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SFAS 133

Table of Contents

Overview
Cash Flow Hedges
Fair Value Hedges

Controversial Issues

Issues Before the DIG

Some Initial Issues to Consider
Training and discovery costs are costly and time consuming Rodger Pearson (Manager of Accounting Research at Union Carbide) carbr30.wav SFAS 133 examples are incomplete and too academic See Bob Jensen's http://www.cs.trinity.edu/~rjensen/13300tut.htm Rodger Pearson at Union Carbide carbr10.wav Auditors may become overly conservative due to litigation fears Problems of testing for hedging effectiveness and quarterly changes in effectiveness Options are troublesome --- Anthony Belinfanti (Manager of Currency & Interest Rate Risk at Union Carbide) carbt15.wav Why might this be the case? --- options & futures are standardized unlike forwards & swaps Outside the U.S. many contracts do not fit SFAS 133 There may not be contracts in Asia, only "gentlemen' agreements" carbr16.wav

Costs of Detection, Documentation, and IT Changes for Derivative Contracts
Detecting derivatives and embedded derivatives to account for worldwide Rodger Pearson Says Find Them and Be Consistent carbr04.wav Weaving SFAS 133 into ERP or other aspects of the corporate information system SAP at Union Carbide carbt04.wav Drilling Down Goals of SAP carbt05.wav Using SAP and Bloomberg to Track and Value Derivatives carbt06.wav Have bosses & external auditors give advanced approval of everything you plan to implement Union Carbide's Tony Belinfanti carbt10.wav Simulate implementation before pulling the trigger carbt12.wav

Miscellaneous Considerations
SEC Market Risk Disclosures in Rule 4-08(n) of Regulation S-X and Item 310 of Regulation S-B Tabular Sensitivity Analysis --- Union Carbide carbr40.wav Value at Risk

Timing and Transition Issues
Should a company elect early adoption? Union Carbide's Tony Belinfanti carbt01.wav Arthur Andersen's John Woods

Overview of SFAS 133

Objectives
Describe key aspects of Statement 133 Learn the definition of a derivative Describe why the FASB changed derivative and hedging accounting guidelines Identify existing pronouncements that are impacted Describe hedge criteria required for all qualified hedges Understand effective dates and disclosure requirements

Key Aspects of Statement 133
All derivatives are reported at fair value on the balance sheet Changes in fair value for derivatives not designated and qualifying in a hedging relationship are recorded in earnings Special accounting is provided for the change in value of derivatives designated and qualifying as: Fair value hedges Cash flow hedges Foreign currency hedges

Fair Value Hedge
A fair value hedge is a hedge of the exposure to a change in fair value of a recognized asset or liability or of an unrecognized firm commitment attributable to a particular risk. Key aspects: Hedged item is exposed to price risk Changes in fair value of hedged item and hedging instrument are recorded in earnings Basis of hedged item is adjusted by the change in value

Cash Flow Hedge
A cash flow hedge is a hedging relationship where the variability of the hedged item's cash flows is offset by the cash flows of the hedging instrument. Key aspects: Hedged item is a forecasted transaction or balance sheet item with variable cash flows Effective gain or loss reported in OCI Earnings recognition matches hedged transaction Ineffective gain or loss recorded in earnings

Foreign Currency Hedge
The Board intended to increase the consistency of hedge accounting guidance by broadening the scope of eligible foreign currency hedges. Key aspects: Includes hedges of cash flows, fair value, and net investments in foreign operations Permits limited use of nonderivative instruments Expands hedge accounting, particularly for forecasted transactions, intercompany transactions and tandem currency hedges

FASB Objectives
*Retain* Statement *52 Concepts*
Derivatives or nonderivatives may be designated as hedges of foreign currency risks if: A firm commitment A net investment in a foreign operation hedge

FASB Objectives
*Expand* Statement *52 Concepts*
Forecasted transactions, including intercompany transactions, with foreign currency risk (e.g., royalty receipts/payments) may be hedged with any type of derivative Expanded ability to use tandem currencies (e.g., practicability or feasibility criteria in Statement 52 no longer required)

FASB Views:
Four Cornerstone Decisions of Statement 133
Derivatives are contracts that create rights and obligations that meet the definitions of assets and liabilities Fair value is the only relevant measure for derivatives Only items that are assets or liabilities should be reported as such on the balance sheet Special hedge accounting should be provided, but should be limited to transactions involving offsetting changes in fair values or cash flows for the risk being hedged

What is a Derivative?
Statement 133 creates a new definition of the term derivative. The definition is based on certain distinguishing characteristics. Certain scope exceptions exist.

Three Characteristics
Underlying and either a notional amount or a payment provision or both No initial net investment or smaller initial net investment than contracts with similar responses to changes in market factors Net settlement or its equivalent

Underlying
An interest rate (e.g., LIBOR) The price of a security or commodity (e.g., price of a share of ABC stock or a bushel of wheat) A foreign exchange rate (e.g., DM/U.S. $ spot rate) A measure of creditworthiness (e.g., Moody's credit rating) An index on any of the above or something else (e.g., S&P 500, CPI) Other specific items

Notional Amount
*A notional amount* is a number of: Currency units Shares Bushels Pounds Other units Notional amount is used to determine the settlement amount (for example, a price x a number of shares)**

Payment Provision
*A payment provision* specifies a fixed or determinable settlement if the underlying behaves in a specified way. For Example: $1 million might be paid if interest rates increase by 300 basis points**

Initial Net Investment
A derivative requires either: No initial net investment or A smaller initial net investment than other contracts that have a similar response to changes in market factors

Net Settlement
Net settlement explicitly required or permitted by the contract (transfer of cash or other assets) Net settlement by a market mechanism outside the contract (e.g., futures exchange) Delivery of a derivative or an asset that is readily convertible to cash

Exceptions
"Regular-way" security trades Normal purchases and sales Traditional insurance contracts Financial guarantee contracts OTC contracts with certain underlyings Derivatives that are an impediment to sales accounting

Contracts Not Considered Derivatives
for Purposes of Statement 133
Instruments indexed to an entity's own stock and classified in stockholders' equity Stock-based compensation covered by Statement 123 (issuer only) Contingent consideration in a business combination covered by Opinion 16 (issuer only)

Embedded Derivatives:
*Definition*
Embedded derivatives are implicit or explicit terms that affect the cash flows or value of other exchanges required by a contract in a manner similar to a derivative The combination of a host contract and an embedded derivative is referred to as a hybrid contract Examples of hybrid contracts are: Structured notes Convertible securities Securities with caps, floors, or collars

When Does a Contract Have an
Embedded Derivative Subject to
Statement 133
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Accounting for Contracts with
Embedded Derivatives
If the embedded derivative is required to be separated from host and can be reliably identified and measured: Embedded derivative -- Apply Statement 133 Host contract -- Apply applicable GAAP for similar contracts

Accounting for Contracts with
Embedded Derivatives (Cont.)
*If the embedded derivative cannot* be reliably identified and measured: Account for the entire contract at fair value through earnings The contract may not be designated as a hedging instrument**

Why the Change?
Quantity and variety of derivatives are increasing Accounting conventions and standards were outdated, incomplete, and inconsistent Effects of derivatives were not transparent in the financial statements

FASB Statements Impacted by
Statement 133
Supersedes: Statement 80 (futures contracts) Statement 105 (disclosures of off-balance-sheet risk) Statement 119 (derivative disclosures) Numerous EITF Issues Amends: Statement 52 (foreign currency) Statement 107 (fair value disclosures) Statement 115 (accounting for debt and equity securities) Numerous EITF Issues

Hedge Criteria and Issues
The following criteria apply to all qualifying hedges: Documentation requirements Effectiveness assessment Disclosure requirements

Required Documentation
Formal documentation is required at the inception of the hedge and must include: Identification of the hedging instrument and the hedged item or transaction The nature of the risk being hedged The risk management objective/strategy How effectiveness will be assessed

Highly Effective
Effectiveness represents the derivative instrument's ability to generate offsetting changes in the fair value or cash flows related to the risk hedged. Key aspects: Management expects the hedge to be highly effective at offset Effectiveness is measured whenever earnings are reported and at least quarterly "Highly effective" at offset is intended to be similar to "high correlation" in Statement 80

Hedge Effectiveness Test
Exclusion of portion of derivative value (e.g., time value, forward points) is permitted Change in fair value of the excluded portion is recorded in earnings

Ineffectiveness
Sources of ineffectiveness include: Different notional and principal amounts Different maturity or repricing dates Different underlying interest rate basis (such as variable rate debt at prime, swap at LIBOR) Currency differences Credit differences

Effectiveness Implications
If not highly effective, none of the hedge qualifies for special accounting If highly effective, any ineffectiveness (as defined) will be recorded through earnings

Hedge Termination
Terminate hedge accounting prospectively when: Hedge qualification criteria is no longer satisfied (e.g., when a forecasted transaction is no longer probable) Derivative expires or is sold, terminated, or exercised Hedge designation is removed

Considerations for a Derivative
Accounting Policy Manual
Categories of management-approved hedge strategies and derivative types Hedge effectiveness methodology Basis of accounting Use of codes on trade tickets to identify hedging instruments Accounting and valuation system, including management reports Preapproval/coding related to hedge transactions

Effective Dates
For all entities Fiscal years beginning after June 15, 2000 Can be adopted at the beginning of a fiscal quarter after June 15, 1998 Early application of selected provisions not permitted -- all or none No retroactive application to prior periods

Transition Adjustments
Transition adjustment varies based on derivative hedging relationship prior to adoption: Fair-value-type hedge -- Cumulative-effect-type adjustment of net income (and consider gain or loss on hedged item) Cash-flow-type hedge -- Cumulative-effect-type adjustment of accumulated OCI Freestanding derivative (no hedging relationship) -- Cumulative-effect-type adjustment of net income

Prior Basis Adjustments
Derivative gains and losses recorded as adjustments of cost prior to initial application: Are not affected Are not part of the transition adjustment

Embedded Derivatives
Instruments with embedded derivatives that were issued, acquired, or modified after 12/31/98 are subject to: Fair value accounting for the embedded derivative Transition accounting for the host and embedded derivative

Cash Flow Hedges

Statement 133 overview
General comments Freestanding and embedded derivatives Each derivative on balance sheet at fair value If no CF hedge, fair value changes to earnings Unifies hedge criteria -- Designation/effectiveness Contrast with prior practices Expands definition of derivative Accommodates many prior hedge practices Introduces limited eligibility for written options Adopts transaction (versus enterprise) risk focus Adds complexity to hedge mechanics Valuing hedged items (hobbles synthetic approach) Bifurcation requirements Mark time value to fair value (options and forwards) Measuring and recognizing hedge ineffectiveness Tracking gains and losses in equity (accumulated other comprehensive income), then in earnings Increased volatility in earnings and equity Effective date Effective for all fiscal quarters of all fiscal years beginning after 6/15/00 -- 1/1/01 for calendar-year companies -- Can early adopt at beginning of any quarter -- CF hedge designation and documentation must be completed by initial implementation date

Statement 133 overview, continued
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Cash flow hedges definition (¶28)
The following expected future cash flows may vary based on changes in interest rates: Interest payments on variable-rate debt Interest receipts on variable-rate assets Proceeds from the issuance of fixed-rate debt Payment for the purchase of fixed-rate assets Special CF hedge accounting for qualifying hedges of potential variability in future cash flows due to interest rate or other risks Since hedged cash flow has not yet occurred, derivative g/1 is first deferred in accumulated other comprehensive income (OCI) Derivative g/1 is later recognized in earnings in same period the hedged item affects earnings

Cash flow hedges
hedgeable risks(¶29(h))
Hedgeable risks for a forecasted purchase/sale or variable cash flows of a financial asset/liability include changes in: The cash flows of the entire asset or liability Market interest rates Hedgeable risks for a forecasted purchase/sale of variable cash flows of an asset/liability include changes in: Default or changes in obligor's creditworthiness (credit rating) Foreign currency exchange rates Non-financial asset -- foreign currency risk -- the entire purchase price or sales price of the asset

Cash flow hedges
ineligible risks (FASB Q&A E1)
Cannot designate a hedge of variability in cash flows due to changes in only the "risk-free"rate Market interest rates defined as the risk-free rate plus sector spread Impact on "Treasury locks" and other hedging strategies

Cash flow hedges
hedgeable transactions (¶29)
Single transaction or group of individual transactions that: Is probable of occurrence, Is transacted with an external third party, and Presents an exposure to variations in cash flows that could affect reported earnings If group, share the same risk exposure (¶462)

Cash flow hedges
hedgeable transactions (¶462)
A group of individual transactions must share the same risk exposure Company could designate a group of forecasted interest payments on several variable-rate debt instruments But, interest payments in the group must vary with the same index (e.g., 3-month LIBOR)

Cash flow hedges
ineligible items (¶29)
Items remeasured to fair value for hedged risk currently in earnings -- Trading securities -- Interest on FX receivables/payables Variable interest cash flows on a HTM security Dividends on trust preferred securities classified as minority interests Grouped items if not exposed to the same risk Equity investments in unconsolidated subs Company's own equity instruments Transactions with stockholders -- Projected purchases of treasury stock --Payments of dividends

Cash flow hedges criteria (¶28)
Hedge designation Designate and document hedge at inception -- Hedged item -- Hedging instrument -- Risk being hedged -- Methodology for assessing hedge effectiveness Hedge effectiveness Hedge must be "highly effective" in offsetting changes in cash flows for risk hedged -- Expecting effectiveness (getting in batter's box) -- Achieving ongoing effectiveness (getting a hit) Define "reasonable basis" for assessment -- For example, spot-rate or intrinsic-value changes -- Address whether time value is "in or out" Addressing effectiveness Assess effectiveness at least quarterly Measure and book ineffectiveness -- All (even small) ineffectiveness goes in earnings -- Yet CF "underhedge" does not affect earnings (change in derivative's FV is LESS THAN change in PV of expected future cash flows) Recognizing ineffectiveness If excluded from effectiveness, time value (option premium/forward points) erodes -- Must go in earnings -- Erodes as derivative is marked to fair value -- Cannot amortize over derivative's life "Short cut" method for assessing effectiveness (¶68) Applies to certain interest-rate swaps only Key terms of swap and hedged item must match Allows company to assume perfect effectiveness Eliminates need to reassess effectiveness thereafter Similar to pre-133 synthetic instrument accounting (except for balance sheet effects) May be difficult to achieve for corporate debt Swap notional amount = hedged item's principal Swap has zero fair value at inception Formula identical for each net settlement under swap Hedged item cannot be prepayable No other terms invalidate assumed effectiveness Creditworthiness of parties need not be comparable Additional cash flow hedge prerequisites -- All interest flows on hedged item are designated -- No interest flows beyond swap term are designated -- No floor or cap in swap unless also in hedged item -- Repricing dates the same for swap and hedged item -- No basis differences between swap and hedged item -- But, rates on item and swap need not be the same

Cash flow hedges
written options (¶28(c))
Limited eligibility of written options The written option combined with hedged item must provide at least as much gain potential as loss potential Test is met if all possible percentage favorable changes provide favorable cash flows at least equal to unfavorable cash flows incurred from an unfavorable change of the same percentage Swaps that are written options Cancelable at counterparty's option, without penalty Embedded written options (puts, calls) Index-amortizing swap (series of cancelable swaps) In sum, any swap combined with a written option

Cash flow hedges
illustrations - Appendix
Example A -- Swap existing floating rate debt to fixed under shortcut method Example B -- Forecasted debt issuance using Treasury futures Example C -- Cap interest on existing floating rate debt using an interest rate cap

Cash flow hedges
Example A -- floating rate debt

On 1/1/05, Company issued 100 mm note at LIBOR, semiannual payments and semiannual variable-rate reset dates, noncallable, 5-year term
LIBOR is 5/7% at 1/1/05
Company wants to lock in a 6% fixed rate; Company enters into an interest-rate swap to pay 6% fixed and receive LIBOR
Swap terms include a 100 mm notional principal, a 5-year term, and semiannual variable-rate reset
Assume that, at hedge inception (1/1/05), the fair value of the swap is zero
Assume that, during the six-month period ended 6/30/05, interest rates increase
Assume a comparable term pay-fixed, receive-variable interest rate swap is priced at 6/30/05 at a 7% pay-fixed rate

Given these facts, the direction of fair value changes are as follows:

Variable-rate debt -- no change in fair value given that rates reset to market
Pay-fixed 6%, receive-variable interest rate swap -- increases in value

	6/30/05	12/31/05
Cash flows on debt: Principal amount Variable rate Variable interest payment on debt	100,000,000 5.70% 2,850,000	100,000,000 6.70% * 3,350,000
Cash flows on swap: Variable interest receipt Fixed interest payment Interest payment (receipt) on swap	(2,850,000) 3,000,000 150,000	(3,350,000) 3,000,000 (350,000)
Net cash flow on debt and swap	3,000,000	3,000,000

*Rate increased 100 basis points on 7/1/05 reset.

Cash flow hedges
Example A -- floating rate debt, cont.

	6/30/05	12/31/05
Fair value of pay-6%-fixed swap	3,804,000 (1)	3,437,000 (2)

(1) Present value of nine $500,000 semiannual interest payments, discounted at 3.5% per semiannual period

(2) Present value of eight $500,000 semiannual interest payments, discounted at 3.5% per semiannual period

Journal entries at 6/3/05:
Interest expense 2,850,000
Interest payable 2,850,000
To accrue interest payable on debt.

Interest receivable                                           2,850,000
Interest expense                                                  150,000
    Interest payable                                                                                                     3,000,000
To accrue net payable under swap (receive 5.7% and pay-fixed 6%).

Interest rate swap (asset) 3,804,000
Accumulated OCI 3,804,000
To record fair value of swap (excluding accrual).

Assume that, at 12/31/05, rates have remained the same as at 6/30 and the swap fair value has decreased to 3,437,000 due to the 12/31 payment and passage of time
Assume that interest rates reset on 6/30/05 for both swap and variable-rate debt reflecting a 100 bp increase in LIBOR

Journal entries at 12/31/05:
Interest expense 3,350,000
Interest payable 3,350,000
To accrue interest payable on debt ((6.7% x 100mm)/2).

Interest receivable                                           3,350,000
    Interest payable                                                                                                       3,000,000
    Interest expense                                                                                                         350,000
To accrue net receipt under swap (receive 6.7% and pay-fixed 6%).

Accumulated OCI 367,000
Interest rate swap (asset) 367,000
To record change in fair value of swap (excluding accrual).

Company documented that swap and variable-rate debt terms for nominal amounts, payment frequency, reset dates, and maturity match
Effectiveness was observed throughout hedge term
Hedge is not exposed to basis risk because swap and debt each have identical variable rates (LIBOR)

Cash flow hedges
Example B -- forecasted issuance
*Forecasted Issuance of Fixed-Rate Debt* Company has probable debt issuance Enters into Treasury futures (!) Designates futures as hedge of issuance Recognize futures at fair value in balance sheet Mark futures to fair value through equity (OCI) Recognize any ineffectiveness immediately in earnings When issued, record debt at proceeds received Derivative asset/liability relieved by settling futures Recognize interest at contract rates in period earnings Over life of debt, amortize deferred amount in OCI into earnings (adjust interest expense using interest method)

Cash flow hedges
Example C -- cap on floating debt
Company has floating-rate debt Enters into interest-rate cap (series of call options) Designate cap as hedge of floating interest payments Assume risk management strategy indicates time value will be excluded from effectiveness method Recognize interest-rate cap (both time and intrinsic value) as an asset at FV in balance sheet Mark cap's intrinsic value to fair value in equity (OCI) Recognize any ineffectiveness immediately in earnings Recognize floating-rate interest expense in earnings Recognize offsetting effect of cap in earnings At maturity, cap has zero fair value Premium is ineffective (gives no offsetting cash flow)

Fair Value Hedges

SFAS 133 Introduction
General Comments Freestanding and embedded derivatives addressed Each derivative on balance sheet at fair value If no hedge, fair value changes to earnings Hedging activity not equal to hedge accounting Formalizes hedge criteria -- Designation/effectiveness Contrast with prior practices Expands definition of derivative Accommodates many prior hedge practices Introduces limited eligibility for written options Adopts transaction (versus enterprise) risk focus Adds complexity to hedge mechanics Valuing hedge items Bifurcation requirements Mark-to-fair-value time value (options/forwards) Calculating hedge ineffectiveness Tracking gains and losses in equity (i.e., other comprehensive income), then in income for cash flow hedges Impact Increased volatility in earnings and equity -- Greater use of fair value accounting -- Most hedge ineffectiveness recorded in earnings Effective date Effective for all fiscal quarters of all fiscal years beginning after 6/15/00 -- 1/1/01 for calendar-year companies -- Can early adopt at beginning of any quarter

SFAS 133 Introduction
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Fair Value Hedge
DEFINITION
Designation of a derivative instrument as a hedge of exposure to: -- "...Changes in the fair value attributable to a particular risk." Exposure must be associated with: -- Existing recognized asset or liability or -- Firm Commitment Hedgeable Transactions Single transaction or group of individual transactions that: Share the same risk exposure for hedge designation purposes (if group), Is transacted with an external third party, and Presents an exposure to variations in fair value that could affect report earnings.

Fair Value Hedging
CRITERIA

Hedging relationship must be designated
Risk management objective and strategy for hedge must be formally documented, including:
-- Hedged item (specific transactions)
-- Hedging instrument (derivative)
-- How effectiveness will be assessed (highly effective)
-- Risk being hedged (as specifically defined)

Permitted Risks

Must represent an exposure of earnings
For nonfinancial items (other than loan servicing rights) must be risk of ENTIRE changes in fair values
For financial assets or liabilities, fair value changes attributable to:
-- Entire asset/liability
-- Market interest rates (but not just the Risk Free Rate - E1)
-- Foreign exchange rates
-- Creditworthiness

**Hedge effectiveness**
Prospective Steps	Regression/Statistical	$ Offset
Establish expectation of effectiveness Ongoing Reaffirmation of expectations of effectiveness	Y Y	Y Y
Retrospective Steps Proving effectiveness has been achieved Measuring ineffectiveness in earnings/equity	Y N	Y Y

Time value generally marked to fair value
-- Option premiums
-- "Forward points"
-- No straight-line amortization
"Short-cut" method is restrictive
-- If key terms of hedged item and interest-rate swap match, assume perfect effectiveness prospectively

Effectiveness - "Short-cut" method

Applies to certain interest-rate swaps
Key terms of swap and hedged item must match
Allows company to assume perfect effectiveness
Eliminates need to reassess effectiveness thereafter
-- Similar to current synthetic accounting practice (except for balance sheet effects)
Swap notional amount = hedge item's principal
Swap has zero fair value at inception
Formula identical for each net settlement under swap
Hedged item cannot be prepaid
No other terms invalidate assumed effectiveness
Creditworthiness of parties need not be comparable

Effectiveness - "Short-cut" method - (fair value hedge specific)

Swap expiration matches interest-bearing asset/liability maturity
No floor or cap on floating leg of swap
Interval between repricing dates on the floating leg of swap are frequent (3 to 6 months or less)
-- Justifies current market rate assumption

**Selected Prohibited Items**
Items ultimately remeasured at fair value in earnings -- Trading securities -- Existing FX assets/liabilities (FX risk only) Market interest-rate risk of held-to-maturity securities -- Obligor's creditworthiness permitted Preferred stock Minority interests in consolidated subs -- Trust preferred unless classified as debt Equity investments in unconsolidated subs Company's own equity instruments Grouped items if dissimilar or no shared risk Transactions with stockholders -- Projected purchases of treasury stock -- Payments of dividends

**Fx Hedging Overview**
Three Types of Foreign Currency Hedges Items not Qualifying for Fx Hedging

Three Types of Foreign Currency Hedges

	Eligible Hedged Item	Eligible Hedging Instrument
Fair Value	Unrecognized Firm Commitments AFS Securities *	Derivative or Cash Instrument Derivative Instrument Only
Cash Flow	Forecasted Transaction Forecasted Intercompany Transaction	Derivative Instrument Only Derivative Instrument Only
Net Investment	Net Investment in a Foreign Operation: -- Beginning Balance Only	Derivative or Cash Instrument

*Certain restrictions apply

**Items Not Qualifying as Foreign Currency Hedges**
Recognized Foreign Currency Assets or Liabilities -- That may give rise to a foreign currency transaction gain or loss under Statement 52 (e.g., a foreign currency denominated receivable or payable) (¶21 (c) (1)) Forecasted Acquisition of Foreign Currency Assets or Liabilities -- That may give rise to a foreign currency transaction gain or loss under Statement 52 (¶29 (d)) Hedging Entire Fair Value of a Foreign Currency Asset or Liability (Issue H3) -- Fx exposures may not be hedged; already remeasured in earnings currently -- Also Fx - coupon payments arising from fixed-rate debt is not hedgeable as either a firm commitment or forecasted transaction (Issue H4) Compound Currency Swaps Generally Not Eligible as Hedging Instruments

**Mortgage Banking Hedging Activities**
Mortgage Servicing Rights Hedging -- Fair value of contracts Warehouse/Pipeline Hedging -- Existing commitments -- Unexpected fall-out -- Unexpected pull-through

**How do we hedge mortgage servicing rights?**
Loan servicing rights are not financial instruments, however, they are considered financial items for purposes of applying SFAS No. 133. Hedging or Mortgage Servicing Rights considered a "Fair Value Hedge." Permitted risks to be hedged in fair value hedge of financial items (or loan servicing rights) Risk of Changes in Fair Value: -- Entire hedge item -- Attributable to market interest rates -- Due to changes in foreign currency rates -- Due to changes in the obligor's credit worthiness -- Prepayment option in prepayable instrument Unrecorded servicing rights can be hedged as unrecognized firm commitments Interaction between SFAS No. 125 stratification criteria and SFAS No. 133 create complexities Mortgage Servicing Groups of MSRs must be similar from a fair value sensitivity perspective -- If entire hedged portfolio changes in value by 10% -- No "individual item" within the portfolio may change in value by < 7% or > 13% Current methods of grouping MSRs under SFAS No. 122 will likely cause the SFAS No. 133 aggregation limits to be breached include -- Mortgage loan level -- Geography -- Product type -- Origination date -- Mortgage coupon

**How do we hedge warehouse loans and the loan pipeline?**
Hedging the warehouse loans or firm commitments can be considered either a fair value or cash flow hedge -- Fair value hedge ---» Interest rate risk of existing loan/commitment -- Cash flow hedge ---» Cash flow variability upon forecasted loan sales due to interest rates Hedging the loan pipeline is more complicated: -- Interest rate lock commitments ---» are neither firm commitments nor derivatives -- Firm commitments ---» see above -- Unexpected fall-out/pull-through ---» not directly hedgeable; focus on cash flow hedging (probability of forecasted loan sales)

**Fair Value Hedge - MECHANICS**
Measurement of Derivative Change in Fair Value ----------» Earnings * Measurement of Hedged Item Change in Fair Value ----------» Earnings * *Hedge ineffectiveness resulting from excess derivative gains/losses reported currently in earnings. To assess effectiveness, risk management strategy may exclude the time value component of a derivative's change in fair value (e.g., option premium, forward discount or premium) -- Time value recognized currently in earnings -- Ineffectiveness related to intrinsic value recorded in earnings

**Illustrations of Short Cut**
Example A: Interest Rate Swap/Existing Fixed Rate Debt (short-cut method) Example B: Fx Forward/Firm Commitment to Purchase Equipment Example C: Interest Rate Swap/Fixed Rate Receivable

Illustrations - Example A

On 1/1/05, Bank XYZ issued 100 mm fixed-rate note at 6%, semiannual payments, noncallable, 5-year term
Bank wants to convert the fixed rate to LIBOR; Bank enters into an interest-rate swap to pay LIBOR and received 6% fixed.
Swap terms include a 100 mm notional principal, a 5-year term, and semiannual variable-rate reset on the floating pay leg
LIBOR is 5.7% at 1/1/05

Assumptions

Short-cut requirements have been met at inception
At 6/30/05, interest rates decrease; at 12/31/05, rates increase.

Given these facts, fair values are as follows:

	1/01/05	6/30/05	12/31/05
Fair value of pay LIBOR swap	$0	$3,804,000	$3,437,000

	6/30/05	12/31/05
Cash flows on debt: Principal amount Fixed rate Variable interest payment on debt	100,000,000 6.00% (3,000,000)	100,000,000 6.00% (3,000,000)
Cash flows on swap: Fixed interest receipt Variable interest payment* Interest (payment) receipt on swap	3,000,000 (2,850,000) 150,000	3,000,000 (2,350,000) 650,000
Net cash flow on debt and swap	(2,850,000)	(2,350,000)

*Rate decreased 100 basis points on 7/1/05 reset.

Journal entries at 6/30/05:

Interest expense 3,000,000
Interest payable 3,000,000

To accrue interest payable on debt at ((6.0% x 100mm)/2).

Interest receivable                                                  3,000,000
   Interest expense                                                                                                          150,000
     Interest payable                                                                                                      2,850,000

To accrue net payable under swap (receive 6.0% and pay 5.7%).

Interest rate swap (asset) 3,804,000
Debt 3,804,000

To record fair value of swap ($3,804,000 - $0).

Journal entries at 12/31/05:

Interest expense 3,000,000
Interest payable 3,000,000

To accrue interest payable on debt at ((6.0% x 100mm)/2).

Interest receivable                                                  3,000,000
   Interest payable                                                                                                        2,350,000
     Interest                                                                                                                       650,000

To accrue net receipt under swap (receive 6.0% and pay 4.7%).

Debt 367,000
Interest rate swap 367,000

To record change in fair value of swap ($3,437,000 - $3,804,000).

**Illustrations - Example B**
Hedged item: Firm commitment to buy equipment in lira from Italian manufacturer Exposure: FV changes in price due to foreign currency rates Hedging derivative: Foreign currency (FX) forward Recognize FX forward as asset or liability at FV and mark to fair value in earnings. Recognize FX-related changes in FV of firm commitment in earnings (ineffectiveness will result if different from derivatives) Upon purchase, record equipment at cost "fixed" by FX forward (assuming forward deemed fully effective) Settlement of FX forward relieves asset/liability

**Illustrations - Example C**
Hedged item: Fixed-rate, US$ loan receivable Exposure: FV changes in loan due to interest rates Hedging derivative: Interest-rate swap (Pay fixed; Receive floating) Recognize interest-rate swap as asset or liability at FV and mark to fair value in earnings Recognize interest-rate related changes in FV of loan receivable in earnings Record interest income on receivable Account for revaluation premiums and discounts -- Impairment, amortization, etc.