Accounting for Derivatives

1
Accounting for Derivatives

• (A Tale of Preparation, Caution and Skepticism)
• A Presentation to the NASACT 2004
• Conference
• By Edward J. Mazur
• GASB Member
• November 16, 2004

2
Topics

• The Challenge
• The Literature
• Existing Standards
• GASBs Current Project on Derivatives
• Published Concerns over Derivatives
• Points to Ponder
• Appendix Technical Presentation on Financial
  Instruments by GASB Project Manager

3
A Possible Scenario

• Come see the Governor in 30 minutes!
• Provide a briefing on all investment and debt-
  related derivative transactions now in effect
• Also, be prepared to discuss risks to the State
  from these transactions
• The Governor will give you an hour

4
The Challenge

• Could you respond readily with little or no
  staff help?

5
Definition

• A derivative is a financial instrument created
  from or whose value depends on(is derived from)
  the value of one or more separate assets or
  indexes of asset values
• OR

6
GASB Definition (TB 2003-1)

• A derivative.is a financial instrumentwith all
  3 of the following characteristics
• One or more underlyings and notional
  amounts, or payment provisions determin(ing)
  the amount of the settlement.
• Requires no initial net investment, or
  investment smaller thanfor contractshav(ing) a
  similar response to changes in market factors
• Termspermit net settlement,by a means outside
  of the contract, or ..provides delivery of an
  assetnot substantially different from net asset.

7
The Literature (a partial list)

• International Accounting Standard 39, Financial
  Instruments Recognition and Measurement,
  3/31/04
• FASB No. 149, Amendment of Statement 133 on
  Derivative Instruments and Hedging Activities,
  4/03
• The Financial Jungle A Guide to Credit
  Derivatives, 6/01, PriceWaterhouseCoopers
• FASB No. 133, Accounting for Derivative
  Instruments and Hedging Activities, as amended
  12/10/01
• FASB Financial Accounting Series, Special Report,
  Financial Instruments and Similar Items,
  12/22/00

8
The Literature (contd)

• FASB No. 133, Accounting for Derivative
  Instruments and Hedging Activities, 6/98
• FASB Financial Accounting Series, Special Report,
  Major Issues Relating to Hedge Accounting,
  10/95
• Understanding Interest Rate Swaps, Mary S.
  Ludwig, 1993
• FASB Financial Accounting Series, Special Report,
  Review of 1994 Disclosures about Derivative
  Financial Instruments and Fair Value of Financial
  Instruments, 12/95
• FASB No.80, Accounting for Futures Contracts,
  8/84

9
Product Creativity (or Complexity)

• Fixed-to-floating swaps and options
• Floating-to-fixed swaps and options
• Caps
• Collars
• Rate locks/caps
• Debt service caps
• Forward delivery bonds
• Basis swaps
• Conversion options

10
Products(contd)

• Structured notes
• Total return swaps
• Swaptions associated with synthetic refundings
• Swaps based on CPI, actual bond rates, other
  exotic indexes
• Levered swaps
• Barrier swaps
• Hybrid structures

11
Related GASB Pronouncements

• Technical Bulletin No. 2003-1, Disclosures
  Requirements for Derivatives not reported at Fair
  Value on the Statement of Net Assets, June 2003
  (superceded TB No. 94-1)
• Focus
• Updated definition of derivatives
• Disclosure of governments objective
• Disclosure of terms, fair value, and risk
• References NCGA 1and 6, GASB 1,25,31,38, and
  40, and FASB 133 149

12
Current GASB Project

• Title Derivatives and Hedging
• Objective whether current disclosures are
  appropriate, and whether derivatives should be
  displayed at fair value on statement of net
  assets
• Considerations If displayed, hedge accounting
  may be utilized----perhaps leading to matching
  debt to investments

13
Current Project Issues

• New definitions? Beyond TB 03-1 FASB 133
• Exclusion of certain types
• Normal purchases and sales
• Firm commitments
• Anticipated transactions
• Insurance contracts
• Embedded derivatives?
• Are derivatives assets and liabilities?
• Permit hedge accounting? Fair value hedge?

14
Project Issues (contd)

• Testing hedge effectiveness?
• Shortcut method of hedge accounting?
• Include futures in scope? FASB 80 currently
  applies to governments
• Permit hedge accounting for matched-book
  financings?
• Update and expand on required disclosure?

15
Possible Reporting Options

• Measure at fair value, no hedge accounting
• Measure at fair value, report gains and losses
  below the performance indicator
• Measure at fair value, deferral accounting
• Synthetic Instrument Accounting
• Context-based Measurement

16
Caution(Ripped from the Headlines)

• Moodys State HFAs Using More Swaps,Bond
  Buyer, 10/14/03
• .risks include counter-party and termination
  risk, basis risk, tax-rate risk, and amortization
  mismatch risk. Both issuers and investors
  should look for these risks to be understood
  before moving forward with HFA related swap
  transactions.

17
Caution(contd)

• SPs New System Gauges Derivatives Risk, Bond
  Buyer, 9/30/04
• (responds to) how certain derivatives will
  affect an issuers ratings.
• .will examine the issuer termination and
  collateral posting risk, the counterparty
  termination credit risk, the economic viability
  of the derivative portfolio, and the quality of
  the swap and debt management policies and
  procedures.
• Moodys) assesses.materiality of.deriviative
  activity.and.vulnerability to interest rate
  volitility.
• (Fitch) said it considers borrowers
  policies.for managing .risks of.debt
  structures, investments and .related interest
  rate hedging products.

18
Caution(contd)

• MSRBs Jester Warns Derivatives Misuse Will
  Heighten Regulation, Bond Buyer, 9/13/04
• .another 20 broker-dealer firms will face
  enforcement action .for abusive pricing
  practices.
• .the biggest potential problem for
  the.industry is the improper use of
  derivatives.
• The fastest growing, most profitable part of the
  municipal finance industry operates in a universe
  that is completely unregulated next to the
  municipal market.

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Points to Ponder (Healthy Skepticism)

• Why is there so much profit in derivatives?
• Who is on the other side of the transaction?
• Why cant the traditional fixed rate municipal
  market operate at a significantly lower cost to
  issuers?
• Are governments realizing the full effects of
  their tax exempt status?

20
Concluding Questions

• Are you truly prepared to enter into derivative
  transactions?
• Do you understand market motives and concerns?
• Do you better appreciate GASBs need to address
  accounting and reporting for derivatives through
  a new standard?

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Disclaimer and Contact Information

• The views presented today are those of Mr. Mazur
  and do not represent the opinions of the
  Governmental Accounting Standards Board, which
  are determined only after due process and
  deliberation.
• Contact information emazur_at_mindspring.com

22
Appendix

• The following is a presentation on Financial
  Instruments, dated October 25, 2004, prepared by
  Mr. Randal Finden, GASB Project Manager, for use
  in technical sessions at AICPA conferences.
• Contact information for Mr. Finden is included.