Derivatives Implementation Group

Statement 133 Implementation Issue No. F9

QUESTION

1. If an entity wishes to hedge its exposure to changes in the fair value of only the right to receive repayment of principal (and not the fair value of the interest payments) for a portfolio of fixed-rate loans that are not prepayable, may the entity designate a percentage (for example, 60 percent) of the contractually required principal repayment as the hedged item in a fair value hedge in accordance with paragraph 21(a)(2)(b) of Statement 133?

2. If an entity wishes to hedge its exposure to changes in the fair value of only the right to receive repayment of principal (and not the fair value of the interest payments) for a portfolio of fixed-rate loans that are prepayable, may the entity designate a percentage (to be determined retrospectively) of the contractually required principal repayment as the hedged item in a fair value hedge in accordance with paragraph 21(a)(2)(b) of Statement 133? (Note that this percentage would be adjusted retrospectively at each assessment date to result in a hedge of an identical amount of principal for each assessment period over the term of the loans.)

3. If an entity wishes to hedge its exposure to changes in the fair value of its right to receive both all remaining interest payments and the repayment of principal for a portfolio of fixed-rate loans that are prepayable, may the entity designate a percentage (to be determined retrospectively) of the original loan portfolio principal balance, bearing interest at a fixed rate until the balloon repayment date, as the hedged item in a fair value hedge in accordance with paragraph 21(a)(2)(a) of Statement 133? (Note that this percentage would be adjusted retrospectively at each assessment date to result in a hedge of an identical amount of principal, bearing interest at the loans' contractual rate, for each assessment period over the term of the loans)?

BACKGROUND

An entity holds a portfolio of fixed-rate loans that contractually require repayment of the original principal balance ($100 million) 5 years from the date of origination. The changes in fair values (both overall and attributable to changes in the benchmark interest rate) of loans that are not prepaid can be expected to move proportionately with each other and with the portfolio as a whole. Assume for purposes of this Issue that all of the other criteria in paragraph 21(a)(1) of Statement 133 have been met (including the aggregation criteria). Therefore, the entity concludes the portfolio of loans (which all mature on the same date) meets the criteria for portfolio hedging in paragraph 21(a)(1) of Statement 133.

The entity wishes to reduce its fair value exposure for $60 million of the total principal repayment of the loan portfolio at maturity. Paragraph 21(a)(2) of Statement 133 specifies the criteria for hedging a portion of an asset or liability or a portion of a portfolio of similar assets and liabilities. It requires the hedged item to be (a) a percentage of the entire asset or liability or of the entire portfolio, (b) one or more selected contractual cash flows of the asset or liability or portfolio, (c) a put option, a call option, an interest rate cap, or an interest rate floor embedded in an existing asset or liability that is not an embedded derivative accounted for separately under the provisions of paragraph 12, or (d) the residual value in a lessor's net investment in a direct financing or sales-type lease. Paragraph 432 states that if an entity hedges a specified portion of a portfolio of similar assets or similar liabilities, "that portion should relate to every item in the portfolio. If an entity wishes to hedge only certain items in a portfolio, it should first identify a smaller portfolio of only the items to be hedged."

For questions 2 and 3, assume the loans in the portfolio, which are prepayable, have similar expected prepayment performance. Based on historical experience, the entity estimates that some of the loans will be prepaid either in full or in part. The entity is unable to determine, however, which specific loans will be prepaid. The entity estimates that at least 60 percent of the original portfolio principal balance of $100 million will remain outstanding until the contractual repayment date of the loans in the portfolio.

RESPONSE

Question 1

Yes. An entity may designate as the hedged item a percentage of a selected contractual cash flow (such as the repayment of principal at maturity), even though paragraph 21(a)(2) of Statement 133 makes reference to the hedged item being "a percentage" only in subparagraph 21(a)(2)(a), which relates to the entire recognized asset or liability (or entire portfolio), and not in subparagraph 21(a)(2)(b), which relates to one or more selected contractual cash flows. By indicating that the hedged item in a fair value hedge may be one or more selected contractual cash flows, paragraph 21(a)(2)(b) permits a company to hedge one or more individual contractual payments of the loans in the portfolio. The derivative selected as the hedging instrument must be highly effective at offsetting changes in fair value of the group of selected individual cash flows designated as being hedged. If the loans meet the criteria in paragraph 21(a)(1) of Statement 133 for portfolio hedging, it is reasonable to conclude that a percentage of each of those selected individual cash flows will reflect fair value changes that are proportionate to the fair value changes of the entire group of selected individual cash flows. Assuming the derivative selected as the hedging instrument would be highly effective at offsetting changes in the fair value of the selected individual cash flows (provided the notional amount of the derivative was sufficient), there would be a basis for expecting that the change in that derivative's fair value (with a proportionately reduced notional amount) would be highly effective in offsetting the change in fair value of the designated percentage of each of those selected individual cash flows.

Questions 2 and 3

No. An entity may not designate a percentage (to be determined retrospectively at periodic dates) of either the original loan portfolio principal balance or of the contractually required principal repayment as the hedged item in a fair value hedge in accordance with paragraph 21(a)(2) of Statement 133 to result in a hedge of an identical amount of principal for each assessment period over the term of the loans. Since the entity cannot determine which loans will prepay, it cannot reduce the portfolio to a smaller subset (of loans that will not have been prepaid at the end of the five-year period) as required by paragraph 432 of Statement 133. As a result, it cannot specify a hedged item that consists of a specified portion of every loan in the portfolio and therefore cannot satisfy the requirements of paragraph 21(a)(2). Statement 133 distinguishes between fair value and cash flow hedges with respect to prepayment activity since paragraph 21(f) specifically requires that an entity consider the effect of an embedded prepayment option in designating a fair value hedge of interest rate risk. The corresponding paragraph discussing the requirements surrounding hedging individual risks in a cash flow hedge (that is, paragraph 29(h), which addresses bifurcation by risk) does not contain a comparable discussion about considering the effect of prepayments in a cash flow hedge. Along the same lines, paragraph 21(a)(1) contains a specific condition that when hedging a portfolio of similar assets or liabilities under a fair value hedge, the prepayment history and expected prepayment performance in varying interest rate scenarios must be similar. The corresponding paragraph discussing the requirements for hedging groups of forecasted transactions under a cash flow hedge (paragraph 29(a)) does not contain any discussion about prepayment activity.

The guidance in those paragraphs reflects the fundamental difference that prepayment activity has on a fair value hedge as compared to a cash flow hedge. A typical prepayment option can have a significant impact on the fair value of a fixed-rate financial instrument whereas it does not generally have much impact on the cash flows from a floating rate financial instrument (since there is no significant economic difference, and impact on cash flows, between repricing due to interest rate reset or due to return of principal and reinvestment at the then-current floating rate). Hedge accounting under the scenarios in Questions 2 and 3 would result in circumvention of the requirement in paragraphs 21(a)(1) and 21(f) to consider prepayment risk in a fair value hedge of interest rate risk.

Prepayment risk is integrally related to the change in fair value of the loans due to changes in the benchmark interest rate. Fair value hedge accounting for $60 million of the portfolio using, for example, a plain-vanilla interest rate swap could only be accomplished by erroneously assuming that the prepayment option has been eliminated for that portion of the portfolio. However, if an entity can obtain a hedging instrument with fair value characteristics that can be expected to result in fair value changes for the hedging instrument that offset those of the loan portfolio (such as an interest rate swap with an embedded call provision that is a mirror image of the prepayment option embedded in the loans in the portfolio), that hedging relationship could meet the Statement 133 criteria for fair value hedge accounting.

The above response represents a tentative conclusion. The status of the guidance herein will remain tentative until it is formally cleared by the FASB and incorporated in an FASB staff implementation guide. Constituents should send their comments, if any, to James J. Leisenring, Derivatives Implementation Group Chairman, FASB, 401 Merritt 7, P.O. Box 5116, Norwalk, CT 06856-5116 (or by e-mail to derivatives@fasb.org) by February 23, 2001.

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