SEC weighs swaps accounting rule that could cost banks, roil market.

The Securities and Exchange Commission is considering a change in how banks account for derivatives which could cost banks millions of dollars and add volatility to the burgeoning market.

The SEC has not yet come out with a ruling, but it has recently met with the major accounting firms to 'draft rules on the accounting treatment of widely used index amortizing swaps.

The regulatory agency has Said it favors mark-to-market accounting rather than the current accrual method for the derivatives used by publicly held companies. Any rules would apply not just to commercial banks.

The SEC's effort to see that derivatives are valued fairly and used properly would force banks to mark-to-market their off-balance sheet positions now and in the future, rather than recording the derivatives as income.

"It wouldn't change the swaps; they would still end up in the same place," said a source of the proposal. "But it would add volatility to the market. People may be less willing to enter into swaps in the first place."

According to Sanford C. Bernstein & Co., regional banks were heavy users of index amortizing derivatives before the Fed raised interest rates last February. At Columbus-based Bane One Corp., for instance, two-thirds of its $28 billion in fixed-rate swaps were index amortizing instruments at the end of the second quarter.

Charlotte-based First Union Corp. has nearly one quarter of its $15 billion swaps portfolio in index amortizing derivatives, the brokerage said.

The SEC, in considering a possible rule Change, is concerned with swaps contracts that include embedded written options. An embedded written option gives the counterparty to the deal - not the regulated company - the option to call the contract.

Interest rate swaps generally involve an exchange of payments between two parties. One party agrees to pay a floating rate to the counterparty and the other a fixed rate.

Sources said the SEC feels that swaps contracts should be marked-to-market, unless the swaps contract is being used to hedge other holdings.

However, they also said the SEC feels that an embedded written option in a swaps contracts implies that it will not be used to hedge other holdings.

As a result, any losses derived by mark-to-market accounting would be recorded on a company's income statement.

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