting adjustments to earnings based on the average holding period, average maturity or duration of the items in the hedged portfolio, or in some other manner that would not allocate adjustments to the individual items in the hedged portfolio. The Board rejected those approaches because determining the carrying amount for an individual item when it is (a) impaired or (b) sold, settled, or otherwise removed from the hedged portfolio would ignore its related hedge accounting adjustment, if any. Additionally, it was not clear how those approaches would work for certain portfolios, such as a portfolio of equity securities.
449. Advocates of macro hedging generally believe that it is a more effective and efficient way of managing an entity's risk than hedging on an individual-item basis. Macro hedging seems to imply a notion of entity-wide risk reduction. The Board also believes that permitting hedge accounting for a portfolio of dissimilar items would be appropriate only if risk were required to be assessed on an entity-wide basis. As discussed in SFAS 133 Paragraph 357, the Board decided not to include entity-wide risk reduction as a criterion for hedge accounting.
450. Although this Statement does not accommodate designating a portfolio of dissimilar items as a hedged item, the Board believes that its requirements are consistent with (a) the hedge accounting guidance that was in Statements 52 and 80, (b) what the Board generally understands to have been current practice in accounting for hedges not addressed by those Statements, and (c) what has been required by the SEC staff. The Board's ultimate goal of requiring that all financial instruments be measured at fair value when the conceptual and measurement issues are resolved would better accommodate risk management for those items on a portfolio basis. Measuring all financial instruments at fair value with all gains or losses recognized in earnings would, without accounting complexity, faithfully represent the results of operations of entities using sophisticated risk management techniques for hedging on a portfolio basis.
SFAS 133 Paragraph 477
477. This Statement also makes an exception to permit an entity to designate a financial instrument denominated in a foreign currency (derivative or nonderivative) as a hedge of the foreign currency exposure of a net investment in a foreign operation. Net investment hedges are subject only to the criteria in SFAS 133 Paragraph 20 of Statement 52. The net investment in a foreign operation can be viewed as a portfolio of dissimilar assets and liabilities that would not meet the criterion in this Statement that the hedged item be a single item or a group of similar items. Alternatively, it can be viewed as part of the fair value of the parent's investment account. Under either view, without a specific exception, the net investment in a foreign operation would not qualify for hedging under this Statement. The Board decided, however, that it was acceptable to retain the current provisions of Statement 52 in that area. The Board also notes that, unlike other hedges of portfolios of dissimilar items, hedge accounting for the net investment in a foreign operation has been explicitly permitted by the authoritative literature.
Key Paragraphs from IAS 39
IAS 39 does not seem to directly take up the issue of portfolio/macro hedge accounting. However, Paul Pacter from the IASC makes no mention of any differences with respect to SFAS 133 and IAS 39 for portfolios in his document on differences between the two standards ( see http://www.iasc.org.uk/news/cen8_142.htm ). I assume by default that the SFAS 133 limitations on use of hedge accounting for portfolios extends by default to IAS 39.