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