By Ed Rombach and Nilly
Essaides
The biggest question mark of
FAS 133 remains its impact on EPS and stock price. While
it’s still early days on FAS 133 reporting (see FAS
133’s Impact on Earnings), there are some clues in
Q1/10Q as to what FAS 133 reveals (or does not; see
Earnings
Analysis: What FAS 133 Does Not Show).
In a recent exchange of information
between two fund managers on an internet chat room, one
responded quite viscerally to published derivatives
losses at GE and AIG. “You were right to shed yourself
from GE, AIG etc.,” he wrote. “GE is highly questionable
and overvalued and their derivatives book has
significant exposure, took a $1.2 billion loss recently,
probably more to come [sic]. AIG loves ‘toxic waste’ as
well.”
This reaction came despite GE’s
explanation that its first quarter, $1.2bn loss will be
mainly offset by changes in floating-rate interest
costs.
Perhaps more telling, however, is
the fact that this fund manager appears to be in the
minority. Overall, the market shrugged off the reported
loss. On the day of the 10Q release (4/19/01), GE’s
stock closed at $48.51. It weakened slightly for the
next few days, before resuming its uptrend and peaking
at $53.40 on 5/21/01.
Further drilling into GE’s headline
derivatives losses reveals that the overall loss was
comprised of smaller charges, with the biggest component
being a one-time transition charge at adoption. Further,
the effects of FAS 133’s reporting on GE’s financials
can be separated into two:
(1) FAS
133 impact on income:
·
Fair-value hedge
losses of $503 million in the quarter ending March
31.
· An
additional $53 million in losses net of taxes
reclassified to earnings from shareholders equity
(OCI).
· A $68
million gain in hedges of net investment that did not
qualify for effectiveness (most likely derivative or
cash positions that do not qualify for hedge accounting
under FAS 133, and recorded in “interest and other
financial charges).
(2) FAS 133 impact on
Equity/OCI:
· A
transition adjustment loss of $827 million.
· A $64
million derivative gain attributable to hedges of net
foreign investments that met the effectiveness measure
(in a separate equity component related to currency
translation adjustments).
Importantly, GE’s first quarter
derivative returns contained an insignificant $3 million
negative charge for ineffective hedges of future cash
flow (i.e., cash flow hedges). Also, it included a $1
million negative charge for “amounts excluded from the
measure of effectiveness,” or derivatives that do not
qualify as hedges under FAS 133. The combined amount is
less than three one hundredths of one cent per share net
effect on earnings.
The bottom line: Of the
reported $1.2 billion in losses, the largest portion was
related to the one-time transition adjustment. Another
$503 million was a loss offset by gains on the underling
I/R position. The actual losses attributable to
ineffectiveness or derivatives that must be marked to
market in income – the sort of hit to income analysts
and treasurers have feared—totaled $4 million, and are
immaterial at best.
Why is GE disclosing this
information? It may be that GE wants to make sure
that it is meticulous in its presentation, leaving no
stone unturned. It may also be making a point with
regard to the efficacy of its hedging. Further, and
perhaps most important, GE is laying out the “base line”
for future analysis of its FAS 133 reports. Of course,
if future quarters produce massive swings in these
numbers, analysts would surely take notice.
Comparative ineffectiveness impact
So far, this razor
thin type of ineffectiveness on hedges appears to common
among reporting companies. In most cases, companies
provide a “boiler-plate” disclosure statement,
along the following lines: “The ineffective portion of a
derivative's change in fair value will be immediately
recognized in earnings,” followed up by something to the
effect that there was no ineffective portion of
designated hedges, or that they were 100 percent
effective, or that the impact was insignificant or
immaterial.
But the ineffectiveness effect is
not always negligible. In some cases, as in the case of
John Hancock (see table below), it’s quite
substantial.
Note that some of these
percentages are affected by the very small size of the
EPS number, for example John Hancock.)
Exactly how investors will read this
ratio remains to be seen, since, for many companies,
this is but the first quarter of FAS 133 reporting.
However, if some companies develop a track record of
consistently high ineffectiveness in income, it may
force either more qualitative explanation, or else bring
into question the efficacy of their risk-management
program.
Ultimately, the real headline
stories will be those that unavoidably reveal outsized
hedging ineffectiveness that contribute in a meaningful
way to earnings per share and stock performance.
END