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Demystifying Hedge Accounting
The document discusses hedge accounting strategies for credit unions, presenting case studies of two credit unions - ABC Credit Union and 123 Credit Union - that were seeking to hedge their portfolios of CDs against interest rate risk using cash flow hedges, and the different solutions for qualifying for hedge accounting based on the historical correlation of their balances to the hedge instrument benchmark rate. Key takeaways include using an advisor to properly plan and execute hedging strategies that qualify for hedge accounting, obtaining auditor approval, and ensuring hedge effectiveness is quantitatively assessed.
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Demystifying Hedge Accounting
- 1. John Trefethen Director, Sales TravisQuast Director, Hedge Accounting
- 2. 1www.DerivActiv.com Demystifying HedgeAccounting • Founded 2004 • Leading, independent provider of valuations and hedge accounting • Over 400 institutional clients globally • 10+ years of hedge accounting experience • Joined DerivActiv in 2006 • Previously worked for a MN-based Fortune 500 company Travis Quast Director Hedge Accounting
- 3. 2www.DerivActiv.com Demystifying HedgeAccounting • What is Hedge Accounting? • A Tale of Two Case Studies • “ABC Credit Union” • “123 Credit Union” • Top 3 Takeaways
- 4. 3www.DerivActiv.com Demystifying HedgeAccounting A textbook definition A practical definition A method of accounting where entries for the ownership of a security and the opposing hedge are treated as one. Hedge accounting attempts to reduce the volatility created by the repeated adjustment of a financial instrument's value, known as marking-to-market. A way to avoid “lumpiness” in your income statement
- 5. 4www.DerivActiv.com Demystifying HedgeAccounting Change in Fair Value recorded in OCI (equity) Change in Fair Value of Derivative offsets hedged item (Runs through P&L) Fair Value Cash Flow Change in Fair Value through P&L LUMPINESS Qualifies Does Not Qualify ASC 815 (FAS 133) Accounting Summary
- 6. 5www.DerivActiv.com Demystifying HedgeAccounting MUST-HAVES • Formal documentation at hedge inception • Use an advisor like ALM First to plan and execute a hedging strategy that qualifies for hedge accounting • Obtain pre‐approval from your auditor • Hedging relationship expected to be highly effective • Changes in cash flows that could affect earnings
- 7. 6www.DerivActiv.com Demystifying HedgeAccounting INITIAL • Hedge Designation Memorandum and effectiveness analysis ONGOING • Periodic hedge effectiveness testing • Monthly: credit unions and other financial institutions • Quarterly: regulatory requirement • Required journal entries Hedge Memo (6-10 pages)
- 8. 7www.DerivActiv.com Demystifying HedgeAccounting 1 Fair Value Hedge 2 Cash Flow Hedge Purpose: Unlock an interest rate Hedge: Mortgage portfolio Purpose: Lock-in an interest rate Hedge: CDs or NMDs Swap Counterparty Credit Union Borrower Fixed % Fixed % Variable % Swap Counterparty Credit Union Portfolio of CDs/NMDs Variable % Fixed % Variable %
- 9. 8www.DerivActiv.com Demystifying HedgeAccounting 1 Fair Value Hedge 2 Cash Flow Hedge Purpose: Unlock an interest rate Hedge: Mortgage portfolio Purpose: Lock-in an interest rate Hedge: CDs or NMDs Swap Counterparty Credit Union Borrower Fixed % Fixed % Variable % Swap Counterparty Credit Union Portfolio of CDs/NMDs Variable % Fixed % Variable % The requirement that each loan in the portfolio be very similar is so restrictive that most credit unions do not attempt
- 10. 9www.DerivActiv.com Demystifying HedgeAccounting $4.1B in assets 260,000 members THE SITUATION • “ABC Credit Union” desires to hedge its portfolio of CDs by entering into a pay-fixed, receive-floating cash flow hedge. $3.9B in assets 240,000 members THE SITUATION • “123 Credit Union” desires to hedge its portfolio of CDs by entering into a pay-fixed, receive-floating cash flow hedge.
- 11. 10www.DerivActiv.com Demystifying HedgeAccounting $4.1B in assets 260,000 members THE PROBLEM • Management would like to apply hedge accounting, BUT… • Balances are small relative to the desired hedging notional amount. $3.9B in assets 240,000 members THE PROBLEM • Management would like to apply hedge accounting, BUT… • Balances are small relative to the desired hedging notional amount.
- 12. 11www.DerivActiv.com Demystifying HedgeAccounting $4.1B in assets 260,000 members THE SOLUTION • Tier 4 money market rates have historically been correlated with LIBOR. • Thus tier 4 floating-rate interest payments can be the hedged forecasted transactions. $3.9B in assets 240,000 members NOT THE SOLUTION • Tier 4 money market rates have historically been not correlated with LIBOR. • Thus tier 4 floating-rate interest payments cannot be the hedged forecasted transactions.
- 13. 12www.DerivActiv.com Demystifying HedgeAccounting $4.1B in assets 260,000 members THE SOLUTION • Tier 4 money market rates have historically been correlated with LIBOR. • Thus tier 4 floating-rate interest payments can be the hedged forecasted transactions. $3.9B in assets 240,000 members THE SOLUTION • Designate a portion of the derivative as the hedge, thus reducing lumpiness by that percentage • OR index tier 4 money market rates to LIBOR.
- 14. 13www.DerivActiv.com Demystifying HedgeAccounting 1) GET RID OF LUMPINESS • Take advantage of hedge accounting! 2) PLAN AHEAD • Use an advisor like ALM First to plan and execute a hedging strategy to get terms that will qualify for hedge accounting. • Obtain pre‐approval from your auditor for any new hedging strategy. 3) DO IT RIGHT • Beware of widely publicized “shortcut” and “critical terms match” methods, which have led to numerous restatements. • Quantitative methods in which hedge effectiveness is assessed and measured are much safer.
- 15. 14www.DerivActiv.com Demystifying HedgeAccounting John Trefethen Director, Sales 952-746-6040 jtrefethen@derivactiv.com Minneapolis || New York || Panama City www.DerivActiv.com 866-200-9012 Travis Quast Director, Hedge Accounting 952-746-6174 tquast@derivactiv.com