Mark-to-market accounting undercuts banks' loan hedging

RMA Journal, The, May, 2003 by Allan Yarish, Brian Hurdal

FAS mandates that derivatives be recognized in the statement of financial condition as either assets or liabilities and are to be disclosed at fair value. Changes in fair value of the derivative instrument may be offset by changes in the value of the hedged asset. However, distortions that arise from differences between fair value accounting of derivative instruments and the accrual accounting valuations used in valuing bank loans makes hedge accounting difficult if not impossible to achieve. This article explains the problem and offers a possible solution.

Money can't buy happiness, but risk managers like to think credit derivatives bring the next best thing-peace of mind in a volatile, unpredictable world. That's the argument for credit default swaps: They help manage the downside of bank lending--the risk of borrower default following an unforeseen change in financial condition.

The over-the-counter capital markets, the place where credit derivatives are originated and traded, have an enormous capacity for absorbing credit risk. As risk managers gained insight into the power of credit derivatives, banks became active users of credit derivatives to diversify loan portfolios and free up capital for additional lending. Credit default swaps today are widely used in portfolio risk management, according to the January 2003 Federal Reserve Senior Loan Officer Opinion Survey.

About 35% of the 36 largest domestic banks surveyed by the Federal Reserve said they used credit default swaps to hedge risk in their outstanding commercial loans and loan commitments. Non-U.S. banks use default swaps even more extensively. About half of the foreign banks surveyed said they purchased credit protection using default swaps. Twenty-five percent hedged 8% or more of their loan commitments with default swaps.

Both domestic and foreign banks said they preferred buying credit protection through default swaps over selling loans because swap agreements preserved the bank's relationship with the borrower.

Since the early 1990s, when default swaps were first introduced, the over-the-counter credit swap market has seen tremendous growth. The popularity of the default credit swap (CDS) is evident from the rapid growth in the notional values of these contracts. In 2001, the International Swaps and Derivatives Association (ISDA) began tracking the value of outstanding swaps; as of 2002 year-end, the notional value of outstanding credit default swaps was reported at $2,149 billion, or more than double the market size a year earlier, according to ISDA survey data.

A large part of the appeal of credit swaps is explained by their simplicity. Credit default swaps allow one party to "buy" protection from another party against potential losses in a specified loan or loan pool. The "seller" of protection, usually another commercial bank or an investment bank, agrees to make compensating payment to the buyer following any of several triggering "credit events," such as bankruptcy or failure to pay. The protection "buyer" effectively exchanges the reference entity credit risk for risk that the "seller" is willing and able to compensate the "buyer" following a "credit event."

Default swaps are easily traded in the secondary market, much like investment-grade bonds. Bank loans, on the other hand, are generally illiquid investments and are held to maturity. Five-year swap maturities trade most frequently, as this part of the credit curve typically has the highest liquidity.

Mark-to-Market versus Accrual Accounting

The other side of the story is the financial accounting standard, FAS 133 (Accounting for Derivative Instruments and Hedging Activities), a set of reporting guidelines for derivative contracts that continues to pose compliance issues for U.S. GAAP reporting companies. Non-U.S. companies will have similar hurdles to deal with when IAS 39, a comparable set of accounting rules drafted by the International Accounting Standards Board, becomes effective a year or two from now.

The objective of both FAS 133 and IAS 39 is straightforward and easily stated: Derivatives are reportable on the balance sheet as either assets or liabilities and are to be disclosed at fair value. Any changes in mark-to-market (MTM) fair value of the derivative instrument are offset by changes in the value of the hedged asset.

Inevitably, the differences between MTM accounting valuation used in valuing derivative instruments and the accrual accounting valuations used in valuing bank loans can lead to valuation distortions--and distortions in bank earnings from one quarter to the next.

Unlike financial derivatives, bank loans typically are valued at their loan origination value (book value) under accrual accounting rules. When full repayment is considered doubtful, this book value is revised downward, and the loan becomes an "adversely classified" asset.

Short-term valuation differences also can result when bank loans are hedged against longer-term derivatives. In bank risk management, a practice sometimes applied is to use a five-year default swap to hedge a shorter-term loan, such as a two-year revolver. This allows the bank to take advantage of better market liquidity--and pricing--in the five-year maturity range.