implemented by the Financial Accounting Standards Board in 2001 that would force companies to mark the value of all their derivatives to market.
FAS 133, Accounting for Derivative Instruments and Hedging Activities, would require all firms -- including banking companies - to determine the worth of their derivatives, usually on a quarterly basis, and to include them as part of their financial statements.
The rule further stipulates that, if a bank uses an interest rate swap to offset a fixed-rate loan, it could not just record the interest rate of the swap as part of interest income. It would also have to include the fair value of the swap, as well as the loan value, on its income statement.
FASB created the standard to give investors a clearer idea of a company's risk profile. Under some of the methods used before the rule was adopted, the balance sheet did not reflect whether the entity and its shareholders were better or worse off when derivatives' values changed, said Robert Wilkins, senior project director for FAS 133.
The only problem is, marking derivatives to market would make it much harder - if not impossible - for companies to forecast and manage their earnings. It will be very difficult to predict earnings, said Donald Heroman, senior vice president and treasurer at $93.2 billion-asset SunTrust Banks Inc. of Atlanta. If the market got bad news the last day before the end of the month, that day alone could affect your income statement by millions of dollars.
Unlike other financial instru-ments, such as Treasury bonds, there is no readily available quote for derivatives. We are somewhat dependent on internal models, Mr. Heroman said.
The ability to deliver expected earnings is important for all companies and has been a thorny issue for banks. Last year SunTrust was forced to restate its profits for 1994, 1995, and 1996 because it was accused by the Securities and Exchange Commission of manip-ulating its loan-loss provisions to boost earnings.
Analysts said they expect most banks will wait until the last minute to comply with the new standard. Most banks that actively use derivatives for hedging are not likely to be affected by rule 133 until March 31, 2001.
Katrina Blecher, an analyst at Brown, Brothers Harriman & Co., is sounding the alarm now, however.
I think there will be significant earnings volatility once FAS 133 is implemented, she said. That, in turn, could weigh on bank share prices, as investors who once relied on those stocks for consistency are disappointed.
Ray Garea, senior vice president for Franklin Mutual Advisors and the manager of $4.5 billion in funds, says the standard is certainly an issue that might affect earnings. I'm sort of hoping FASB comes to its senses and doesn't implement it.
Those who have been following the rule's development explained that banking companies can minimize any volatility from marking to market by setting up hedges that closely match their risk.
There could be some ineffec-tiveness in some of the hedges, which could result in volatility, said David Morris, director of accounting policies at Chase Manhattan Corp. and chairman of the International Swaps and Derivatives Association's accoun-ting committee.
But he added, If you can't come up with a good hedging strategy, then it probably doesn't make sense to be hedging in the first place.
Deidre Schiela, a partner at PricewaterhouseCoopers in Stamford, Conn., who is advising FASB on the formulation of rule 133, agreed. There is volatility because derivatives are not perfectly effective by their nature, she said. But if it's 90% effective, then only 10% will have to be marked to market.
FAS 133 also has more restrictive criteria for what counts as a hedge. For example, there are tougher criteria regarding hedges for a portfolio of loans as opposed to a hedge for a single asset.
This could lead some banking companies to forgo hedging some risks if they found it too burdensome to comply with the standard. It will force us to try and find more cash instruments that will effectively hedge the risk but won't be marked-to-market, said SunTrust's Mr. Heroman.
Or, banks might find other ways to hedge their risks, such as using fixed-rates rather than floating rates for their loans, in certain situations.
If a company thinks it is economically important to hedge, they should continue to do so, and analysts should understand what they're accomplishing, said Michael Joseph, a partner at Ernst & Young in New York.
Though Ms. Blecher was one of the first to register concern about the potential impact of FAS 133, she says she is sure the stock market will eventually come to terms with it.
Sooner or later investors will realize that it doesn't affect the underlying earnings power of the banks, she said.
