When it’s time to select the right model and discount rate for performing FAS 157 credit adjustments, treasury organizations face several tough choices.
FAS 157 brought a new level of complexity to corporate hedge accounting, by introducing the “own credit” component to determining the fair value of a financial instrument. Under FAS 157, companies must not only take into account the non-performance risk of their counterparts, but also apply a discount rate that is based on their own credit worthiness.
This is clearly the case when the company is in a liability position, although some auditors argue that regardless of whether the derivative is an asset or a liability, both parties must apply both rates when measuring the fair value of the instruments.
For corporate treasury and accounting groups, one of the biggest hurdles to the implementation of FAS 157 has been identifying the correct rate input, for both their own credit and that of their counterparts. It is hard enough to collect data inputs for calculating the non-performance risk of their derivative counterparties. The data is available, but to get it, companies must have a way to access it, be it on Bloomberg or via another data subscription service. It is even more difficult for treasury to identify which discount rate to use calculating the fair value of a derivative.
Step 1 – Choose a Model
The first step toward FAS 157 compliance is to select a model or approach for adjusting an instrument’s fair value to a company’s own or its counterparty’s credit. There are a couple of ways companies can perform the credit adjustment.
- Point in time measurement. The most straightforward, common, and practical approach so far is to apply a relevant (more on this below) discount rate and apply it at the point of measuring the instrument’s fair value.
- Probability models. A much more sophisticated approach involves using probability models, e.g., Lattice models or Value at Risk (VaR) to determine the likelihood of loss at different confidence intervals. Such models may incorporate inputs such as probability of default and recovery rates for particular instruments or entities; however, inputs aside, the actual modeling requirements are far beyond the capability of most corporate treasury organizations. (Perhaps ominously, a recent PwC write up hinted at the idea that these probability-based rate assumptions would and should become more prevalent.)
Step 2: Choose a Rate
Assuming most corporate hedgers opt for the first and more practical approach (see above), they still have to decide which rate to use, when making the FAS 157 credit adjustment to their derivatives’ fair value. While banks’ CDS spreads may be accessed through data subscription services, most middle- and many large-size companies do even have a corresponding CDS rate. So what are the alternatives? There are few, and none is perfect:
1. The spread over LIBOR the company pays for its bank revolver. This rate is clearly observable (a.k.a Level 2 input under the FAS 157 hierarchy). However, for many companies, the revolver rate had been negotiated some time ago, and may no longer be an economically-accurate reflection the company’s creditworthiness. Then again, the negotiated rate is likely to be lower, which means it would reduce liabilities by a lesser amount. To “refresh” the revolver spread, many companies are asking their lenders what their spread over LIBOR borrowing rate “would be” were they to refinance in the current market. However, if this “what if” spread becomes a significant factor in the valuation, it could move the derivative valuations to Level 3 since the input is not observable.
2. The spread on debt in the secondary market. While good in theory, many companies do not have debt that is trading in the secondary market. But even if they do, the spread over Treasuries, for example, captures more than just the issuer’s underlying credit; in fact, it is difficult to figure out what part of the spread is attributable to the specific company’s credit, vs. supply and demand issues or general industry concerns.
3. Relative credit rating. Companies can also look to the credit spread associated with their credit rating category; however, this, too, is a very “messy” indicator. Rating categories are very wide, encompassing a large variety of corporations with very different balance sheets, debt levels etc. On March 10, 2009, for example, the CDS rates for BBB-rated industrials ranged from 82 to 583 basis points. So figuring out which spread is correct is less than obvious, even if it is observable (still Level-2).
4. Mark to model. It is often easier and better to choose an observable rate even if it is imprecise than it is to try to come up with a theoretical rate that would be closer to “reality.” When the observable rates are lower than the would-be rates (see above), it is a no-brainer because using the lower rate will produce a better “result.” In other cases however, when the markets dry up or supply and demand are out of sync, the observable input may be very detrimental, i.e., implying a much wider spread. The FASB and the SEC have made it clear that when there are such “off-market” bids, they cannot just be ignored.
Potential Complications: The Asset/Liability Flip Flop
Last but not least, applying one’s own credit “discount rate” in calculating the fair value of derivatives may produce counter-intuitive results, particularly for companies with wider credit spreads – which in these days is a very common issue, even for banks. Here is how it works: Typically long-term swaps (pay fixed/receive variable) begin their life-cycle at zero fair value (the fixed rate paid is equal to the market expectation of the variable rate received). In an upward sloping yield curve environment, the initial anticipated cash outflows on the swap are offset by future anticipated inflows. This suggests that when applying a discount rate to the entire instrument, both near-term and long-term cash flows, the value of the longer-term cash flows (positive) can turn an instrument with zero fair value into a liability. In future periods, market-valued assets could be discounted into liabilities. Discounting might actually increase an assets value.
This outcome is problematic. Until recently , the pricing of the swap this way would be “off market” since historically the market did not discount all future cash flows at a discount rate plus the discount rate based on the company’s credit standing. However, more recently, companies attempting to monetize their gains (perhaps to reduce counterparty exposure) have been quoted “credit-discounted” values. Interestingly, banks attempting to reduce their credit exposures to corporations have offered to settle the derivatives at a discount.
Disclosure, Disclosure, Disclosure
Regardless of how management decides to handle the issue of selecting a model and choosing a rate that captures the company’s “own credit” risk, there is one critical step all companies must take: they should disclose what model and what rate they are using in calculating the fair value of derivatives and explain why they chose it. Providing a full and detailed description of the company’s choice is the best antidote to challenges from audit firms or others.