Preferred Issues: Golden State’s Hedge Rule Road Show

SAN FRANCISCO — It’s not every day you get to wrestle with a far-reaching, complex accounting standard that’s despised by your industry and largely misunderstood by investors, and most bankers would like to keep it that way.

But James W. Bean Jr., director of corporate accounting policies for Golden State Bancorp, has taken to his role as the San Francisco thrift’s guru on Financial Accounting Standard 133 with a fervor that verges — dare one say — on delight.

Ever since FAS 133, the hotly contested standard on derivatives and hedging procedures, became slated for implementation, Golden State has been approaching analysts and investors with the offers of a mini-tutorial on how the standard affects an institution like its own.

These sessions aren’t just a public service, despite the obvious enjoyment Mr. Bean, a former adjunct professor of finance, takes in helping his listeners make heads or tails of the complex standard.

As one of the largest mortgage servicers to hedge a big chunk of its portfolio against prepayment risk, which is closely tied to interest rate fluctuations, $61 billion-asset Golden State is under some pressure to make sure that the implications of this standard are well understood before it releases its first-quarter earnings report in April.

Starting this quarter Golden State, like all companies following Generally Accepted Accounting Principles, will have to reveal the fair-market value of its derivatives on its balance sheet.

But the real worry arises from another reporting change caused by the standard: Now companies must include on the income statement the difference between the gain or loss of the hedge and the gain or loss of the hedge’s underlying asset or liability.

This is a big issue for mortgage servicers that hedge their portfolios against the risk that interest rates will fall and borrowers will choose to refinance their mortgage elsewhere. That’s because hedges for this particular risk are rarely perfect, even if they meet a FASB test designed to measure whether the instrument has been employed for risk-management purposes.

(Perfect hedges, like those used to hedge against interest changes in order to ensure a fixed rate of funding, occur when the change in the value of the derivative and the change in the value of the hedged item are the same and therefore cancel each other out.)

Because the value of mortgage servicing rights portfolios is subject not just to interest rate changes but to the individual preferences of the homeowners who took out the mortgages, a bank can’t predict with “definite certainty” that the portfolio’s servicing rights and the hedges against pre-payment risk will line up one-to-one, said Fred Cannon, director of investor relations for Golden State and its California Federal Bank.

Michael Joseph, a partner at Ernst & Young in New York, said the risk for many mortgage servicers is “that they have to prove the hedge correlates to the underlying loans.”

For an institution like Golden State, the changes wrought by this standard will show up on one area of the income statement: non-interest income, which includes mortgage servicing fees and gains on the sale of assets.

Even a hedge that is 99.6% effective could add or take away several million dollars from the income statement and send the company’s operating earnings far afield from the figure Wall Street is expecting, Mr. Cannon said. “The last thing you want to do is surprise analysts.”

The challenge “is that we can’t disclose what the effect” of the standard “will be, and analysts don’t have a model” that can predict the impact of the changes, he said.

California Federal’s First Nationwide Mortgage subsidiary, the ninth-largest servicer in the nation, hedges about $62 billion of mortgage servicing rights.

Golden State is far from the only institution readying itself for the impact of FAS 133 on its income statement.

Wells Fargo & Co. is the country’s largest mortgage servicer, and Countrywide Credit Industries is the fourth-largest, according to National Mortgage News, a sister publication to American Banker. Both servicers hedge portions of their portfolio, analysts say. Both declined to comment on their implementation of FAS 133.

Thanks to the wild card it introduces into the income statement, FAS 133 continues to rankle earnings-driven management. “I’d like to know why FAS 115 goes through the balance sheet but FAS 133 hits the income statement,” said Carl Webb, Golden State’s president and chief operating officer.

And the new standard has introduced the fear that investors won’t realize what’s happening if the new accounting procedures cause an unexpected blip in the company’s results.

Mr. Bean has done a half-dozen presentations on the standard so far for analysts, Golden State’s board of directors, even Mr. Webb. And Mr. Bean expects to do several more before the company releases its earnings report for this quarter.

On an overcast day in downtown San Francisco last week, Mr. Bean was thrilled to have the use of a whiteboard and spent most of the three-hour session scribbling examples of “caps,” “floors,” and hedging situations that cross the risk-management line into what he loosely calls “gambling.”

“This is by far and away the most complex accounting standard I’ve ever dealt with,” he said.

Still, Golden State is proof that the standard has been beneficial. The company now checks on the value of its hedges daily, rather than weekly, and more actively manages hedges by buying or selling the tools with investment banking firms than two years ago.

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