Get Ready to Reveal Credit-Swap Risks

FASB voted last week to require banks and other companies that sell credit derivatives to disclose more information to investors starting at the en...
Marie LeoneAugust 8, 2008

Accounting rulemakers voted last week to keep the pressure on banks and other institutions that sell credit derivatives and push forward with a disclosure requirement aimed at helping investors get a better read on the financial instruments. In a 3-to-2 vote, the Financial Accounting Standards Board decided to stick to its original plan and make the disclosure provision effective for fiscal years ending after November 15, 2008.

Expressing urgency about putting the new date in place, the board rejected the recommendation of its staff, as well as suggestions from many constituents, to delay the provision’s effective date for a few months.

For companies with calendar year–ends, the decision leaves them with about four months to digest and comply with the revisions made to FAS 133 and FIN 45, two rules that address how companies account for and disclose information about hedging activity. The rule voted on last week is more specific than the disclosure requirements within either of the existing rules, as it focuses on purveyors of credit derivatives. Such instruments include credit-default swaps, credit-spread options, and credit-index products. The reason for the laser-focused amendment is the explosive growth in credit-default-swap contracts and the part they played in the current credit crisis.

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By the end of 2007, the notional value of credit-default-swap contracts rose to $62.2 trillion, up from $34.4 trillion in 2006 and $17.1 trillion the year before, according to the International Swaps and Derivatives Association. Credit-default swaps are bought by bondholders to protect against default, meaning that the bond issuer doesn’t make its coupon payments. If the bond issuer defaults on the payments, the seller of the swap pays the holder the face value of the bond.

In the wake of the current credit crisis, however, bond defaults rose precipitously, more than anyone — including default swap sellers — expected. As a result, some sellers were left with obligations that depleted or severely hampered their cash positions and weakened their credit ratings. According to FASB, some investors were concerned that the existing disclosure requirements in FAS 133 and FIN 45 didn’t “adequately address the adverse effects” of changes in a seller’s credit risk, financial strength and performance, and cash flow.

So on May 30, FASB issued a draft proposal addressing the concerns of financial-statement users. Specifically, the amendment says that for every derivative — or group of similar derivatives — the seller must disclose the nature of the instrument (term, reasons for entering into the contract, and current status of the payment/performance risk); the maximum potential amount of future payments the seller is required to make under the contract terms; the fair value of the derivative; and the nature of any recourse provisions that would allow the seller to recover the amount it pays out — such as collateral pledged or assets held by third parties that the seller has the right to liquidate.

The new disclosure amendment addresses only a small piece of the daunting 800-page FAS 133, which is considered to be one of the most complex rules of all U.S. generally accepted accounting standards. The bulk of the changes to FAS 133, which reportedly will simplify hedge accounting, will be discussed at a separate FASB meeting, following the August 15 comment period deadline.

In addition to voting on the effective date and disclosure requirements, FASB also decided to limit the scope of the project to credit derivatives rather than all financial instruments, which would have slowed the board down. Board members agreed that they were keen on keeping the derivative project on a fast track, mainly because of the “near-term need” to address issues related to the credit crisis. The decision to narrow the scope is a departure from international financial reporting standards: in August 2005, the International Accounting Standards board issued IFRS 7, a disclosure rule that comprises all financial instruments, not just derivatives.

Goldman Sachs took issue with FASB’s rifle-like approach. In a comment letter, Matthew Schroeder, managing director of accounting policy at the investment bank, wrote that FASB’s approach of creating disclosure requirements “in response to targeted and pressing issues” was not effective. He continued: “While we appreciate the importance of addressing the issue at-hand, we believe that rule-making in this way adds to the complexity of current disclosure guidelines.” Schroeder recommended that FASB develop a “single” framework for financial-instrument disclosures similar to IFRS 7.

Most of the authors of the 16 letters submitted to FASB agreed that additional disclosures are needed, but asked for more time to implement the changes. One exception was Huy Tran, managing director of accounting policy at credit insurer MBIA, who wrote that, since the company already reports some of the items required by the proposed amendment, it would not have problems complying by December 31, 2008.

Meanwhile, Freddie Mac’s principal accounting officer, David Kellermann, wrote that by complying with current rules, the mortgage lender discloses the risk characteristics of the underlying contract assets, the performance statistics, and delinquency rates of its derivatives. As a result, the proposed changes would be “redundant.”

FASB board members Leslie Seidman and George Batavick sided with the companies that called for a delay in the effective date. Seidman noted that changing the date to fiscal years that begin after November 15, 2008, would mean that the amendment would coincide with the effective date of the revised FAS 161, the much broader hedge-accounting disclosure rule.

Furthermore, Seidman pointed out that by accelerating the compliance deadline, FASB would be adding to an already long list of year-end rulemaking duties that companies have to deal with — including fast-approaching comment deadlines for drafts on accounting for transfers and servicing of financial assets (FAS 140) and consolidating variable-interest entities (FIN 46R), as well as implementation of standards for making exchanges of nonmonetary assets (FAS 153) and hedge-accounting disclosures (FAS 161). That burden, she thought, was not “reasonable.”

While conceding that the rule delay wouldn’t amount to more than pushing the effective date to the following quarter, FASB member Thomas Linsmeier was adamant about acting sooner rather than later. “In this market, with the credit crisis, two or three months may be a big deal” in terms of investor disclosures, he said. “The demands of investors [for this information] are reasonable,” added FASB chairman Robert Herz.