Given the extreme volatility in credit markets and the shutdown of commercial paper (CP) issuance over the last year, many CP issuers missed their forecasts, which were hedged with payer swaps. Because the shut down affected then current forecasts and called into account the ability to accurately predict when markets would thaw, many CP issuers were forced to de-designate their hedging relationships, which were getting FAS 133 accounting. Now that the commercial paper market has thawed, many issuers are now looking to re-designate these swaps and get FAS 133 hedge accounting treatment. There are a host of issues that should be considered, including calculating the correct hypothetical derivative (for those using short-cut, this is no longer possible) and the bifurcation of the derivative into its loan and derivative components.
Since the fixed rates on swaps have come down over the past year and commercial paper issuers are in payer positions, these swaps are very likely to be in large liability positions. One of the key criteria under DIG G7 for the hypothetical derivative is to have a zero fair value at the time of designation. Therefore, in most instances, the fixed rate on the hypothetical derivative will be a lot lower than on the swaps whose fair value it will be compared with. The floating leg of the hypothetical will usually match the forecast profile of the anticipated commercial paper issuance under DIG G19.
Most audit firms have put out literature stating that the swap that companies are looking to re-designate should be split into an “on-market” component and a loan. In other words, if the derivative is a payer swap that has a fixed rate of 3% and a fair value of -$1,000,000, and the then current on-market swap rate is 2%, following this logic, I technically have a “on-market” swap at 2% + a loan at 1%. Most audit firms assert that the change in value of the loan component should be treated as ineffectiveness (those using dirty values might need to back out those principal settlements). This line of reasoning doesn’t make too much sense to me since any instrument that has a fair value other than zero could potentially fall into this trap. Unfortunately, I don’t make the rules, so those looking to re-designate these relationships should involve their auditors, particularly on this point.