Hedge accounting update aims to align risk management with hedging

Finance & Accounting

The Financial Accounting Standards Board’s proposed update to its hedge accounting standard could help companies with their risk management, but they will probably need sophisticated hedging expertise to benefit.

FASB issued the proposed accounting standards update in May to align a company’s hedge accounting more closely with its risk management strategies (see story). The proposals build on the hedging standard that FASB issued in 2017, increasing transparency around how the results of hedging activities are presented, on the face of the financial statements as well as in the footnotes, for investors and analysts when hedge accounting is applied.

The 2017 standard was part of the financial instruments convergence project that FASB and the International Accounting Standards Board began pursuing in the early 2000s in an effort to harmonize U.S. GAAP with International Financial Reporting Standards. But FASB and the IASB ultimately couldn’t agree on how to treat credit losses and loan impairments, so they ended up with different versions of the current expected credit loss, or CECL, model. FASB eventually produced separate standards for classification and measurement, credit losses, and hedging, while the IASB came out with its unified IFRS 9 standard for financial instruments.

Unlike the CECL standard, which remains controversial, the hedge accounting standard proved so popular when FASB finalized it in 2017 that many financial services firms were eager to adopt it ahead of the effective date. However, some firms with sophisticated hedging and risk management strategies wanted extra tweaks, which the proposed update aims to address. The comment period ended on July 5. Unlike the 2017 hedge accounting update, only the most sophisticated firms are likely to use the latest update to the standard when it’s ultimately finalized.

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FASB, GASB and FAF logos on the wall at headquarters in Norwalk, Connecticut

Courtesy of GASB

“I think some may use it, but I don’t think organizations will use it as widely as the FASB intended,” said Tim Kviz, national assurance managing partner in the SEC services practice at BDO USA. “You’re not going to see a lot of people scrambling to try to use this strategy. It’s a pretty sophisticated strategy, and it requires a pretty sophisticated hedging desk.”

He points to when FASB first adopted its earlier hedging standard, Financial Accounting Standard 133, in 1998. “Way back when 133 was adopted, mortgage companies were hedging their loans held for sale,” he said. “They were using hedge accounting, and because the loans were pre-payable, their portfolio was changing on a daily basis. They did daily designations and de-designations. So you’d start the morning and designate hedge accounting, and at the end of day you’d de-designate. The next day, wash, rinse and repeat, over and over and over again.”

In 2008 when the fair value option came into play, that mostly eliminated the need to hedge mortgage loans held for sale using hedge accounting because companies could designate mortgage loans held for sale at fair value under the fair value option and record the changes in fair value, largely due to interest rates, until they sold the loans.

“That was a very effective replacement for trying to apply hedge accounting on a very complex asset,” said Kviz. “Now, some organizations decided to take some mortgage loans that were held on the balance sheet — not held for sale — and enter into fair value hedges with them. And that’s more complicated because you’ve got assets that are held for sale and, well, they are held for investment, but they are pre-payable. So, while it’s a 30-year asset, it’s going to have an average duration of much less than that. When hedging it, you have to worry about the prepayments and how effective the relationship will be because of the prepayments.”

That practice prompted questions at the Securities and Exchange Commission. “As organizations were trying to hedge mortgage loans held for investment, questions were raised to the SEC about this,” said Kviz. “The SEC suggested that the FASB take a look at this and find a way to simplify hedge accounting for portfolios of loans held for investment that were pre-payable as part of their hedging project. And that was the genesis behind the creation of what was called the ‘last of layer’ method.”

Using this method, companies could take a pool of loans and designate a portion of them in a hedge. “FASB said you can take this big pool and you can estimate out, and there is some portion of the cash flows from those loans that will remain outstanding over the period that you want to hedge, say, for example, 10 years,” said Kviz. “So you go down and look at the last cash flows that would be generated from that bigger pool and say, ‘I’m just going to hedge the last X amount of those cash flows.’ And because I’m not hedging the entire term — I’m only hedging a partial term — I can construct essentially a bullet note, where I’m borrowing and I’ve got cash flows that will be paid over time and a repayment so I can create a 10-year note and I can enter into a swap and it will be very effective. Rather than hedging the entire asset, you’re just hedging a subset of the cash flows, but you have to have enough cash flows to be outstanding over the entire. Period.”

FASB initially believed this would be an effective solution. “FASB thought, OK, for the folks that are trying to hedge these mortgage loans, you can create this sublayer and hedge that sublayer, and it will be a very effective hedge,” said Kviz. “So you can take this pool, close the pool, designate that last layer in a hedge and set it, and it will be out there for 10 years, and you won’t have to worry about the de-designation and designation on a regular basis. In concept that all sounded great, but the challenge with that in actual practice is the organizations that are likely to take advantage of this type of hedging are typically the larger organizations that have more dynamic hedge accounting programs or hedging programs so they are actively hedging their entire portfolio. And the way they actually hedge is not asset by asset, or liability by liability. They look at their net position and hedge their net position from a risk management perspective. Then, if they need to apply hedge accounting, they look for assets and liabilities that can create or offset the accounting risk that they’re trying to manage through hedge accounting, and then try and pair those assets or liabilities up with derivatives in their derivative portfolio, and qualify for hedge accounting. And you’re rebalancing that position on a regular basis, so you’re not setting and forgetting your hedge layer.”

That effort could be a challenge. “I think organizations that use this strategy may designate, but they’re likely going to have to de-designate at some point after they’ve rebalanced and then re-designate a new relationship,” said Kviz. “That’s one reason why I don’t think it will be widely used.”

The “last of layer” method was part of the update that came out in 2017. “Now, what this new proposal does is it takes that ‘last of layer’ method and tries to address some of the concerns that were raised by folks that were trying to apply this,” said Kviz. “One of them was that under the old proposal I could only hedge the last layer, but I had to take a closed pool and, in order to do that approach, I might take, for example, a $100 million pool of loans and only designate $10 million of that last layer. But I’ve got another $90 million of loans that I can’t designate in a hedge relationship. And if I want to do another hedge, I have to find another pool of loans. This portfolio layer method is just building off the ‘last of layer’ method. It’s saying, ‘Well, you don’t have to do just the last layer. You can start with that last layer, and then you can layer another layer on top of that and another on top, so you can do multiple layers with varying durations.’ I might do a 10-year layer, a seven-year layer, a five-year layer, a three-year layer, all looking at that closed pool of loans and ensuring that the estimated cash flows that will come off of those loans will be sufficient to fill those layers. That was the key tweak, allowing this multiple-layer approach, which expands the amount of hedging that you can do.”

That will probably prove to be more than most organizations that have been using hedge accounting can handle. “The actual application of hedge accounting is challenging as it is, and when you start getting into hedging pre-payable assets, it’s even more complex,” said Kviz. “Unless you’ve got a very sophisticated hedging program to manage that risk, you’re not likely to use that as a strategy. No one historically really had applied that portfolio layer strategy. It’s not a real risk management strategy. It’s a way of using hedge accounting to reduce GAAP volatility. Most large institutions don’t hedge assets and liabilities. They hedge duration, so they look at their interest rate-sensitive assets, they look at the interest rate-sensitive liabilities, and they look at the net position. And they just hedge the net position. That’s the real risk management strategy from an economic standpoint. From the accounting standpoint, this whole portfolio layer thing was hypothetical. It was concocted as a way of dealing with hedging mortgage loans held for investment to make it easier.”

Even though the latest update might not be used by many organizations, it’s optional like the 2017 standard, so it probably won’t generate much controversy when it goes into effect. So far, only about 25 comment letters have come in on the proposed accounting standards update.

“Because hedge accounting is optional and this strategy is optional too, I don’t see any reason why the FASB wouldn’t make this immediately effective once they issue it,” said Kviz. “I think they have a desire to get this out pretty quickly, so I would expect in the next couple of months they will deal with the deliberations, and if they decide to move forward, then we’ll have a standard. And I’m guessing that from an adoption standpoint, it will be effective immediately, assuming you’ve adopted ASU 2017-12. As long as you’ve adopted that standard, then I don’t see any reason you would need to defer this standard because everything is optional.”

He doubts there will be an early adoption period, as FASB offered for the 2017 standard. “You can always hedge, but you don’t have to hedge,” said Kviz. “It’s purely if you want to. So why do you need an implementation period? If you’re ready, go for it, and if you’re not, don’t do it until you’re ready.”

Before the standard is finalized, it’s possible that FASB may make some changes in response to the comments it has received. “There were some comments raised by a number of folks about the guidance that was issued about how to deal with hedge accounting basis adjustments,” said Kviz. “I think the FASB will listen to that and they could potentially change how you deal with basis adjustments. There was also some feedback about how you deal with the layers when there are anticipated breaches of the layer and actual breaches of the layer. There are some differences in how you deal with de-designations. There was some feedback about that. My guess is the FASB will reconsider some of that guidance and will think about whether or not those two should be aligned so that the process for dealing with de-designations might be the same, whether it’s an anticipated breach or an actual breach. And then a number of folks commented about not limiting this strategy to pre-payable assets, but allowing it for pre-payable liabilities as well. The FASB had talked about that during deliberations and decided not to include it in the scope. It’s possible that will be part of a subsequent project to expand its use. I don’t think there’s an appetite to introduce that into this proposal because that might delay the issuance of the proposal.”

The final accounting standards update may be coming out before long. “I expect in the coming months it will be on the agenda for redeliberations,” said Kviz. “Usually the process is they get the comment letters, the staff will consume them, summarize them and prepare a summary for the board, and then present the summary for the board and then request direction on next steps, and then the staff will move forward with next steps.”

Even if the update isn’t widely used, it will be handy for companies that need it. “If you step back, this is a great example of the FASB actually trying to make hedge accounting easier for people and an attempt to align the hedging with risk management,” said Kviz. “In certain cases, the hedge accounting is disconnected from the risk management, so they’re clearly making concerted attempts to align the two to better match the concepts that make sense for both preparers and users, so it’s great to see the FASB focusing on these issues.”

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