FASB releases Exposure Draft for Fair Value Hedging Activities – Portfolio Layer Method
- May 6, 2021
Financial Institutions | Kennett Square, PA
On May 5, 2021, the Financial Accounting Standards Board (FASB) released an Exposure Draft to enhance and provide clarity on the last-of-layer method, which was first introduced in Accounting Standards Update (ASU) No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. This narrow scope guidance allows entities to more efficiently hedge interest rate risk associated with portfolios of prepayable financial instruments under the fair value hedge accounting model. Currently, the last-of-layer concept is limited to using a single, bullet-notional derivative against a closed portfolio of prepayable assets, which often results in operational inefficiencies to right-size portfolios and missed opportunities to optimize hedging structures.
The proposed guidance will further expand the last-of-layer concept to allow:
- Multiple layer hedging within the same closed portfolio
- Utilization of different derivative structures including spot-starting and forward-starting bullet-notional swaps as well as amortizing-notional swaps
- Horizontal and vertical stacking of different hedged layers within the same closed portfolio
The FASB has not proposed an effective date, but application will be prospective except for the basis adjustments changes which would have a modified retrospective application.
Example application of proposed guidance
- Horizontal and vertical stacking of hedged layers is permitted.
- All assets must have contractual maturity greater than five years and be prepayable by year 10.
- If there is a shortfall, the five-year swap would lose hedge accounting first.
The proposed portfolio layer method balances the scale further between fair value and cash flow hedging by allowing entities to leverage their asset portfolios in interest rate risk management activities at a larger scale. The concept of hedging pools of variable-rate assets has been widely accepted and used by entities under the cash flow hedging model since the inception of topic 815. Due to the limitations of the fair value hedging model, portfolios of fixed-rate assets did not enjoy the same flexibility until ASU 2017-12 opened the door to the last-of-layer method, which allowed entities to create a closed portfolio of prepayable fixed-rate assets and designate in a fair value hedging relationship a stated amount of that closed portfolio that was not expected to be affected by prepayments, defaults, and other events (i.e. expected to remain outstanding for the duration of the hedge). We have worked with many financial institutions in applying this strategy to hedge prepayable assets like mortgages, commercial loans, and available-for-sale securities. We believe this enhanced portfolio hedging model will further optimize asset hedging programs.
Overall, the proposed portfolio layer method does not change the qualifying criteria for an asset to be designated in a hedging relationship; however, certain criteria are refined further to allow for multiple layer hedges of a single closed portfolio, including:
- All assets in the closed portfolio should have a contractual maturity date on or after the end of the earliest-ending hedge period of hedges associated with the closed portfolio. Multiple subgroups may be created within the closed portfolio to support different hedges – the intent is to not allow long-dated swaps to be pointed to short-dated assets. The reverse is permitted as partial term guidance would apply.
- All assets in the closed portfolio should be or should become prepayable by the end of the latest-ending hedge period of hedges associated with the closed portfolio.
Dedesignation and over-hedging impact
To apply hedge accounting under the portfolio layer method, entities will be required to continue performing a prepayment analysis that will support the hedged stated amounts of the closed portfolio. The FASB now prescribes what individual hedged layers are to be affected by either voluntary early dedesignations or anticipated and actual breaches.
- If an entity voluntarily early dedesignates one or more hedging relationships, the basis adjustment shall be allocated using a systematic and rational approach to all assets with a maturity date on or past the hedge maturity date.
- If the aggregate amount of the hedged layers currently exceeds the amount of the closed portfolio (that is, a breach has occurred), an entity would be required to sequence the order that hedging relationships would be discontinued based on the hedging relationship with the shortest remaining period until the hedged item’s assumed maturity date.
- If there are multiple hedged layers with the same assumed maturity date, an entity would be required to discontinue hedging relationships using a “last-in, first-out” approach.
The FASB further clarified the recording, recognition, and presentation of basis adjustments associated with the portfolio layer method.
- Basis adjustments will be prohibited from being allocated while the hedging relationships are active but must be allocated to the appropriate balance sheet line items if more than one asset class is included in portfolio hedges.
- Basis adjustments are prohibited from being included in the credit loss calculation.
- Follow-the-asset approach on recognizing basis adjustments on breached portions of closed portfolios. This would require monitoring of timing for assets that cause the breach, which will increase operational complexity for the programs.
- A modified retrospective approach to reporting basis adjustments is being proposed for existing last-of-layer hedging relationships to better align with new multiple layer hedges.
Consistent with ASU 2017-12, a one-time reclassification of securities from HTM to AFS will be permitted, if eligible for the portfolio layer method.
We have followed this project closely over the years, and we have had a significant role in working with the FASB to help shape the proposed new guidance. Please subscribe to our upcoming updates and webinars for more in-depth discussions on specific strategies and the impact of hedge accounting changes.
We are here to answer your questions and help you understand the potential impact the new guidance may have on your hedging program.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.21-0134
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