PricewaterhouseCoopers Credit Derivatives: Understanding the Impact on Financial Statements David Lukach, Partner Chip Currie, Senior Manager Structured Finance Group

1 Agenda Objectives Analyzing financial statements to assess credit derivatives Ground rules of FAS 133 Credit derivatives used for credit risk management Investments in credit linked notes (CLNs) Special Purpose Vehicles / Special Purpose Entities FASB’s SPE consolidation project

Objectives

3 Understand how financial statements are affected by credit derivatives The accounting treatment of credit derivatives Special Purpose Vehicles FASB Consolidation Project

Analyzing financial statements to assess credit derivatives

5 Analyzing Financial Statements: Where do you start? Footnotes to financial statements – serve as the roadmap –Accounting Policy footnotes –Financial Instruments and Fair Value footnotes –Trading Revenues and Assets and Liabilities –Investment Securities –Loans –Credit Related Products / Derivative Contracts Management’s Discussion and Analysis Value at Risk Disclosures

6 What am I looking for? Discussion of the Banks’ derivative activities –Risk management strategies and objectives –Trading –Hedging Information regarding where the derivative transactions are presented in the financial statements –Balance Sheet –Income Statement

7 Where will this likely point me to? Balance Sheet –Trading Account Assets –Allowance for credit losses –Investment Securities –Derivatives (asset or liability) Income Statement –Interest Revenues and Expenses –Provision for Loan Losses –Trading Revenues –Investment Securities Revenue Other Comprehensive Income (stockholders’ equity)

Ground rules of FAS 133

9 Credit Products Most credit products are considered derivatives subject to the requirements of FAS 133 –Credit Default Swaps –Total Return Swaps Financial guarantees contacts are not considered derivatives

10 FAS 133 Model Overview Credit Derivatives Trading Hedges Trading Activities Speculative derivatives Portfolio credit derivatives “Undesignated”derivatives Hedges of trading assets Hedge Accounting Complex accounting rules FAS 133 sets forth very detailed criteria Types of “credit” hedges Loan portfolios Individual loans

11 Why is getting hedge accounting important? Hedge accounting allows the Bank to match the timing of recognition of gains and losses on the derivative with timing of recognition of gains and losses on the hedged item –Loss on loan –Gain on derivative Reduces income statement volatility Reflects the economics of the transaction

12 Why is getting hedge accounting important? Trading activities are recorded at fair value with changes in fair value reflected in the income statement Gain on derivative is recorded in earnings when its market value increases Loss on loan is recognized when it is measurable and probable Timing mismatch derived from loan losses vs. derivative MTM

13 FAS 133 Fair Value Hedge Model MTM Derivative MTM underlying for risk hedged Income Statement Perfectly effective hedges – no income statement impact Hedge ineffectiveness (+/- 20%) income statement volatility Ineffectiveness does not mean “bad” hedges

14 FAS 133 Fair value hedge model involves changes to traditional loan accounting Hedged loans are no longer held at amortized cost Loan balances are adjusted for changes in fair value attributable to the hedged risk : –Interest rate risk –Credit risk When loans are hedged the traditional model for loan loss reserves (allowance for loan losses) is modified –Balance Sheet: Loans adjusted, in part, to fair value (loans) –Income Statement: Changes in fair value recorded in P&L (provision for loan loss or trading) Change in the fair value of the derivative is recorded in P&L

Credit derivatives used for credit risk management

16 Using credit derivatives Frequently banks use credit derivatives: to hedge risks inherent in their loan portfolio to diversify credit risk = synthetic portfolio management to obtain regulatory capital relief

17 Typical Bank Hedging Strategy Bank Credit Default Swap Counterparty Portfolio of Loans 10 Loans Total Principal $100m Single Loan Principal $100m Pay 50 bps on $100m notional Contingent Payments on Reference credits Purchased Credit Default Swap

18 Hedging – A few of the requirements In order to achieve hedge accounting, the bank must demonstrate that the changes in the fair value of the derivative is “highly effective” at offsetting changes in the fair value of the hedged credit spread –Definition of highly effective: 80% - 125% ratio of: ›Change in fair value of derivative vs. ›Change in fair value of the hedged loan relating to credit risk

19 Interest Rate and Credit Risk Defined Risk Free Spread to LIBOR Credit Spread Interest Rate Risk The “benchmark rate” Credit Risk or

20 Hedge accounting issues Difficult to get hedge accounting for a portfolio of loans using a credit derivative (not homogeneous) –A portfolio must have similar risks –Credit risks of different borrowers generally are not highly correlated Can not get hedge accounting for CDS hedging the risk of undrawn loan commitments (difficult to demonstrate probability) Banks are finding it difficult to demonstrate that single name credit derivatives are effective at hedging a loan –Differences in credit default swap spreads vs. FASB proscribed method of calculating change in fair value due to credit risk

21 Hedge accounting issues Key Point: Even if hedges qualify for hedge accounting, ineffectiveness is recorded in earnings –Some level of income statement volatility –For example, 80% offset = 20% inefficiency (can be a gain or loss)

22 What if the CDS Does Not Qualify for Hedge Accounting? All derivatives must be reported at FV All changes in FV must be reflected in current earnings when they occur Income statement volatility due to immediate recognition of changes in FV of CDS Bank is not permitted to reflect changes in FV of loan unless it qualifies as a hedging relationship

23 Key Derivatives Disclosures FAS 133 changed disclosure requirements Certain information is no longer required as many readers found the information to be irrelevant –Notional values –Average fair values Must disclose the amount of ineffectiveness in hedging relationships: –Evaluate the Company’s hedging relationships –Isolate the impact of any ineffectiveness recorded in the income statement –Disclosure may be at a very high level

24 Key Points Income statement volatility is unavoidable –CDS will not be a perfect hedge Trading activity is not necessarily speculative –Some economic hedges will not qualify for hedge accounting

25 Key Points Qualitative information is important – Where do I look ? MD&A and Footnotes –Risk Management Strategy –VAR Disclosures –Accounting Policy footnote Balance Sheet Income Statement

Investments in credit linked notes

27 Credit Linked Notes (“CLNs”) CLNs are debt instruments whose repayment of principal and/or interest are contingent upon the credit performance of specifically identified reference assets CLNs can be issued directly by an institution or created synthetically (as illustrated in the following slide) A CLN investment can provide a bank with specifically tailored credit risks/returns Banks invest in CLNs to help diversify their credit portfolio Banks also issue CLNs to help hedge their credit portfolio Investing in CLNs or issuing CLNs can cause income statement volatility under FAS 133

28 Bank Invests in Credit Linked Note Special Purpose Vehicle Credit Default Swap Counterparty Pay X bp on $300m notional Contingent Payments On Reference credits Bank $100m cash Credit Linked Notes Market $300m cash $300m highly rated securities Credit Linked Notes $200m cash Investors

29 FAS 133 – Embedded Derivatives FAS 133 addresses accounting for freestanding derivatives and embedded derivatives (complex notion) Derivatives embedded in cash instruments are required to be bifurcated and accounted for separately if certain conditions are met –The combined instrument is not already being accounted for at FV (with changes in FV reflected in income) –Embedded instrument is equivalent to a free standing derivative (cannot hide a derivative to avoid FAS 133) –The embedded instrument would not be considered clearly and closely related to the host instrument (different types of risk)

30 Application to Investments in CLNs CLNs can be viewed as –A host debt security issued by the Special Purpose Entity, plus –An embedded CDS Host debt security –Changes in FV are not reflected in current earnings –Changes in FV are reflected in other comprehensive income The embedded CDS generally will be separately accounted for as a derivative under FAS 133 The embedded CDS would not be considered clearly and closely related to the host debt security because it reflects credit risk of an independent third party reference credit

31 Conclusions The embedded CDS written by the Bank must be separately accounted for as a derivative The bifurcated CDS likely will not qualify for hedge accounting The bifurcated CDS will be reported at FV with changes in FV reported in current earnings The host debt instrument (after bifurcation of the credit derivative) will be accounted for as AFS The same analysis applies if the CLN is issued by the Bank –Bifurcated CDS may qualify for hedge accounting

Special Purpose Vehicles / Special Purpose Entities

33 What is an SPE? No clear definition in the accounting literature for an SPE Generally it is a entity established for a limited purpose to benefit an individual or an entity –Investing in specified assets –Securitizing risks Can be structured in a variety of legal forms –Corporations –Trusts –Partnerships –Limited Liability Companies

34 Why do people use SPEs? They are frequently utilized to legally isolate specific assets and liabilities SPEs can efficiently allocate risks to multiple market participants (Synthetic CLOs) SPEs can also be used to tailor or customize risks ( to create specific risk profiles) Obtain access to different sectors of the market –Insurance companies –Hedge funds

35 Consolidation of SPEs Who should consolidate a SPE? Consolidation vs. non-consolidation of SPEs impacts the balance sheet of the bank Potential impact on the income statement from consolidation of an SPE Consolidation of the SPE may not invalidate the business purpose of the SPE (achieve credit risk reduction)

36 Bank Hedging – Synthetic CLO Special Purpose Vehicle Pay 50 bps on $100m notional Contingent Payments On Reference credits Investors $97m cash Notes Market $100m cash $100m highly rated securities Bank Investors $3m cash Equity Portfolio of Loans 10 Loans Total Principal $100m Single Loan Principal $100m

37 Accounting Literature - SPEs The accounting literature regarding consolidation of SPEs is very complicated and requires significant professional judgment In order to achieve off balance sheet treatment (unconsolidated by the bank), the capital structure of the SPE is very important Key factors in determining when SPEs are off balance sheet are: –Equity in legal form is held by an independent third party(ies) –Equity equal to at least 3% of assets –Equity must expose the independent third parties to first dollar loss on the assets of the SPE –Equity cannot be hedged or protected in any way –Equity must be outstanding for the entire life of the transaction

38 What if this SPE is consolidated? If a bank consolidated a synthetic CLO SPE, it would be reflected in the consolidated financial statements of the bank –Assets owned by the SPE (highly rated securities) –The notes issued by the SPE –Embedded derivative in notes issued by SPE –Equity of the SPE (minority interest) Primary impact is a balance sheet “gross-up” –Assets of SPE –Liability and equity issued by SPE

39 What if this SPE is not consolidated? Bank would account for the CDS The same methodology as for a freestanding CDS (a derivative)

FASB SPE consolidation project

41 History/Motivation For a number of years the FASB has been working on developing a new consolidation project for Special Purpose Entities (1982) In light of recent events the FASB is “fast tracking” issuance of an interpretation to existing consolidation literature

42 When is it coming? Final interpretation is expected to be issued by August 1, 2002 The interpretation will be immediately effective for transactions completed after issuance Accounting for SPEs established prior to the issuance of new guidance will be impacted –In fiscal years beginning after December 15, 2002 –No grandfathering of old transactions –Ability to revise SPEs –Calendar year companies apply new rules on 1/1/03

43 Expected changes to existing GAAP model Minimum acceptable legal form equity to keep SPE off balance sheet will increase from 3% to 10% SPEs which do not have sufficient legal form equity will be consolidated by the “primary beneficiary” –Similar to the sponsor concept that exists today Provide more guidance on how to define a primary beneficiary Primary beneficiary = Bank who transfers credit risk

44 Summary New model will be effective for structures completed after its issuance For calendar year companies, new rules will apply to all SPEs as of January 1, 2003 Current SPEs –Revise or modify – if possible to meet the requirements of the new rules –Terminate SPEs –Consolidate SPEs if new GAAP requirements for off balance sheet are not met ›Restatement of prior year financial statements will not be required ›Adoption through cumulative change in accounting principal