In a hurried effort to shine light on the credit derivatives market - viewed as potentially the next domino to fall in the credit-market crisis - a new project by accounting standard setters could require firms to disclose more details about their exposure to the over-the-counter instruments currently on their books.
The Financial Accounting Standard Board (FASB), based in Norwalk, Conn., decided on April 30 - at its first meeting on the topic - to proceed with the credit derivatives disclosure project.
The decision arrived a month after the FASB issued FAS 161, a new standard covering disclosures for derivative and hedging instruments overall that becomes effective for companies with fiscal years starting after Nov. 15. The board decided, however, to speed up new credit derivative disclosure requirements to calendar years ending on that date.
That means the FASB must move quickly. It plans to release a final statement toward the end of the third quarter, and before that must expose the draft for comment for 30 days, leaving only a few months to work out the language.
Not a moment too soon from an investor standpoint. "Any disclosure is good," said Adam Hurwich, on managing member of hedge fund Calcine Management and the only investment firm representative on the FASB's investors technical advisory committee (ITAC), which provides input to the board on developing projects. Hurwich said his firm has shied away from credit derivatives "because over time I became increasingly uncomfortable with the fact that I really have no control of six sigma-type events and I have no protection" from counterparty risk.
The ratings agencies, also represented on the ITAC, support additional disclosures as well, although they are exempted from Regulation FD, which requires firms to broadly distribute material information, and already have been requesting detailed information about borrowers' exposures.
"Anytime you improve disclosure and transparency, it can have two effects," said Mark LaMonte, senior credit officer at Moody's Investors Service and an ITAC member. One, he said, is opening investors' eyes to risks they hadn't perceived.
Uncertainty about the credit derivatives market may have prompted investors to overcompensate pricing that risk into those companies' stock prices, "So additional disclosures, if they really demonstrate what the real risk is, could alleviate some of that concern," LaMonte said.
The FASB carved credit derivatives out of FAS 161 in part to complete the larger derivatives project on schedule, sources said. In addition, the accounting standard setter appears intent on including a controversial disclosure - the notional amount for CDS - that it decided against including in FAS 161. Urgency stemming from the market's rapid growth is also a factor. "In view of the current turmoil in the credit markets, some have expressed concerns that Statement 133's current disclosure requirements do not adequately address potential adverse effects of changes in credit risk on the financial position and performance of the sellers of credit derivatives," the FASB noted in the handout for last week's meeting. FAS 133 provides a general accounting framework for derivative instruments and hedging activities.
Derivative Growth
The International Swaps and Derivatives Association's (ISDA) most recent numbers showed the notional amount outstanding of credit derivatives growing by 32% in the first half of 2007, to $45.46 trillion, and it was up 75% over the full year.
JPMorgan Chase, the largest dealer in credit derivatives, saw its credit derivatives book grow at a similar rate. The New York-based bank's 10-K filing with the Securities and Exchange Commission states that its notional value of credit derivatives increased by 72% in 2007 to $7.967 trillion after more than doubling in 2006.
The bank provides several disclosures of credit derivative-related information, such as the amount of credit protection bought and sold for its own portfolio and in its role as a dealer. It also notes that a single-notch downgrade - from AA' to AA-'- would have required the firm to post at year end an additional $237 million in collateral, beyond its $33.5 billion in current collateral, to support derivative exposures. Moreover, a six-notch downgrade - unlikely but not unimaginable in today's environment - would have required $2.5 billion in additional collateral.
The bank also states that its net credit derivatives exposure, at $22.083 billion, is much lower than the notional amount, although it's up from $5.732 billion a year earlier. The bank also provides a table showing its net, marked-to-market exposures to credit derivative receivables according to counterparties' credit ratings. Counterparties rated below investment grade - much riskier in terms of fulfilling their contractual obligations should a credit event occur - made up 14% of those receivables, or $9.451 billion.
Other major dealers such as Citibank and Bank of America provide similar disclosures. However, there are no common standards applied by credit derivative users, that would enable financial statement scrutinizers to compare apples to apples.
FAS 133 requires disclosures, but an exemption provided in paragraph (10)d of that standard is thought to apply to a portion of credit derivatives. FASB staff views credit derivatives as similar to financial guarantees, so at least a portion of those exempted from FAS 133 would fall under FASB Interpretation No. 45's disclosure requirements. Not all, however, because FIN 45 covers situations in which the underlying asset is delivered to settle the contract, but it appears at least some credit derivatives today settle when the protection seller delivers the net difference between the par value of the underlying asset and its fair value. Today's large volume of credit derivatives, especially credit default swaps (CDS), suggest that a significant portion of those contracts would require net settlement.
FIN 45's paragraph 13 requires several disclosures that the FASB is considering requiring for credit derivatives, including the approximate term of the guarantee; how the guarantee arose and the events triggering payment; the current credit risk of the referenced asset; and the current carrying amount of the liability for the guarantors obligations under the guarantee. The board gave the staff the go-ahead last Wednesday to proceed with FIN 45-type disclosures in mind, and also decided to amend FIN 45 to expand its disclosures.
Maximum Future Payments
The most problematic disclosure may be the maximum potential amount of future payments the seller could be required to make under the guarantee - or the credit derivative contract under the new project. Hee Lee, a partner in Ernst & Young's financial services on-call advisory unit and an accounting advisor to the ISDA, said FAS 161 originally proposed including notional risk disclosures, similar to the FIN 45 requirement. "But after consulting with financial statement readers, FASB decided that may not be appropriate because could they could be misleading," Lee said.
Lee noted that the same financial goal could be reached using a single five-year CDS or a series of yearly CDS on the same referenced asset, but each strategy would reveal a different notional value. In addition, Lee said, a CDS may provide protection on only a portion of a collateralized debt obligation representing a basket of securities; the overall basket may have a AAA' rating, but the credit quality of the portion protected by the CDS may be difficult to determine. "Now, FASB appears to be turning around and essentially, in our view, asking for a similar notional-type exposure," Hee said.
Hee added that CDS are often done under a master trust agreement and are hedged and their risk managed on a portfolio basis. "If they have to present the gross exposure, that's misleading if there's a hedge on the other side," Lee said. "I think that's the biggest concern, particularly among dealers."
The biggest dealers already appear to disclose much of this information. Nevertheless, placing such disclosures in the framework of generally accepted accounting principals (GAAP) should appease concerns that credit derivative users may each be playing by different rules. "Broadly, some of the disclosures under consideration may be in place already, so it may be an issue of requiring more explicit disclosures. And some companies may have leaned toward providing less information rather than more, as we've seen in past situations," said Neri Bukspan, chief accountant at Standard & Poor's and an ITAC member.
The credit derivative project may have inherent weaknesses, since it will address disclosures only for guarantors and not the parties buying the credit protection. "I would like to see both," Bukspan said.
In terms of other potentially useful disclosures, Neri said including insurance policies that provide guarantees of similar credit derivatives should also be considered in the project. In addition, he said, "We've pointed to the need to know how credit derivatives are being used broadly and how they coincide with the enterprise's risk and liability management practices, as well as buyers of protection disclosing counterparty risk."
The big banks such as JPMorgan already provide the ratings profiles of their derivative receivables. The recent credit market turmoil has also prompted some users to expand their disclosures to appease investors' concerns. New York's AIG, probably the largest protection provider, goes into far more detail in its 2007 10-K about how its credit derivative exposures and their risks compared with those of the previous year's. The FASB's efforts could result in more detailed disclosures occurring routinely.
Marc Anderson, a partner in PricewaterhouseCoopers' national professional services group, noted that FASB plans to release a statement soon requiring additional disclosures for financial guarantee insurance contracts, and that those disclosures may be relevant to credit derivatives as well. It applies to a limited group of insurance companies providing insurance products that may resemble credit derivatives. "A lot of attention has been focused on financial guarantee insurers writing protection in the form of credit default swaps and insurance. The coverage they're providing is similar, and disclosures relating to one product may make sense on a broader level," Anderson said.
Lee said useful disclosures could also include the type of credit derivative-related collateral firms are posting as well as stress tests to show how ratings downgrades could affect not only the users' exposure to the underlying assets but also their counterparties' exposure. "The SEC is asking for some of that information already, but that's only for public companies. FASB's disclosures would apply to all firms," Lee said.
Lee cautioned, however, that disclosures typically require system changes to track information. The earlier effective date could be problematic in that regard. "A lot of folks out there don't necessarily have systems to aggregate credit ratings for all the referenced entities," Lee said.
If the FASB's project reaches fruition, credit derivative users caught up in the market frenzy of recent years could suddenly find themselves required to disclose to investors and lenders more information about their derivative risk exposures. Even hedge funds - major participants in the credit derivatives market - would have to provide the new disclosures to their prime brokers if they want the financing pipes to remain open.
Given the sudden collapse of Bear Stearns, a major dealer in credit derivatives, those hedge funds are likely to be just as interested in new disclosures from their counterparties. Hurwich said the most useful types of disclosures were clear: "Tell me who your counterparties are, the nature of the counterparty relationships, why you're comfortable with those counterparties and whether there are any cross-correlations of risk."
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