May 1, 2004
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Derivatives Accounting (FAS 133/IAS 39)
Ineffectiveness Vs. EPS Analyzing Q1 Results
June 29, 2001

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.

Stock price effects? Zilch

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).

Impact on EPS

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

 


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