PricewaterhouseCoopers Credit Derivatives: Understanding the Impact on Financial Statements

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PricewaterhouseCoopersCredit Derivatives
Understanding the Impact on Financial Statements

• David Lukach Partner
• Chip Currie Senior Manager
• Structured Finance Group

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Agenda

• Objectives
• Analyzing financial statements to assess credit
  derivatives
  
• Ground rules of FAS 133
• Credit derivatives used for credit risk
  management
  
• Investments in credit linked notes (CLNs)
• Special Purpose Vehicles / Special Purpose
  Entities
  
• FASBs SPE consolidation project

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Objectives
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Objectives

• Understand how financial statements are affected
  by credit derivatives
  
• The accounting treatment of credit derivatives
• Special Purpose Vehicles
• FASB Consolidation Project

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Analyzing financial statements to assess credit
derivatives
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Analyzing Financial Statements Where do you
start

• Footnotes to financial statements serve as the
  roadmap
  
• Accounting Policy footnotes
• Financial Instruments and Fair Value footnotes
• Trading Revenues and Assets and Liabilities
• Investment Securities
• Loans
• Credit Related Products / Derivative Contracts
• Managements Discussion and Analysis
• Value at Risk Disclosures

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What am I looking for

• Discussion of the Banks derivative activities
• Risk management strategies and objectives
• Trading
• Hedging
• Information regarding where the derivative
  transactions are presented in the financial
  statements
  
• Balance Sheet
• Income Statement

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Where will this likely point me to

• Balance Sheet
• Trading Account Assets
• Allowance for credit losses
• Investment Securities
• Derivatives (asset or liability)
• Income Statement
• Interest Revenues and Expenses
• Provision for Loan Losses
• Trading Revenues
• Investment Securities Revenue
• Other Comprehensive Income (stockholders equity)

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Ground rules of FAS 133
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Credit Products

• Most credit products are considered derivatives
  subject to the requirements of FAS 133
  
• Credit Default Swaps
• Total Return Swaps
• Financial guarantees contacts are not considered
  derivatives

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FAS 133 Model Overview

• Hedge Accounting
• Complex accounting rules
• FAS 133 sets forth very detailed
• criteria
• Types of credit hedges
• Loan portfolios
• Individual loans

• Trading Activities
• Speculative derivatives
• Portfolio credit derivatives
• Undesignatedderivatives
• Hedges of trading assets

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Why is getting hedge accounting important

• Hedge accounting allows the Bank to match the
  timing of recognition of gains and losses on the
  derivative with timing of recognition of gains
  and losses on the hedged item
• Loss on loan
• Gain on derivative
• Reduces income statement volatility
• Reflects the economics of the transaction

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Why is getting hedge accounting important

• Trading activities are recorded at fair value
  with changes in fair value reflected in the
  income statement
  
• Gain on derivative is recorded in earnings when
  its market value increases
  
• Loss on loan is recognized when it is measurable
  and probable
  
• Timing mismatch derived from loan losses vs.
  derivative MTM
  

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FAS 133 Fair Value Hedge Model
MTM Derivative
MTM underlying for risk hedged
Income Statement

• Perfectly effective hedges no income statement
  impact
  
• Hedge ineffectiveness (/- 20) income statement
  volatility
  
• Ineffectiveness does not mean bad hedges

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FAS 133 Fair value hedge model involves changes
to traditional loan accounting

• Hedged loans are no longer held at amortized
  cost
  
• Loan balances are adjusted for changes in fair
  value attributable to the hedged risk
  
• Interest rate risk
• Credit risk
• When loans are hedged the traditional model for
  loan loss reserves (allowance for loan losses) is
  modified
  
• Balance Sheet Loans adjusted in part to fair
  value (loans)
  
• Income Statement Changes in fair value recorded
  in PL (provision for loan loss or trading)
  
• Change in the fair value of the derivative is
  recorded in PL

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Credit derivatives used for credit risk management
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Using credit derivatives

• Frequently banks use credit derivatives
• to hedge risks inherent in their loan portfolio
• to diversify credit risk synthetic portfolio
  management
  
• to obtain regulatory capital relief

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Typical Bank Hedging Strategy
Purchased Credit Default Swap
Pay 50 bps on 100m notional
Single Loan Principal 100m
Credit Default Swap Counterparty
Bank
Portfolio of Loans 10 Loans Total Principal 100
m
Contingent Payments on Reference credits
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Hedging A few of the requirements

• In order to achieve hedge accounting the bank
  must demonstrate that the changes in the fair
  value of the derivative is highly effective at
  offsetting changes in the fair value of the
  hedged credit spread
• Definition of highly effective 80 - 125 ratio
  of
  
• Change in fair value of derivative vs.
• Change in fair value of the hedged loan relating
  to credit risk

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Interest Rate and Credit Risk Defined
Interest Rate Risk The benchmark rate
Credit Risk
Credit Spread
or
Spread to LIBOR
Risk Free
or
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Hedge accounting issues

• Difficult to get hedge accounting for a portfolio
  of loans using a credit derivative (not
  homogeneous)
  
• A portfolio must have similar risks
• Credit risks of different borrowers generally are
  not highly correlated
  
• Can not get hedge accounting for CDS hedging the
  risk of undrawn loan commitments (difficult to
  demonstrate probability)
  
• Banks are finding it difficult to demonstrate
  that single name credit derivatives are effective
  at hedging a loan
  
• Differences in credit default swap spreads vs.
  FASB proscribed method of calculating change in
  fair value due to credit risk
  

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Hedge accounting issues

• Key Point Even if hedges qualify for hedge
  accounting ineffectiveness is recorded in
  earnings
  
• Some level of income statement volatility
• For example 80 offset 20 inefficiency (can
  be a gain or loss)
  

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What if the CDS Does Not Qualify for Hedge
Accounting

• All derivatives must be reported at FV
• All changes in FV must be reflected in current
  earnings when they occur
  
• Income statement volatility due to immediate
  recognition of changes in FV of CDS
  
• Bank is not permitted to reflect changes in FV of
  loan unless it qualifies as a hedging
  relationship
  

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Key Derivatives Disclosures

• FAS 133 changed disclosure requirements
• Certain information is no longer required as many
  readers found the information to be irrelevant
  
• Notional values
• Average fair values
• Must disclose the amount of ineffectiveness in
  hedging relationships
  
• Evaluate the Companys hedging relationships
• Isolate the impact of any ineffectiveness
  recorded in the income statement
  
• Disclosure may be at a very high level

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Key Points

• Income statement volatility is unavoidable
• CDS will not be a perfect hedge
• Trading activity is not necessarily speculative
• Some economic hedges will not qualify for hedge
  accounting
  

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Key Points

• Qualitative information is important Where do I
  look
  
• MDA and Footnotes
• Risk Management Strategy
• VAR Disclosures
• Accounting Policy footnote
• Balance Sheet
• Income Statement

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Investments in credit linked notes
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Credit Linked Notes (CLNs)

• CLNs are debt instruments whose repayment of
  principal and/or interest are contingent upon the
  credit performance of specifically identified
  reference assets
• CLNs can be issued directly by an institution or
  created synthetically (as illustrated in the
  following)
  
• A CLN investment can provide a bank with
  specifically tailored credit risks/returns
  
• Banks invest in CLNs to help diversify their
  credit portfolio
  
• Banks also issue CLNs to help hedge their credit
  portfolio
  
• Investing in CLNs or issuing CLNs can cause
  income statement volatility under FAS 133

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Bank Invests in Credit Linked Note
Market
300m cash
300m highly rated securities
Pay X bp on 300m notional
100m cash
Credit Default Swap Counterparty
Special Purpose Vehicle
Bank
Credit Linked Notes
Contingent Payments On Reference credits
Credit Linked Notes
200m cash
Investors
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FAS 133 Embedded Derivatives

• FAS 133 addresses accounting for freestanding
  derivatives and embedded derivatives (complex
  notion)
  
• Derivatives embedded in cash instruments are
  required to be bifurcated and accounted for
  separately if certain conditions are met
  
• The combined instrument is not already being
  accounted for at FV (with changes in FV reflected
  in income)
  
• Embedded instrument is equivalent to a free
  standing derivative (cannot hide a derivative to
  avoid FAS 133)
  
• The embedded instrument would not be considered
  clearly and closely related to the host
  instrument (different types of risk)

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Application to Investments in CLNs

• CLNs can be viewed as
• A host debt security issued by the Special
  Purpose Entity plus
  
• An embedded CDS
• Host debt security
• Changes in FV are not reflected in current
  earnings
  
• Changes in FV are reflected in other
  comprehensive income
  
• The embedded CDS generally will be separately
  accounted for as a derivative under FAS 133
  
• The embedded CDS would not be considered clearly
  and closely related to the host debt security
  because it reflects credit risk of an independent
  third party reference credit

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Conclusions

• The embedded CDS written by the Bank must be
  separately accounted for as a derivative
  
• The bifurcated CDS likely will not qualify for
  hedge accounting
  
• The bifurcated CDS will be reported at FV with
  changes in FV reported in current earnings
  
• The host debt instrument (after bifurcation of
  the credit derivative) will be accounted for as
  AFS
  
• The same analysis applies if the CLN is issued by
  the Bank
  
• Bifurcated CDS may qualify for hedge accounting

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Special Purpose Vehicles / Special Purpose
Entities
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What is an SPE

• No clear definition in the accounting literature
  for an SPE
  
• Generally it is a entity established for a
  limited purpose to benefit an individual or an
  entity
  
• Investing in specified assets
• Securitizing risks
• Can be structured in a variety of legal forms
• Corporations
• Trusts
• Partnerships
• Limited Liability Companies

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Why do people use SPEs

• They are frequently utilized to legally isolate
  specific assets and liabilities
  
• SPEs can efficiently allocate risks to multiple
  market participants (Synthetic CLOs)
  
• SPEs can also be used to tailor or customize
  risks ( to create specific risk profiles)
  
• Obtain access to different sectors of the market
• Insurance companies
• Hedge funds

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Consolidation of SPEs

• Who should consolidate a SPE
• Consolidation vs. non-consolidation of SPEs
  impacts the balance sheet of the bank
  
• Potential impact on the income statement from
  consolidation of an SPE
  
• Consolidation of the SPE may not invalidate the
  business purpose of the SPE (achieve credit risk
  reduction)

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Bank Hedging Synthetic CLO
Market
100m cash
100m highly rated securities
Single Loan Principal 100m
Pay 50 bps on 100m notional
97m cash
Special Purpose Vehicle
Investors
Bank
Contingent Payments On Reference credits
Notes
Portfolio of Loans 10 Loans Total Principal 100
m
3m cash
Equity
Investors
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Accounting Literature - SPEs

• The accounting literature regarding consolidation
  of SPEs is very complicated and requires
  significant professional judgment
  
• In order to achieve off balance sheet treatment
  (unconsolidated by the bank) the capital
  structure of the SPE is very important
  
• Key factors in determining when SPEs are off
  balance sheet are
  
• Equity in legal form is held by an independent
  third party(ies)
  
• Equity equal to at least 3 of assets
• Equity must expose the independent third parties
  to first dollar loss on the assets of the SPE
  
• Equity cannot be hedged or protected in any way
• Equity must be outstanding for the entire life of
  the transaction

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What if this SPE is consolidated

• If a bank consolidated a synthetic CLO SPE it
  would be reflected in the consolidated financial
  statements of the bank
  
• Assets owned by the SPE (highly rated
  securities)
  
• The notes issued by the SPE
• Embedded derivative in notes issued by SPE
• Equity of the SPE (minority interest)
• Primary impact is a balance sheet gross-up
• Assets of SPE
• Liability and equity issued by SPE

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What if this SPE is not consolidated

• Bank would account for the CDS
• The same methodology as for a freestanding CDS (a
  derivative)
  

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FASB SPE consolidation project
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History/Motivation

• For a number of years the FASB has been working
  on developing a new consolidation project for
  Special Purpose Entities (1982)
  
• In light of recent events the FASB is fast
  tracking issuance of an interpretation to
  existing consolidation literature

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When is it coming

• Final interpretation is expected to be issued by
  August 1 2002
  
• The interpretation will be immediately effective
  for transactions completed after issuance
  
• Accounting for SPEs established prior to the
  issuance of new guidance will be impacted
  
• In fiscal years beginning after December 15
  2002
  
• No grandfathering of old transactions
• Ability to revise SPEs
• Calendar year companies apply new rules on
  1/1/03
  

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Expected changes to existing GAAP model

• Minimum acceptable legal form equity to keep SPE
  off balance sheet will increase from 3 to 10
  
• SPEs which do not have sufficient legal form
  equity will be consolidated by the primary
  beneficiary
  
• Similar to the sponsor concept that exists today
• Provide more guidance on how to define a primary
  beneficiary
  
• Primary beneficiary Bank who transfers credit
  risk

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Summary

• New model will be effective for structures
  completed after its issuance
  
• For calendar year companies new rules will apply
  to all SPEs as of January 1 2003
  
• Current SPEs
• Revise or modify if possible to meet the
  requirements of the new rules
  
• Terminate SPEs
• Consolidate SPEs if new GAAP requirements for off
  balance sheet are not met
  
• Restatement of prior year financial statements
  will not be required
  
• Adoption through cumulative change in accounting
  principal