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June 2009 Newsletter
How to Value a Floor in Bank Lending
Don’t Be Floored By Debt Terms
The tough credit environment and large write offs for banks have spurred new lending practices. On the good side, the less-gloomy economic outlook is encouraging more banks to loosen their credit requirements. But there’s a twist (or two). Banks are shortening the duration of their revolvers to reduce their credit risk. They are also taking steps to limit their interest rate exposure by sometimes requiring corporate clients to include a floor as part of the deal. The floor, an option, gives the banks a guaranteed rate of return. If interest rates drop below a certain level, their results won’t be impacted as their clients will continue to pay a set rate.
There at least two problems with this picture:
- The floor changes the economics of the deal.
- The floor, a derivative, raises thorny accounting issues under FAS 133.
Right off the bat, if the banks are pushing for a floor, that means there’s money on the table. It’s important that treasurers understand the banks’ motivation but also the pricing. Not figuring out the cost of the floor is like giving away the store. The cost of a floor, a call option, may be upward of a million dollars, depending on implied volatility, duration and strike price. The price of a floor goes higher particularly during periods of interest rate volatility. By requesting a floor, the banks are protecting their earnings. Corporate treasurers should do the same.
Before agreeing to a floor (i.e., writing the call option), treasury must value the option to monetize the benefit to the bank. Depending on the duration of the debt, the strike price on the floor (the guaranteed minimum return) and the yield curve, the floor can vary substantially in value. Treasury must be able to value the instrument in order to have a productive discussion with the banks.
Recently, a client called to ask about the impact a proposed floor would have on his company’s hedging relationship (very bad impact: see below). At the date of our discussion, the floor in question had a market value of over $1.5 million – a liability for the corporate and an asset for the bank – and asset for which the bank was not offering any compensation. If a company does not have interest-rate option-pricing capabilities, treasury can ask a couple of its banks what they would charge for a floor with a similar strike as the floor required by the lending bank. The price quotes will pinpoint the monetary value of the option, and thus how much the borrowing company would have to pay to “unwind” this feature from its debt.
Once the value is ascertained, the company can have a productive discussion with its bank. One approach would be to require the bank to provide a cap (a put option) of equal value that would offset the value of the floor, i.e., a guarantee that rates won’t rise above a certain threshold. If the put and the floor are of equal value, the result is a “costless collar.”
Even without demanding a put, with the information about the value of the floor in hand, treasurers can shop the deal more effectively and have more productive discussions with other bank counterparts. Finally, if the floor is the difference between getting the loan and not getting the loan, companies can ask the bank to purchase a floor and “roll” the cost into the borrowing spread instead. It may appear to cost more, but it will clearly highlight to all the cost of that embedded floor (and will be hedgeable). It’s also important that companies highlight to their bank any existing interest rate swaps that convert variable-rate borrowings to fixed, which, with the addition of the embedded floor, would cease to be economically effective.
The other and potentially big problem with including a floor as part of a bank lending facility is the accounting. Because of FAS 133, the derivatives accounting rule, the floor may end up creating significant volatility in the income statement. If the borrowing is already covered by an existing swap, adding the floor will likely kick that hedge outside the “highly effective” zone; with the swap no long effective, the company will have to de-designate the swap, discontinue hedge accounting and freeze OCI until the date of maturity. Because of the way the floor changes the economics of the interest rate exposure, it’s not possible to offset the economic risk using a simple swap. A company would need to purchase a floor and designate it in concert with the interest rate swap in the hedge relationship (another good reason to check the value of the floor, before you give it away).
Embedded floors and caps are considered clearly and closely related to debt under FAS 133 paragraph 61 (f) so there is no need to bifurcate and account for the floor as a derivative. If you are successful in asking for a cap, the resultant collar is also scoped out of derivative accounting.
FASB Reorganizes All Accounting Literature
New Codification System Will Make Old Approach Obsolete
The Change: Starting July 1, the FASB will be switching out of its old “cataloguing” system using standard numbers and adopt a codification approach – a theme-based database that sorts out US GAAP by topic, and subtopics all the way down to the paragraph level the most granular), with each level carrying a specific numeric identifier. At the same time, the Board will collapse the multi layers of GAAP (e.g., Emerging Issues Task Force abstracts, AICPA, white papers, etc.) into a single layer of authoritative guidance and then group other guidance under non-authoritative guidance (which will not be part of the codification process).These changes may have the biggest effect on audit firms, but are very likely to impact corporates preparing their financial statements.
The Goal: The Board says its objective is to make it easier for users to find the right information. According to the Board, “The FASB Accounting Standards Codification? Research System features menu-based Topic, Subtopic, and Section navigation. In addition, landing pages for Topics and Subtopics present tree-based navigation to paragraph heading-level content.” It also provides cross referencing to the paragraph in the pre-codification standards. All future guidance will be added directly to the codification system and never issued in the traditional FAS numerical order.
The Effective Date: While the codification system will go live in early July, the Board decided to delay the effective date (from periods starting after July 1 2009), to interim and annual periods ending on or after September 15, 2009. Under this guidance, calendar year-end companies would initially apply the Codification to their third-quarter interim financial statements.
The Impact: Clearly, this new approach to maintaining US GAAP will quickly and directly affect firms in the accounting and auditing space, which will have to revise their manuals and paragraph references in materials they use with clients. A Deloitte partner noted in a recent webinar that the firm has been working intensely for the past three months to update Deloitte’s own manuals.
However, others will also feel the effects. The breadth of the impact was captured by the fact that 6,000 people participated in the Deloitte webinar. Where corporates will be affected is in any reference they have to accounting rules generally in the financial statement and specifically in their hedge documentation. It is no uncommon to have direct references to standards, or specific paragraphs, e.g. FAS 133. Once the effective date hits, the financials cannot carry references to the old FAS line-up. During the webinar, the partners urged companies to not switch the references but rather write a sentence that describes the guidance. This way, when other changes come around, e.g., a switch to IFRS, there’s no further need to find paragraph or standard references.
In fact, the switch to IFRS under the SEC’s roadmap begs the question of why the Board is spending so many resources – and asking preparers and companies to spend so much of their resources – to the codification approach. There is no clear answer. One of the Deloitte partners noted that the IASB may embark on a similar approach and thus make the eventual convergence more seamless from an information consolidation standpoint. However, there’s no clear indication that the IASB plans to follow in the FASB’s step.
It’s important to note, too, that in order to make the codification “search” tool more effective, the FASB will include “relevant portions of authoritative content issued by the SEC and selected SEC staff interpretations and administrative guidance. The SEC Sections-distinguished with an “S” preceding the section number-contain SEC content related to matters within the basic financial statements.” Although the SEC content is organized by topic with the rest of the guidance, it is also presented separately (and the authoritative guidance remain with the SEC).
The Board will update the SEC content as it will for other changes or new guidance, as part of the overall maintenance of the site. But the SEC and its Staff will continue to use existing procedures for communicating new or revised content. As a result, there may be some delay between the time the SEC issues guidance and the update to the codification site.
The Bright Spots: While this may sound overwhelming and for a while it probably will be, as auditors, accountants and companies scramble to update manuals and references, but there are some good news. First, the system does contain a cross referencing tool so users can refer back to their favorite 133 paragraphs. Second, once up and running, the new web interface will make it a lot easier to navigate the often treacherous waters of US GAAP by grouping like content together, e.g., all content about derivatives in one spot vs. FAS 52, FAS 133, FAS 157, DIGs, EITFs, and so forth.
The new website is already up and running and usage is free until the go-live date of July 1, 2009, so it’s a good time to learn how to use the system. (http://asc.fasb.org/help&cid=1176153627761). There are also free tutorials and webcasts to familiarize users with the new system.
Key to Success: What will be the key to the success of this new approach for cataloguing accounting literature is the logic of the database hierarchy, i.e., if the guidance is organized in an intuitive and logical fashion? At least at first glance, that seems to be the case.
The guidance is organized by eight larger topics and down from there, with extensive drop down menus to help users find the relevant language. At the highest level of data hierarchy are eight broad topics, including assets, liabilities, equities, presentation and broad transactions. Below are two examples of how the Board has reorganized its guidance.
Example 1: (Topic) Presentation of Financial Statements
210 – Balance Sheet
215 – Statement of Shareholder Equity
220 – Comprehensive Income
225 – Income Statement
230 – Statement of Cash Flows
235 – Notes to Financial Statements
250 – Accounting Changes and Error Corrections
255 – Changing Prices
260 – Earnings per Share
270 – Interim Reporting
272 – Limited Liability Entities
275 – Risks and Uncertainties
Example 2: (Topic) Broad Transactions
805 – Business Combinations
808 – Collaborative Arrangements
810 – Consolidation
815 – Derivatives and Hedging
820 – Fair Value Measurements and Disclosures
825 – Financial Instruments
830 – Foreign Currency Matters
835 – Interest
840 – Leases
845 – Nonmonetary Transactions
850 – Related Party Disclosures
852 – Reorganizations
855 – Subsequent Events
860 – Transfers and Servicing
If nothing else, the need to review existing (and often old) disclosures and references will yield some new clarity, according to audit firm Deloitte. While companies are not required to make references to GAPP in their financial statements, it’s often hard not to. “The codification may provide an opportunity to make financial statements more useful by drafting language in their (companies} financial statements to avoid specific references and more clearly explain accounting concepts.”
Treasury Plans Overhaul of Derivative Markets
For months, it has been clear that the Credit Default Swap market is in for a serious shakeup (also, equity swaps). But when the proposed changes to derivative regulations were issued by Treasury in mid-May, they were far reaching, scoping in ALL derivatives and focusing on reconfiguring the current mechanics of the over-the-counter (OTC) market in other to provide greater price and risk transparency.
In a letter to Senator Harry Reid on May 13, the Secretary of the Treasury proposed a sweeping regulatory change to the current “operations” of the OTC derivative market. Secretary Tim Geithner’s proposal (to be followed by a more detailed piece of legislation) appears to cover any OTC derivatives; it even specifically mentions swaps as an example of a derivative that would be affected by the change.
The letter lays out the Administration’s main objectives:
(1) Take all standardized OTC product off the OTC market and onto centralized clearing facilities or the exchanges, thus reorganizing the “holders” of risk and the perception of counterparty credit risk.
(2) Promote efficiency and transparency;
(3) Prevent market manipulation and
(4) Ensuring the OTC products are not marketed to less sophisticated end users.
How will this affect corporate end users?
It’s early days and until a more complete version of the proposal is delivered to Congress it will be hard to figure out how the new rules would impact corporate end users. Treasury’s objective of greater price transparency may indeed work in corporate end-users’ favor, as prices are often opaque. Exchanges also stand to benefit from a likely increase in traffic.
The proposed bill itself, written in broad strokes only to date, does not contemplate the effect of these changes on companies and other end users. It focuses on the banking community. “We believe that for any proposal to require mandatory clearing of OTC derivatives … must set forth clear objective criteria to determine whether an OTC derivative is standardized,” according to Ross Pazzol, a partner with Chicago law firm Katten Munchins Rosenman LLP. He goes on to note that a mechanism must be in place to prevent banks from “artificially” tweaking what is a standard derivative into a non-standard one simply to avoid clearing mechanisms.
So while the effects may be very far reaching, or relatively contained, here are a few areas that may well by impacted by the legislation:
1. Cost. The transparency and central clearing of derivative trades will dramatically change banks’ business models, which often rely on OTC trades for a fat margin. Indeed, banks often rely on profit from derivatives trading with corporate clients to support less-rewarding or even money-losing business lines. With the margins gone, banks will likely have an incentive to generate new income, perhaps through fees they’d charge their clients in order to clear trades on their behalf. Alternatively, companies would be able to set up a standing direct relationship with a clearing firm; however, that sort of relationship would undoubtedly come along with a margin or some credit enhancement guarantee. Either way, the cost of derivatives trading will be clear for all to see, likely producing a relatively larger benefit for small and midsize companies that do not share the clout of their large multinational brethren.
2. Standard or not. Companies will also have to figure out, once the definition of standard becomes clearer, whether they prefer the relatively cheaper clearing house “standard” version or rather pay extra for “designer” derivatives that perhaps more perfectly match their needs; the potential discrepancy in timing or notional amount – along with margin calls – has always been a stumbling block for corporate taking advantage of the nonperformance-risk free exchanges. And if companies prefer designer version, those will come with a higher price tag, too, as the banks would have to disclose their position and put up more capital against them.
Will the new rules be a game changer? First off, the suggested changes are in early stages and already, some of the related market regulations, e.g., the plan to merge the SEC with the CFTC is on the rocks. Second, whether the changes make a fundamental difference also will depend on the sort of organization in question. Clearly, large banks will have to make substantial changes to their business model and/or their pricing. But for companies, which make up a much smaller share of derivative activity, the changes may not be as dramatic.
“I think the short answer is that an end user would not necessarily have to trade on an exchange if there is mandatory clearing for standardized OTC derivatives,” ‘writes Mr. Pazzol in an email to Hedge Trackers. “For example, an end user can do a trade in the OTC market today and submit it to NYMEX Clearport for clearing. However, if mandatory clearing comes about, end users would have to either become members of the relevant clearinghouse or establish a clearing relationship with someone who is such a member.” This changes the credit risk inherent in these transactions, because if you clear trades through someone else, you are exposed to their credit risk, not the credit risk of your original counterparty.
The Impact of “Own Risk” on Hedge Accounting
The last edition of Bulletproof discussed how a change in the probability that a hedged item will occur affects hedge accounting as well as journal entries (i.e., what gets frozen in OCI and what does not). This piece focuses on the “other side” of the hedging relationship, i.e., what happens when the derivative hedge is no longer probable to occur.
The chance that either party will not be able to fulfill its obligations under the terms of the derivative is known as nonperformance risk. A lot has been written about assessing counterparty credit risk, in particular in the wake of the Lehman bankruptcy. However, counterparty credit risk is only half the battle. Companies must also take into account whether they are likely to be able to perform under the terms of the derivative.
FAS 157 (Fair value measurement) provides guidance as to how to measure fair value, taking nonperformance risk into account; because derivatives are carried at fair value, and because FAS 133′s guidance on effectiveness testing focuses on the changes in the fair value of the derivative vs. that of the hedged item, the two standards work closely together when it comes to accounting for derivatives.
When the issue at hand is merely credit deterioration, the hedge relationship does not dissolve entirely. Instead, a change in the creditworthiness of (either) counterparty or company would have to be recognized either in earnings or in OCI, depending on what the company had elected to use for measuring ineffectiveness under DIG issue G7. For the most part (with the exception of the Fair Value method, or method 3 under G7), changes in the credit worthiness of one’s own firm and that of its counterpart are excluded from measurement of ineffectiveness. Under method 3, or at least one audit firm has been requiring clients to include the credit component as part of the ongoing measurement of ineffectiveness.
But there’s a difference between accounting for changes in the fair value related to credit deterioration vs. an all-out conclusion that the company or its counterpart is likely NOT TO perform. At that point, 133 takes over and the consequences are much more severe than making a credit adjustment. When it becomes probable that one of the counterparties is in such financial distress that is it no longer probable that it would hold up its side of the deal, FAS 133 kicks in and the guidance is as follows:
If it is probable the counterparty (or the company) will not default an entity would be able to conclude that the hedging relationship in a cash flow hedge is expected to be highly effective in achieving offsetting cash flows
If it is probable the counterparty (or company) will default, an entity would be unable to conclude that the hedging relationship in a cash flow hedge is expected to be highly effective in achieving offsetting cash flows.
When it is probable that a company would not be able to deliver on its derivative, the impact is exactly the same as it would be if an underlying transaction was no longer probable. Hedge accounting is lost. The accumulated balances in OCI are frozen until the original maturity. Only in cases when the probability of performance is remote (i.e., it is more probable that that one of the parties will NOT perform), does 133 instruct companies to reclassified any amounts in OCI into earnings immediately. In other words, if chances of default are higher than chances or non default, the hedge is terminated and all OCI balances are re-classed into income.
Conclusion and paragraph references
There’s been a lot written and said about dealing with the nonperformance risk of bank counterparties, in particular in the wake of shake up in the banking industry. But as corporate earnings suffer (Fortune 500 earnings are down 85% vs. year ago) and corporate bankruptcies rise, it’s important the companies look no only to their banks or to their hedged item but to their derivative liabilities and assess their chances of making good on the contracts.
Here are some of the paragraphs in 133 that contain relevant guidance:
29 b., 33, 45b.(4), 156, 160, 374, 463-465, 493
- G3, G10, G17, G18