Derivatives dealers are considering changing their product lines to reduce the impact of a proposed mark-to-market rule for users of the products.
Dealers and the many bankers who use derivatives believe hedging risk could become much more difficult if rule changes proposed by the Financial Accounting Standards Board are adopted. The industry is concerned that requiring banks to report changes in the market value of derivatives contracts would create the appearance of volatility in their earnings.
FASB is expected to hold hearings on the rule changes next month at its headquarters in Norwalk, Conn. The final derivative accounting rules aren't expected to take effect until 1998.
An analyst at Goldman, Sachs & Co. said the rule changes "have not yet had a chilling effect." But he said new contracts are being written to expire after shorter periods so that users can make adjustments once a final draft of the rule is available.
Bankers are reluctant to speak of how a change that hasn't happened yet could affect how they manage risk, but they argue that the proposals as written could have profound consequences.
"We wouldn't look at index-amortizing swaps anymore," said Jeanne Krips- Tobin, executive vice president for balance sheet management at KeyCorp.
In index-amortized swaps, users trade fixed interest rates for floating, but the amount of money on which the derivative is based declines, depending on changes in interest rates. These deals commonly contain features called embedded written options that give dealers the right to cancel the swaps entirely.
Ms. Krips-Tobin said KeyCorp has viewed these swaps as hedges and not put them on its balance sheet. Under the FASB proposal, however, derivatives users must report swaps with embedded written options on their balance sheets.
Executives at Morgan Guaranty Trust Co., Lehman Brothers Financial Products, and other major derivatives dealers are beginning to tailor instruments that they believe will protect their customers from the possible rule changes.
The trick, dealers say, is embedding the kinds of cash flow trades that derivative users want in another instrument, such as a highly complex bond. Such a security would be reported on the equity side of banks' balance sheets, not the income side.
For example, a company could offer a floating-rate security as a way to hedge prime assets, a Morgan Guaranty dealer theorized. "The question is who would buy this and what it would cost," he said. "It's very hard to estimate."
Such instruments, the dealer added, are purely conceptual right now.
Whether such instruments will be needed remains uncertain. Banks and other derivatives users are expected to voice loud opposition at the FASB hearing. "It's going to be a march on Norwalk," vowed Milton Bellis, spokesman for the International Swaps and Derivatives Association.
"A lot of further study is needed," agreed Comptroller of the Currency Eugene A. Ludwig. He said FASB's proposal "is not ready for prime time in its current form."
