Derivatives Implementation Group

Statement 133 Implementation Issue No. F11

QUESTIONS

Company A has a portfolio of seasoned, 1-4 family, fixed-rate mortgages that it wishes to designate as the hedged item in a fair value hedge of the benchmark interest rate (LIBOR). Each loan within the portfolio has similar settlement terms, is collateralized by property in the same geographic region, and has similar scheduled maturities. The loans are all within a specified interest rate band and are prepayable at par; each of the loans contained in the portfolio is expected to react in a generally proportionate manner to changes in the benchmark interest rate based on calculations performed by Company A. Company A enters into a pay-fixed, receive-LIBOR swap with a fair value of zero at the inception of the hedging relationship. The stated maturity of the swap is consistent with the stated maturities of the loans. The notional amount of the swap amortizes based on a schedule that is expected to approximate the principal repayments of the loans (excluding prepayments). There is no optionality included in the swap. As part of its documented risk management strategy associated with this hedging relationship, on a quarterly basis, Company A intends to (a) assess effectiveness of the existing hedging relationship for the past three-month period and (b) consider possible changes in value of the hedging derivative and the hedged item over the next three months in deciding whether it has an expectation that the hedging relationship will continue to be highly effective at achieving offsetting changes in fair value.

1. Does Company A's portfolio of loans satisfy the requirements of paragraph 21(a)(1) regarding the grouping of similar assets?

    

2. Does the documented hedging strategy described above meet the requirements of paragraph 20(b)?

BACKGROUND

Paragraph 21(a)(1), states:

    If similar assets or similar liabilities are aggregated and hedged as a portfolio, the individual assets or individual liabilities must share the risk exposure for which they are designated as being hedged. The change in fair value attributable to the hedged risk for each individual item in a hedged portfolio must be expected to respond in a generally proportionate manner to the overall change in fair value of the aggregate portfolio attributable to the hedged risk. That is, if the change in fair value of a hedged portfolio attributable to the hedged risk was 10 percent during a reporting period, the change in the fair values attributable to the hedged risk for each item constituting the portfolio should be expected to be within a fairly narrow range, such as 9 percent to 11 percent. In contrast, an expectation that the change in fair value attributable to the hedged risk for individual items in the portfolio would range from 7 percent to 13 percent would be inconsistent with this provision. In aggregating loans in a portfolio to be hedged, an entity may choose to consider some of the following characteristics, as appropriate: loan type, loan size, nature and location of collateral, interest rate type (fixed or variable) and the coupon interest rate (if fixed), scheduled maturity, prepayment history of the loans (if seasoned), and expected prepayment performance in varying interest rate scenarios. [Footnote reference omitted.]

Paragraph 445 indicates that the Board intended the listing of characteristics at the end of paragraph 21(a)(1) to be only an indication of factors than an entity may find helpful in determining whether individual assets or liabilities qualify as similar.

Paragraph 20(b), in part, states:

   Both at inception of the hedge and on an ongoing basis, the hedging relationship is expected to be highly effective in achieving offsetting changes in fair value attributable to the hedged risk during the period that the hedge is designated. An assessment of effectiveness is required whenever financial statements or earnings are reported, and at least every three months….All assessments of effectiveness shall be consistent with the risk management strategy documented for that particular hedging relationship....

Statement 133 Implementation Issue No. F5, "Basing the Expectation of Highly Effective Offset on a Shorter Period Than the Life of the Derivative," as cleared by the Board and clarified by Statement 133 Implementation Issue No. E11, "Hedged Exposure Is Limited but Derivative's Exposure Is Not," indicates that in documenting its risk management strategy for a fair value hedge, an entity may consider the possible changes in the fair value of the derivative and the hedged item over a shorter period than the remaining life of the derivative in formulating its expectation that the hedging relationship will be highly effective in achieving offsetting changes in fair value for the risk being hedged. The entity does not need to contemplate the offsetting effect for the entire term of the hedging instrument.

RESPONSE

Question 1

Yes, Company A's portfolio of loans satisfies the requirements of paragraph 21(a)(1) regarding the grouping of similar assets because the portfolio of loans has been defined in a restrictive manner and Company A determined, by calculation, that each of the loans contained in the portfolio is expected to react in a generally proportionate manner to changes in the benchmark interest rate. Even though certain of the loans may prepay, each loan still may be considered to have the same exposure to prepayment risk since each loan has a similar prepayment option. When aggregating loans in a portfolio, an entity is permitted to consider among other things prepayment history of the loans (if seasoned) and expected prepayment performance in varying interest rate scenarios.

Question 2

Yes, the documented hedging strategy described in the question meets the requirements of paragraph 20(b) for a prospective assessment of effectiveness provided the entity established that the hedging relationship is expected to be highly effective in achieving offsetting changes in fair value attributable to the hedged risk during the period that the hedge is designated. That prospective assessment of hedge effectiveness must consider all reasonably possible changes in fair value of the derivative and the hedged items for the period used to assess whether the requirement for expectation of highly effective offset is satisfied; that assessment may not be limited only to the likely or expected changes in fair value of the derivative or the hedged items. Generally, the process of formulating an expectation regarding the effectiveness of a proposed hedging relationship involves a probability-weighted analysis of the possible changes in fair value of the derivative and the hedged items for the hedge period. Therefore, a probable future change in fair value will be more heavily weighted than a reasonably possible future change.

For example, Company A could assign a probability weighting to each possible future change in value of the hedged portfolio. Depending where market interests rate levels are and the expected prepayment rates for the types of loans in the hedged portfolio, Company A may reach a conclusion that the change in fair value of the swap will be highly effective at offsetting the change in the value of the portfolio of loans, inclusive of the prepayment option. As a result of this analysis, management would conclude that hedge accounting is permitted for the hedging relationship for the next three-month period; however, any ineffectiveness related to the current period must be reflected currently in earnings. (That is, management is required to assess the effectiveness of the existing hedging relationship for the past three-month period.) The amount of ineffectiveness related to the current period will be the difference between the change in fair value of the swap (which could have a notional amount different than the hedged portfolio) and the change in fair value of the existing hedged portfolio. If necessary, the notional amount of the swap in excess of the portfolio balance at the end of each three-month period must be dedesignated and a new hedging relationship designated (with a smaller percentage of the swap as the hedging instrument) going forward to allow high effectiveness to continue in the future.

EFFECTIVE DATE

The effective date of the implementation guidance in this Issue for each reporting entity is the first day of its first fiscal quarter beginning after October 10, 2001, the date that the Board-cleared guidance was posted on the FASB website.

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.