Accounting for Interest Rate Derivatives
FAS ASC 815
Presented by Wilary Winn
Douglas Winn, President
September 27, 2016
1
Today’s Presenter
Douglas Winn – President
Mr. Winn co-founded Wilary Winn in the summer of 2003
and his primary responsibility is to set the firm's strategic
direction.
Mr. Winn is a nationally recognized expert in financial institution accounting
and regulatory reporting and has led seminars on the subject for many of the
country's largest public accounting firms, the AICPA, the FDIC, and the
NCUA. Mr. Winn began his career as a practicing CPA for Arthur Young &
Company – now Ernst & Young.
Mr. Winn co-founded Wilary Winn in the summer of 2003
and his primary responsibility
is to set the firm's strategic
2
direction.
Topics Covered
• Accounting for a long-term swap designed to hedge
against rising rates on rollovers of FHLB advances
Economic purpose
• Example of cash flow hedge using the change in variable
cash flows method
Practical application of the hedging rules
3
Other Items to Consider
• Derivatives are complex and volatile
• Permitted use is therefore limited including quantitative tests
• Must be considered in the context of ALM profile and risks
 Proper ALM software
 Consider alternatives
o Floating rate assets
o Longer duration liabilities
• Not all credit unions are eligible
 Federal over $250 mm in total assets, CAMEL 3 or better (2 or
better management)
4
Other Items to Consider
• Only a few types are permitted – vanilla
 Interest rate swaps, caps and floors, basis swaps, treasury
note futures
 Exchange traded versus over the counter
• Requires prior regulatory approval
• Need to consider counterparties, collateral and margining
• Requires policies, internal controls and qualified personnel
 Audited financials
 2 years of internal controls testing
5
Two Types of Hedge Accounting
1. Fair value hedge
Change in fair value of the hedging instrument runs through the
income statement, along with the change in the fair value of the item
being hedged – used for existing financial assets and liabilities
2. Cash flow hedge
“Effective” portion of the hedge is reported in Other Comprehensive
Income, while the ineffective portion is reported in current earnings –
used for forecasted transactions or variable payments on existing
financial assets and liabilities
6
Formal Designation and Documentation
Required at Inception
The CU’s objective and strategy for the hedge must include (815-20-25-3b
2):
• The hedging instrument – the derivative – interest rate swap
• The hedged item or transaction – the asset or liability being hedged –
the risk of increasing interest rates on FHLB advances
• The nature of the risk being hedged – interest rate risk
• The method that will be used to retrospectively and prospectively
measure the hedge’s effectiveness
7
•
The method that will be used to measure hedge ineffectiveness
•
Benchmark interest rate being hedged – eligible benchmark rates
(815-20-25-6A):
 Treasury rates
 Federal funds effective swap rate
 LIBOR
In addition, for cash flow hedges the following information about
forecasted transactions must be provided:
 Date on which transaction will occur
 Specific nature of asset or liability
 Quantity of the forecasted transaction
8
To qualify for hedge accounting, the hedging relationship
(both at inception of the hedge and on an ongoing basis),
shall be expected to be highly effective in offsetting cash
flows attributable to the hedged risk during the term of the
hedge - a cash flow hedge – (815-20-25-75)
9
Hedge Effectiveness Can be Measured in Two Ways:
1. Dollar-offset approach (815-20-35-5a)
• Compares changes in fair value or cash flow of the hedged item and
the derivative
• Can be applied period by period (cannot be less than 3 months) or
cumulatively
• Most believe a dollar offset range of 80%-125% would be considered
highly effective
2. Statistical methodologies
• May permit a CU to continue to use hedge accounting for the current
period even though the dollar-offset approach appears ineffective
• Complex to implement and requires multiple observation periods
10
Statistical Approaches – Regression Analysis
•
Minimum of 30 observations
•
Must consider changes in the value of the derivative and the
hedged item
•
Time horizon must coincide or be less than the time horizon
of the hedge relationship
•
Must consider whether to regress value changes or value
levels
•
Must review distribution of error terms
EY Derivatives and Hedging, October 2013 4.9.2.4
11
Statistical Approaches – Regression Analysis Continued
•
R-squared result must exceed a pre-specified level (e.g.
0.80)
•
Hedge relationship must correspond to beta (the slope of the
regression line)
•
Standard error must be used to calculate the reliability using
the t statistic
•
T-test must be passed at a 95% confidence level
•
Must consider y-intercept
•
Must compare results to dollar offset results
EY Derivatives and Hedging, October 2013 4.9.2.4
12
R-squared Analysis
Hedged item – floating dividend rate on money market shares
1 Mo LIBOR Line Fit Plot
1.60
Dividend Rate
1.40
1.20
1.00
0.80
0.60
Div. Rate
0.40
Predicted Div. Rate
0.20
0.00
0.00
1.00
2.00
3.00
1 Mo LIBOR
13
4.00
5.00
6.00
A credit union shall consider hedge effectiveness in two
different ways:
1. Prospective Considerations
2. Retrospective Evaluations
14
Prospective Considerations (815-20-25-79 a)
• Can be based on regression or other statistical analysis of past changes
in fair values or cash flows as well as on other relevant information
• Shall consider all reasonably possible changes in fair value (if a fair
value hedge) or in fair value or cash flows (if a cash flow hedge) of the
derivative instrument and the hedged items for the period used to
assess whether the requirement for expectation of highly effective offset
is satisfied
• Not be limited only to the likely or expected changes in fair value (if a
fair value hedge) or in fair value or cash flow (if a cash flow hedge)
• Generally involves a probability-weighted analysis – consistent with
FASB Concepts Statement No. 7
15
Retrospective Considerations (815-20-25-79a)
•
•
•
•
An assessment of effectiveness shall be performed
whenever financial statements or earnings are reported,
and at least every three months
Can be based on dollar offset or statistical approaches
Dollar-offset measurement can be for period or
cumulative
Statistical methods must be similar period to period (e.g.
same number of data points)
16
Entities can assume no ineffectiveness in an interest rate
swap in two instances:
1. A private company that enters into a pay fixed, receive
floating interest rate swap (this exemption does not apply
to credit unions) (815-20-25-131B)
2. A swap can be examined to determine if it can be
accounted for under the Short-Cut Method (this applies to
all companies, including financial institutions)
17
To conclude no hedge ineffectiveness in a hedge with an interest rate swap, all of the following
conditions must be met for both fair value and cash flow hedges (815-20-25-104):
a. Notional amount of swap matches principal amount of item being hedged
b. Fair value of the swap is zero at inception (can ignore bid/ask spread, commissions and other
transaction costs)
c. Formula for computing net settlements remains the same throughout the swap
i.
Fixed rate remains the same
ii. Variable rate index does not change
d. Interest bearing asset or liability is not pre-payable
i.
Unless the prepayment is due to an embedded call (put) option and the swap has a mirror option call
(put) option - options must match exactly
ii. Because the NCUA does not allow a credit union to enter into a swap with this feature, we believe a
swap involving loans that can be prepaid will not qualify for the short-cut method
e. Index on which the variable rate leg is based matches the benchmark interest rate
designated as the interest rate being hedged
Note: For the purposed of determining zero: can ignore bid/ask spread at inception, commissions, and other
transaction costs
18
• WW Risk Management does not recommend the short-cut
method, because if you fail, you cannot reassess
• Another alternative generally used for cash flow hedges is
the critical terms match – notional amount, interest rate,
and maturity
• We recommend that a credit union account for the swap
using the long-haul method, recognizing that swaps that
would qualify for the short-cut or critical terms method will
easily pass the effectiveness testing
19
What if the Hedge is Not or No Longer Effective?
The hedge accounting is discontinued prospectively, resulting
in potential income statement volatility as the derivative is
marked to market with no offset to the hedged item (cash flow
hedge 815-30-40-1)
Cash flow hedge - the net gain or loss remains in AOCI unless
it is probable that the forecasted transaction will not occur by
the end of the originally specified time period plus a 2 month
extension (815-30-40-4)
20
A credit union may designate a derivative instrument as
hedging the exposure to variability in expected future
cash flows that is attributable to a particular risk. That
exposure may be associated with either of the following
(815-20-25-13):
• Payments on an existing recognized asset or liability (such
as all or certain future interest payments on variable-rate
debt or variable rate liabilities – FHLB advance)
• A forecasted transaction (such as a forecasted purchase or
sale)
21
A forecasted transaction is eligible for designation as a hedged
transaction in a cash flow hedge if all of the following criteria
are met (815-20-25-15):
A forecasted transaction is specifically identified as either:
a. A single transaction
b. A group of individual transactions that share the same risk
exposure for which they are designated as being hedged. A
forecasted purchase and a forecasted sale shall not both be
included in the same group of individual transactions that
constitute the hedged transaction.
22
• The occurrence of the forecasted transaction is probable
• The forecasted transactions meets both of the following conditions:
o It is a transaction with a party external to the reporting entity
o It presents an exposure to variations in cash flows for the hedged risk that
could affect reported earnings
• The forecasted transaction is not the acquisition of an asset or
incurrence of a liability that will subsequently be re-measured with
changes in fair value attributable to the hedged risk reported currently
in earnings
• If the forecasted transaction relates to a recognized asset or liability,
the asset or liability is not re-measured with changes in fair value
attributable to the hedged risk reported currently in earnings
23
• If the hedged transaction is the variable cash inflow or outflow of an
existing financial asset or liability, the designated risk being hedged is
any of the following:
o The risk of overall changes in the hedged cash flows related to the asset or
liability, such as those relating to all changes in the purchase price or sales
price
o The risk of changes in its cash flows attributable to changes in the designated
benchmark interest rate (referred to as interest rate risk)
o The risk of changes in its cash flows attributable to all of the following
(referred to as credit risk):
i. Default
ii. Changes in the obligor’s creditworthiness
iii. Changes in the spread over the benchmark interest rate with respect
to the related financial asset’s or liability’s credit sector at inception of the
hedge.
24
Hedge Ineffectiveness for Income Statement is
Measured by the Dollar-offset Method
Cash Flow Hedge:
Ineffectiveness must be separately measured and recorded on
the income statement. If the fair value of the derivative changes
by more than the present value of hedged cash flows, the
difference is the ineffective amount. If the fair value of the
hedged cash flows changes by more than the change in the fair
value of the derivative then no ineffectiveness and no journal
entry is necessary (815-20-35-1c)
25
Ineffectiveness testing for a cash flow hedge involving an
interest rate swap can be done using one of three methods:
• Change in variable cash flows method (815-30-35-16 through 24)
• Hypothetical derivative method (815-30-35-25 through 30)
• Change in fair value method (815-30-35-31 through 32)
26
Non-performance Risk for Cash Flow Hedges Using
Interest Rate Swaps
• The discount rate used for the change in variable cash flows
method and the hypothetical derivative method is the rate
applicable to determining the fair value of the swap (815-30-3520).This means that the non-performance risk of the swap
counterparty would be applied to the swap and the hedged item
cash flows so it would not in itself result in effectiveness. Issue
arises if default of counterparty is “probable”
• Non-performance risk can result in effectiveness using the
change in fair value method (815-30-35-17)
27
Accounting for cash flows
AOCI reclassified into earnings in the same period in
which the forecasted transaction affects earnings
28
Hedge Accounting Examples – Rollover of
FHLB Advances
• Hypothetical derivatives
• Change in variable cash flows
29
Economic Example and Summary of Terms
FHLB Pricing
4 year swap rate 8-31-15 = 1.41%
4 year FHLB advance rate 8-31-15 = 1.70%
1 year FHLB advance rate 8-31-15 = 3 month LIBOR + 7 basis points
Alternative 1: 4 year FHLB advance rate @ 1.70%
Alternative 2: 1 year LIBOR based advance & 4 year interest rate swap which
results in a fixed rate of 1.48%
Benefit: 22 basis points a year for 4 years assuming annual renewal of spread to
LIBOR remains constant
30
Critical Terms
• Notional amount of the swap and FHLB advance match at $50 MM
• Fixed rate on the swap is the same throughout the term and the variable
rate equals LIBOR
• Index on the swap’s variable interest rate leg matches the benchmark
interest rate designated as the risk being hedged (three month LIBOR)
• No interest payments beyond the term of the swap are designated as
hedged
• Swap and borrowings re-price on the same day
• FHLB advance contains a floor and the swap does not include a cap
• Determination that the it is probable that the swap counterparty will not
default on its obligations
31
Example – 4 year swap with 3 years remaining
A $50 MM 4-year pay fixed, receive floating interest rate swap is used to hedge
against the risk of increase in interest rate related cash flows on rollovers of a credit
union’s FHLB advances.
Qtr Days
5
6
7
8
9
10
11
12
13
14
15
16
Total
90
88
90
90
90
88
90
90
90
88
90
90
Fair Value of the Swap
Pay
Receive
Net
Fixed
Floating Payments
(178,208)
(176,250)
(180,167)
(180,167)
(178,208)
(176,250)
(180,167)
(180,167)
(178,208)
(176,250)
(180,167)
(178,208)
(2,142,417)
105,338
120,695
125,352
130,635
134,130
137,791
145,296
150,089
148,489
150,329
157,414
159,384
1,664,941
(72,871)
(55,555)
(54,814)
(49,532)
(44,078)
(38,459)
(34,871)
(30,077)
(29,720)
(25,921)
(22,752)
(18,824)
(477,475)
Fair Value of the FHLB Advance (hypothetical derivative)
Pay
Receive
Net
Present
Qtr Days
Fixed
Floating Payments
Value
Present
Value
(72,717)
(55,304)
(54,430)
(49,057)
(43,539)
(37,884)
(34,250)
(29,453)
(29,017)
(25,232)
(22,078)
(18,234)
(471,193)
5
6
7
8
9
10
11
12
13
14
15
16
Total
32
90
88
90
90
90
88
90
90
90
88
90
90
178,208
176,250
180,167
180,167
178,208
176,250
180,167
180,167
178,208
176,250
180,167
178,208
2,142,417
(105,338)
(120,695)
(125,352)
(130,635)
(134,130)
(137,791)
(145,296)
(150,089)
(148,489)
(150,329)
(157,414)
(159,384)
(1,664,941)
72,871
55,555
54,814
49,532
44,078
38,459
34,871
30,077
29,720
25,921
22,752
18,824
477,475
72,717
55,304
54,430
49,057
43,539
37,884
34,250
29,453
29,017
25,232
22,078
18,234
471,193
Example – 4 year swap with 3 years remaining
A $50 MM 4-year pay fixed, receive floating interest rate swap is used to
hedge against the risk of increase in interest rate related cash flows on
rollovers of a credit union’s FHLB advances.
Fair value of the interest rate swap
Fixed leg
Gross cash flow
(2,142,417)
Discounted cash flow
(2,106,437)
Variable leg
Gross cash flow
Discounted cash flow
1,664,941
1,635,244
Swap fair value
(471,193)
Fair value of the FHLB advance (hypothetical derivative)
Fixed leg
Gross cash flow
2,142,417
Discounted cash flow
2,106,437
Variable leg
Gross cash flow
Discounted cash flow
(1,664,941)
(1,635,244)
Swap fair value
471,193
Effectiveness
100%
33
Credit Union Must Perform Effectiveness Testing
• Effectiveness testing will be based on the changes in
LIBOR only – as a benchmark interest rate
• Ineffectiveness will measured using the change in
variable cash flows method
34
Hedge Ineffectiveness is Based on a Comparison of:
• Variable leg of the interest rate swap
• Hedged variable-rate cash flows on FHLB advance
• Based on the premise that only the floating-rate component of the
interest rate swap provides the cash flow hedge
• The interest rate swap is recorded at fair value on the balance
sheet. The calculation of ineffectiveness involves a comparison of
the following amounts:
o The present value of the cumulative change in the expected
future cash flows on the variable leg of the interest rate swap
o The present value of the cumulative change in the expected
future interest cash flows on the FHLB advances
35
• Hedge ineffectiveness results when the present value of
the cumulative cash flows on the swap exceed the present
value of the cumulative cash flows of the designated FHLB
advances. Conversely, there is no ineffectiveness if the
PV of the designated FHLB advances exceed the PV of the
swap (FAS ASC 815-30-35-3(b))
36
A $50 MM 4-year pay fixed, receive floating interest rate swap was entered
into on August 31, 2015.
Qtr
5
6
7
8
9
10
11
12
13
14
15
16
Total
Days
90
88
90
90
90
88
90
90
90
88
90
90
Fair Value of the Swap
Pay
Receive
Net
Fixed
Floating
Payments
(178,208)
(176,250)
(180,167)
(180,167)
(178,208)
(176,250)
(180,167)
(180,167)
(178,208)
(176,250)
(180,167)
(178,208)
(2,142,417)
105,338
120,695
125,352
130,635
134,130
137,791
145,296
150,089
148,489
150,329
157,414
159,384
1,664,941
(72,871)
(55,555)
(54,814)
(49,532)
(44,078)
(38,459)
(34,871)
(30,077)
(29,720)
(25,921)
(22,752)
(18,824)
(477,475)
Present
Value
(72,717)
(55,304)
(54,430)
(49,057)
(43,539)
(37,884)
(34,250)
(29,453)
(29,017)
(25,232)
(22,078)
(18,234)
(471,193)
At inception hedge value is $0. LIBOR rates have decreased since inception. Value
is as of August 31, 2016.
37
A $50 MM 4-year pay fixed, receive floating interest rate swap was entered into on
August 31, 2015.
Change in Cash Flows on the Hedged Item
Updated
Projected
Increase Discount Present
at Inception Projection (Decrease) Factor Value
Change in Cash Flows on the Variable Leg of the Swap
Projected
Updated
Increase
Discount Present
Factor
Value
at Inception Projection (Decrease)
117,330
139,075
161,565
181,521
194,848
207,949
230,741
248,744
250,546
258,802
279,364
293,848
2,564,332
105,338
120,695
125,352
130,635
134,130
137,791
145,296
150,089
148,489
150,329
157,414
159,384
1,664,941
(11,992)
(18,381)
(36,213)
(50,887)
(60,718)
(70,158)
(85,445)
(98,654)
(102,058)
(108,473)
(121,949)
(134,464)
(887,399)
0.9979
0.9955
0.9930
0.9904
0.9878
0.9850
0.9822
0.9792
0.9763
0.9734
0.9704
0.9673
(11,967)
(18,298)
(35,959)
(50,398)
(59,974)
(69,109)
(83,923)
(96,607)
(99,643)
(105,589)
(118,335)
(130,064)
(879,866)
114,830
135,409
156,565
177,771
188,598
204,282
225,741
242,494
246,796
250,246
276,864
291,348
2,510,944
106,449
120,806
125,363
131,746
134,241
137,824
146,407
150,200
148,500
151,440
157,636
159,406
1,670,017
(8,381)
(14,603)
(31,202)
(46,026)
(54,357)
(66,459)
(79,334)
(92,293)
(98,297)
(98,806)
(119,227)
(131,942)
(832,545)
$822,391 is the effective portion of the hedge. $57,475 is ineffective.
38
0.9979
(8,364)
0.9955 (14,537)
0.9930 (30,983)
0.9904 (45,584)
0.9878 (53,691)
0.9850 (65,464)
0.9822 (77,921)
0.9792 (90,378)
0.9763 (95,971)
0.9734 (96,180)
0.9704 (115,694)
0.9673 (127,624)
(822,391)
Record Fair Value of the Swap and the
Ineffective Portion
OCI
Interest Expense
Derivative Liability
$
$
413,718
57,475
$
39
471,193
Summary of Changes*
Benchmark interest rate
•
Cash flow hedge variable rate financial instruments any contractually specified rate
•
Fair value hedge of fixed rate interest rate risk – SIFMA added
Fair value hedges of interest rate risk
•
Permits partial term hedges
•
Can consider how changes in benchmark interest rates affect the decision to prepay
a pre-payable financial instrument
•
Permits the change in fair value to be based on a benchmark interest rate vs. full
contractual cash flows – permitted only when the market yield exceeds benchmark
interest rate
Critical terms match
• Forecasted transactions and hedge maturity within 31 days
* Exposure draft issued September 8th – comments due November 22nd
40
Hedge Ineffectiveness
•
No longer separately measured and reported
Effectiveness Assessments
•
Quantitative continues to be required at inception
•
Qualitative testing thereafter unless a change in the hedging relationship
•
In failure of shortcut method – can move to long haul
Designation Documentation
• Quantitative testing can be completed at the end of the quarter rather
than at inception
Disclosure Changes
• References to ineffectiveness discontinued
• Additional disclosure required
41
For those considering the use of interest rate derivatives we can:
• Identify the optimal derivative(s) to be used given your credit union's
ALM profile
• Work with you to amend your ALM policies to allow for the use of
derivatives
• Work with you to draft derivatives policies and procedures that ensure
you have the proper internal controls in place and that you meet all of
the NCUA requirements regarding the use of derivatives
• Provide estimates of ongoing fair value for loans, investments, and
liabilities which you have elected to account for at fair value. We can
also help you with the initial selection of the items
42
For those electing hedge accounting we can:
• Develop the appropriate interest rate hedge and hedging item(s)
to be used given your credit union's ALM profile
• Work with you to identify the item(s) to be hedged and the nature
of the risk being hedged
• Ensure you are able to achieve hedge accounting - including
prospective and retrospective effectiveness testing on a dollar
offset or statistical basis
• Provide you with the journal entries needed to report hedging
activities
43
http://www.wilwinn.com/industry-services/services-for-credit-unions/alm/derivatives.html
44
Asset Liability Management, Capital Stress Testing, Concentration Risk
Analyses, and CECL
Matt Erickson
[email protected]
Mergers and Acquisitions, ASC 310-30, Goodwill Impairment Testing,
and TDRs:
Brenda Lidke
[email protected]
Servicing Rights and Mortgage Banking Derivatives:
Eric Nokken
[email protected]
Non-agency MBS:
Amin Mohomed
[email protected]
45
Contact Information
Wilary Winn LLC
First National Bank Building
332 Minnesota Street, Suite 1750W
Saint Paul, MN 55101
651-224-1200
www.wilwinn.com
46