Over the past quarter, credit risk concerns shot into stratospheric levels. How does the rise in non-performance risk and widening CDS spreads affect corporate end users? The answer is in the interface between FAS 133 and FAS 157, which provides guidance on how to measure the fair value of financial instruments.
Companies with outstanding FX, IR or commodities contracts (in an asset position) with bankrupt, downgraded or other institutions that have seen their CDS spreads widen significantly, must take their counterparties’ non-performance risk into account when performing effectiveness tests. [For appropriate guidance, look to DIG Issue G10 (or F.4.3 in IAS 39.]
In a nutshell, the GAAP guidance is as follows:
- Cash flow hedges. Once it’s probable that the counterparty will default, the hedging company is no longer able to assert that the hedging relationship is expected to be highly effective. As a result, the company must discontinue hedge accounting and will need to write down the derivatives’ asset position.
- Fair value hedges. The credit impact will hit the derivative’s fair value; however, because the component of the derivative fair value that offsets changes in the benchmark rates will likely remain unaffected, only the credit-related ineffectiveness must be recognized in earnings.
Playing Catch Up
As of Q3/08, it appeared that auditors were only beginning to formulate their official guidance; however, the gist of the guidance is as follows:
- Termination of a hedge (either because you have closed the hedge or because the counterparty declares bankruptcy), does NOT cause a movement of gains or losses out of OCI or any carrying value adjustments to be reversed from hedged items in fair value hedges.
- Hedge accounting is still “good” up to the point that the hedge must be terminated because the counterparty is no longer deemed creditworthy. It doesn’t invalidate the application of hedge accounting up until that point, nor does it trigger any release from OCI.
- If a derivative asset has to be written down to near zero, the write down is immediate and impacts earnings, but the OCI balance pre credit event remains untouched until the hedged item is recorded.
A possible broader effect may be for corporates to consider trading on the exchanges where there’s zero performance risk; and/or require collateral from their financial counterparties.