CP Issuers – Beware of Re-Designation Pitfalls!

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.

6 Comments

  1. Brent Kenny on March 18, 2010 at 5:31 pm

    Kirshnan,

    You have highlighted one of the most important issues with respect to hedge accounting. The impact of the “off market” component in a derivative that is re-designated is widely regarded as a financing element. As you have pointed out, most accounting firms require that this be included as hedge ineffectiveness. This inherently does not make sense, particularly in cases where the risk management objective is to hedge variability in future cash flows.

    If the risk management objective is to offset future changes in cash flows, an off market derivative can be just as effective as an at market derivative in achieving this objective. For example, an interest rate swap, whether it is at market or off market (provided both have the same underlying index) will experience the same CHANGES in cash flows during the hedge designation period. This is easily highlighted by examining an at market and off market swap over a period of time where the underlying rate does not change. The fair market value of the off market swap will migrate back to zero at maturity and there will be no change in the fair value of the at market swap. Note that in either case, the cash flows on both of these derivatives did not change, consistent with the stated risk management objective.

    However, accounting firms require that the financing component of the off market swap be included in hedge ineffectiveness and some require that it is also included in effectiveness testing. Accounting firms have yet to sufficiently explain these requirements when, in the example highlighted above, a change in fair value off an off market swap has nothing to do with offsetting future changes in cash flows and is in fact contrary to the risk management objective (whereas GAAP requires the assessment of effectiveness to be consistent with the stated risk management strategy). Unfortunately, based on experience, involving your auditors is unlikely to produce a reasonable answer to this inconsistency in their interpretation of the accounting standards.



  2. Krishnan Iyengar on March 19, 2010 at 5:45 pm

    Brent,

    Good observation regarding hedge of anticipated future cashflows, I agree. Hedgers shouldn’t be penalized for using an existing derivative to hedge variability in future cashflows vs. using an at-market one.

    – Krishnan Iyengar



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