Derivatives Implementation Group

Statement 133 Implementation Issue No. G25

QUESTION

Can the first-payments-received technique for identifying the hedged interest payments be used in a cash flow hedge of the variable prime-rate-based or other variable non-benchmark-rate-based interest payments for a rolling portfolio of prepayable interest-bearing loans? That technique, which is more fully described in the response to Question 1 of Statement 133 Implementation Issue No. G13, "Hedging the Variable Interest Payments on a Group of Floating-Rate Interest-Bearing Loans," involves identifying the hedged forecasted transactions in a cash flow hedge as the first interest payments based on the specific nonbenchmark rate received by an entity during each recurring period of a specified length and beginning date for the period covered by the hedging instrument.

BACKGROUND

A U.S. entity makes prime-rate-based loans to its customers for which interest payments are due at the beginning of each month, based on the preceding month’s beginning prime rate being applied to the average outstanding balance throughout the preceding month. The entity determines that it will always have at least $100 million of those prime-rate-based loans outstanding throughout the next 3 years, even though the composition of those loans in the rolling portfolio will likely change to some degree due to prepayments, loan sales, defaults, and additional lending. Replacement of loans within the portfolio may involve loans existing at the inception of the hedging relationship or loans originated after the inception of the hedging relationship.

The entity wishes to hedge the variability in cash flows (resulting from changes in the prime interest rate) from its monthly interest receipts on $100 million principal of those prime-rate-based loans by entering into a 3-year interest rate swap that provides for monthly net settlements based on the entity receiving a fixed interest rate on a $100 million notional amount and paying a floating rate based on a specific prime rate index on a $100 million notional amount. The entity wishes to use, by analogy, the guidance to Question 1 in Implementation Issue G13 and identify the hedged forecasted transactions in its cash flow hedge by designating the hedging relationships as hedging the risk of changes in the entity’s first prime-rate-based interest payments received during each 4-week period that begins 1 week before each monthly due date for the next 3 years that, in the aggregate for each month, are interest payments on $100 million principal of its then-existing prime-rate-indexed floating-rate loans.

Paragraph 28(a)(2) of Statement 133 states, "The hedged forecasted transaction shall be described with sufficient specificity so that when a transaction occurs, it is clear whether that transaction is or is not the hedged transaction."

Paragraph 29(a) of Statement 133 specifies the following criterion for designation as a hedged transaction in a cash flow hedge:

    The forecasted transaction is specifically identified as a single transaction or a group of individual transactions. If the hedged transaction is a group of individual transactions, those individual transactions must share the same risk exposure for which they are designated as being hedged. Thus, a forecasted purchase and a forecasted sale cannot both be included in the same group of individual transactions that constitute the hedged transaction.

 

Paragraph 462 elaborates on the requirements of paragraph 29(a) as follows:

    To illustrate, under the guidance in this Statement, a single derivative of appropriate size could be designated as hedging a given amount of aggregated forecasted transactions such as the following:...

c.  Forecasted interest payments on several variable-rate debt instruments within a specified time period.

However, the transactions in each group must share the risk exposure for which they are being hedged. For example, the interest payments in group (c) above must vary with the same index to qualify for hedging with a single derivative.

Paragraph 29(h) of Statement 133 (as amended) states, in part:

    In a cash flow hedge of a variable-rate financial asset or liability, either existing or forecasted, the designated risk being hedged cannot be the risk of changes in its cash flows attributable to changes in the specifically identified benchmark interest rate if the cash flows of the hedged transaction are explicitly based on a different index, for example, based on a specific bank’s prime rate, which cannot qualify as the benchmark rate. However, the risk designated as being hedged could potentially be the risk of overall changes in the hedged cash flows related to the asset or liability, provided that the other criteria for a cash flow hedge have been met.

RESPONSE

Yes. The first-payments-received technique for identifying the hedged forecasted transactions (that is, the hedged interest payments) can be used in a cash flow hedge of the variable prime-rate-based or other variable non-benchmark-rate-based interest payments for a rolling portfolio of prepayable interest-bearing loans (or other interest-bearing financial assets), provided all other conditions for a cash flow hedge have been met. Similarly, a comparable first-payments-made technique can be used to identify the hedged forecasted transactions in a cash flow hedge of the variable non-benchmark-rate-based interest payments for a group of the reporting entity’s financial liabilities, provided all other conditions for a cash flow hedge have been met.

In cash flow hedging relationships involving variable non-benchmark-rate-based interest payments, the entity continues to be limited to designating the hedged risk as the risk of overall changes in those hedged cash flows (including the risk of decreases in cash flows attributable to credit default) because paragraph 29(h) of Statement 133 (as amended by Statement 138) prohibits an entity from designating interest rate risk as the hedged risk if the cash flows of the hedged transaction are explicitly based on an index different from either of the two designated benchmark interest rates permitted by paragraph 540. Consequently, the shortcut method described in paragraphs 68, 114, and 132 cannot be used because that method is limited to hedges of interest rate risk.

The use of the first-payments-received technique as described in the first paragraph of the response section is permitted by this Implementation Issue as an exception even though that technique excludes the variable interest payments that are contractually due but not paid by the debtor from being hedged transactions, thereby excluding some of the risk of decreases in interest payment inflows attributable to credit default. The guidance in this Implementation Issue related to applying the first-payments-received technique to variable non-benchmark-rate-based interest payments for a rolling portfolio of interest-bearing financial assets should not be applied by analogy to other circumstances.

The guidance in this response regarding use of a first-cash-flows technique may also be applied to a cash flow hedging relationship in which the hedging instrument is a basis swap as discussed in paragraph 28(d). However, use of that technique for those "basis swap" hedging relationships may not be common since paragraph 28(d) limits designating a basis swap as the hedging instrument to cash flow hedges of the interest payments of only recognized financial assets and liabilities existing at the inception of the hedge, whereas the first-cash-flows technique is typically applied to interest payments for rolling portfolios whose composition of financial assets changes over the period of the hedge. As a point of clarification, the example in paragraphs 98 and 99 of Statement 133, in which one leg of the basis swap is used in a hedge of the prime-rate-based payments on an existing five-year asset, implicitly incorporates the unstated assumption that the hedged risk is the risk of overall changes in the interest payments received on that asset and paid on the liability, and not interest rate risk (to be consistent with the amendments of Statement 133 effected by Statement 138), and that the likelihood of credit default and principal prepayments is each remote.

Entities that choose to use the first-payments-received technique are still required by Statement 133 (as amended) to assess the effectiveness of the cash flow hedging relationship and to recognize ineffectiveness in earnings attributable to overhedges. For example, if the hedged interest payments on a variable-rate bank loan are based on the bank’s own prime rate but the hedging interest rate swap is based on the prime rate specified in the Federal Reserve Statistical Release H-15, and the hedging relationship is not expected to be highly effective in achieving offsetting of the overall changes in designated cash flows (pursuant to either prospective considerations or retrospective evaluations), then hedge accounting would not be permitted. In contrast, if the hedging relationship is expected to be highly effective (and all hedge accounting criteria have been met), any difference between the changes in each of those two prime rates (for the period between assessment dates) could cause the hedging relationship to have some ineffectiveness in achieving offsetting cash flows. However, that ineffectiveness would be recognized immediately in earnings only if it resulted from an overhedge pursuant to paragraph 30 of Statement 133. Another potential source of ineffectiveness is margin variability (that is, changes in the spread over the nonbenchmark rate) attributable to the replacement loans being added to (and existing loans removed from) the rolling portfolio of interest-bearing loans. Margin variability would cause changes over time in the hedged cash flows (which are the interest payments received first chronologically), with no offset in the cash flows of the hedging derivative. As a reminder, in determining which interest payments are received first and thus are the hedged transactions, interest payments that are received concurrently may not be arbitrarily sorted to minimize or achieve a desired amount of ineffectiveness in the hedging relationship.

At its July 27, 2004 meeting, the Board reached the above answer. Absent that, the staff would not have been able to provide guidance that the hedging entity may use the first-payments-received technique in identifying the hedged forecasted transactions in a cash flow hedging relationship in which the hedged risk is the risk of overall changes in those hedged cash flows (including the risk of decreases in cash flows attributable to credit default).

EFFECTIVE DATE AND TRANSITION

The effective date of the guidance in this Implementation Issue for each reporting entity is the first day of the first fiscal quarter beginning after August 9, 2004. The guidance in this Implementation Issue should be applied to all of the reporting entity’s hedging relationships at the effective date. If a pre-existing cash flow hedging relationship had identified the hedged transactions using the first-payments-received technique in a manner consistent with the guidance in this Implementation Issue, the issuance of this guidance as an exception should not be viewed as requiring a restatement of previously issued financial statements. Early application of the guidance in this Implementation Issue is permitted.

The above response has been authored by the FASB staff and represents the staff’s views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.