When accounting and economics collide … watch out! A case in point deals with the use of interest rate swaps by bank asset/liability managers.
Interest rate swaps are primarily used to transform floating-rate interest cash flows into fixed-rate cash flows, or vice versa. More often than not, having either objective, a bank would seek to apply hedge accounting, where the idea would be to realize the same earnings outcome as that which would arise with synthetic instrument accounting. That is, if we swap from variable to fixed, we'd expect the earnings impact to be identical to that of a fixed-rate instrument, while if we swapped from fixed to some variable-rate benchmark, we'd expect the all-in earnings impact to correspond to the benchmark rate effects (plus or minus a spread).
Under the umbrella of interest rate exposures, only one of two different kinds of hedge categories would be used. Cash flow hedging applies when swapping from floating to fixed; fair-value hedging applies when swapping from fixed to floating. Cash flow hedging serves to defer the derivative's gains or losses, recognizing their impacts in income concurrently when the variable interest expenses or revenues of the hedged item are realized.
Alternatively, fair-value hedging recognizes all realized and unrealized gains or losses from the swap in current earnings and accelerates the change in the fair value of the hedged item because of the risk being hedged such that it, too, is recognized in current earnings.
Those with an economic orientation would likely find this divergent treatment to be perplexing. In both cases, the intent of the swap is to operate on forthcoming cash flows, seemingly consistent with the orientation of the cash flow hedge, so why isn't cash flow hedge accounting applied symmetrically?
Unfortunately, the FASB imposed a condition that cash flows being hedged under cash flow accounting must be of uncertain amounts. Credit-risk considerations aside, because fixed-rate debt generates certain cash flows, the cash flow requirements are not satisfied when swapping from fixed to floating. Fair-value hedging is thus the only hedging treatment permissible when swapping from fixed to floating.
This restriction is problematic. Applying fair-value hedging requires attesting to the claim that the swap will be effective in offsetting the fair value of the asset or liability being hedged, because of the risk being hedged — in this case, because of changes in the benchmark rate. Unfortunately, this outcome cannot legitimately be expected to arise. In fact, a stronger statement can be made: When swapping from fixed to floating, the swap's result won't offset the fair-value changes of the debt.
Consider the case of a bank seeking to hedge a five-year, fixed-rate loan, with a five-year pay-fixed-receive-floating swap. The loan requires periodic interest payments, with no principal reductions. Accordingly, the swap would have a constant notional size equal to the loan's principal value, with settlements scheduled to coincide with the loan interest payments. In this example, the loan's starting and ending values are the principal amount, such that the change in the fair value of the loan (because of the risk being hedged) will be zero. The results from the swap, on the other hand, will be the sum of its settlements — a sum that certainly won't end up being equal to zero. Will the swap offset the changes of fair value of the debt? Absolutely not!
Back when fair value and cash flow hedging were first devised, the FASB created a special provision known as the "shortcut treatment," applicable to interest rate swap hedges under certain restrictive conditions. This treatment circumvented the above problem by authorizing an accounting treatment that respected the economics of the hedge, thereby fostering the same result as synthetic instrument accounting. Over time, auditing firms have tended to discourage its use, even when the qualifying criteria seem to be satisfied. Moreover the FASB appears to be considering repealing this special treatment.
In practice, there may be somewhat of a work-around for the above difficulty. Economically, if a hedger is seeking to swap from fixed to floating, the critical terms of the swap should match those of the debt being hedged, such that the swap's notional size should match the principal amount of the debt being hedged. On the other hand, if the true objective was to offset the fair value of some fixed-rate debt rather than to swap fixed for floating, a different hedge construction would be required. The correct hedge size in this instance would match the two respective interest rate sensitivities. One convenient measure of interest rate sensitivity is the dollar-value-of-a-basis-point, or the DV01, which reflects the change in value of the instrument that arises with a parallel shift of the yield curve by 1 basis point.
Assuming the more traditional objective applied — i.e., the desire to swap from fixed to floating — a bank would likely match the notional amount of the swap to the principal amount of the debt, but to get hedge accounting, the hedge documentation would say something else. That documentation would need to specify that only a portion of the hedged item or a portion of the swap, depending on which had the greater interest rate sensitivity, would be declared as either the hedged item or the hedging derivative in the designated hedge relationship, as appropriate. If the hedged item were more interest rate sensitive, the hedge relationship would pair a portion of the debt with the whole swap; if the swap were more interest rate sensitive, the hedge relationship would pair the entire debt with a portion of the swap. Critically, these two respective DV01 measures will generally grow smaller over time, but not necessarily at the same rate, such that a re-sizing of the hedge relationship may become necessary from time to time.
Unfortunately, this remedy may have a short shelf life. Another of the possible changes currently under consideration is the termination of the ability to de-designate and re-designate hedges, possibly complicating this remedy or any other hedge strategy requiring dynamic adjustment.
The ideal solution would be for the FASB to relax the constraint that requires hedged items in cash flow hedges to be uncertain cash flows. With this adjustment, cash flow hedge accounting would apply consistently for any forecast cash flow, whether swapping from floating to fixed or fixed to floating. In making this change, the hedge documentation could legitimately reflect the economic objective of the hedge, and the accounting would conform to this appropriately stated intent.
