Mark-to-market accounting undercuts banks' loan hedging

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

Given the limitation imposed by accounting rule-making bodies, the International Association of Credit Portfolio Managers reports finding no viable mechanism for establishing hedge accounting treatment for loans hedged with credit derivatives. The Derivatives Implementation Group, an advisory group affiliated with the Financial Accounting Standards Board, has to date issued very little technical guidance regarding hedge accounting for credit swaps.

How will banks react? Banks could respond to the accounting disparity created by the MTM requirement by unwinding gains halfway through the migration of a loan out of the "highly effective" range. This approach might work if the loans don't become impaired or go into default, because gains otherwise would be reversed as the revolving loan and default swap approach maturity. However, this is an unreasonable expectation and defeats the portfolio manager's main purpose of using credit derivatives, which is protection in the event of default.

Mark-to-market accounting of derivative gains (or losses) also has the unwanted result of increased volatility in reported bank earnings. Banks in general would have a more difficult time explaining volatility in earnings to the market. Gains on the MTM hedge book may not be coincident with losses on the accrual loan book, meaning that last quarter's gains offset this quarter's losses. One possible reaction is that bank GEOs and boards of directors would likely be less enthusiastic about devoting energy and money toward expensive hedges if they cannot demonstrate that hedging reduces both actual losses and volatility in income.

Hedging is important to financial institutions because it enables banks to maintain targeted, niche-oriented relationships while maintaining adequate portfolio diversification. The fact that bank loan losses in the current business cycle compare favorably to losses during the business contractions in the early 1980s and 1990s results in large part from greater emphasis on risk management and portfolio diversification. Credit default swaps also provide banks an opportunity to attract new groups of investors through the sale of participations in collateral debt obligations (CDOs) and similar investment pools backed by financial derivatives.

Some Possible Solutions

Credit default swaps would arguably be much more effective risk management tools if banks could more easily apply hedge accounting to their commercial and industrial loan portfolios. As seen in the WorldCom example, hedge accounting still requires mark-to-market reporting of the net position, or the difference between loan value and derivative instrument.

Ideally, a long-term solution to the accounting mismatch problem might be some form of scope exclusion that would effectively exempt loans hedged with credit default swaps from MTM accounting requirements. This might be accomplished through some modifications to the FAS and IAS standards that would define hedge effectiveness in qualitative terms, that is, seniority matching, maturity matching, or name matching for hedges of credit positions.