IAS 39: Making securitization transparent

The mandate of the International Accounting Standards Board (IASB) is the global development of consistent and comprehensive standards for accounting for financial instruments. IAS 39 Financial Instruments: Recognition and Measurement was released in 1999, prescribing broad changes to financial instrument accounting and reporting practices. The European Commission has proposed that all EU-listed companies prepare their financial statements using IAS 39 accounting standards by January 1, 2005. By that date, at least one year of comparative financial statements must be available for evaluation, effectively making January 2004 the deadline for compliance.

The standard affects risk management practices as well, requiring firms-especially those unaccustomed to mark-to-market valuation of derivatives-to reengineer business practices and systems.

This article reviews the latest revisions to the standard and challenges institutions may face in adapting existing risk management techniques to it as they relate to derivatives and the securitization industry.

The Development of IAS 39

Since the introduction of IAS 39, the IASB has been actively working with industry practitioners, audit firms and other regulatory bodies to refine the standard and provide detailed and practical implementation guidelines. The standard has been modified from its original exposure draft and analyzed in conjunction with the requirements of other standards for disclosure and presentation of financial instruments, as well as regulations on consolidation and derecognition.

IAS 39 regulates and structures the measurement basis for financial assets in the following categories:

* Held-for-trading assets are measured at fair value

* All derivatives are measured at fair value to provide required transparency in financial statements

* Available-for-sale assets are measured at fair value until the asset is derecognized or becomes impaired

* Held-to-maturity assets, originated loans and receivables are measured at amortized cost

For institutions that continue their active hedge programs using derivatives, the choice is to adopt fair value accounting for the derivatives or to retain hedge accounting treatment for these derivatives and conform to the criteria laid down in IAS 39.

Adapting Risk Practices to Conform with IAS 39

IAS 39 provides hedge accounting guidelines for cashflow and fair value hedges. These include explicit requirements for the hedge documentation and designation process and the methods necessary to prove effectiveness on both a retrospective and prospective basis. Transaction-by-transaction designation is time consuming and often does not reflect portfolio hedging techniques that are used by risk managers. The mechanical requirements of hedge documentation for IAS 39 can therefore be problematic when hedge accounting is the preferred method for recognizing income.

To accommodate efficiencies in hedge allocation, IASB has been assessing macro-hedging and potential use of internal contracts to provide documentation of hedge designation. The IASB has indicated that it would support the use of these techniques if it could be assured that all ineffectiveness is recognized in earnings and that there is a clear mechanism by which value changes associated with items in the portfolio can be allocated or unwound when a hedging relationship is discontinued or the item is derecognized.

The Impact of IAS 39 on Risk Managers

With the objective of increasing transparency, IAS 39 states that all derivatives must be recognized on the balance sheet and measured at fair value. This means that all gains and losses-realized and unrealized-from these financial instruments must be recorded. In practice, this accounting treatment can often create volatilities in the income statement due to the mismatch in accounting treatment of derivatives and the assets or liabilities that they are hedging. When fair value treatment is applied, the ability under IAS 39 to designate assets as “held for trading” and recognize their market value to offset derivative valuations can avoid the problems of earnings volatility that result from fair value derivatives accounting alone. Timing of earnings recognition, however, is still an issue if this method is selected.

Thus IAS 39 provides hedge accounting guidelines where effective hedges can be exempt from inclusion in the income statement until their maturity or termination. To qualify for such treatment, companies must provide detailed documentation on their hedge strategies and mark-to-market daily fluctuations in the value of hedge instruments designated as fair value. Companies must also be able to separate embedded options from complex financial structures, demonstrating hedge effectiveness on a granular level. These requirements place huge strains on systems and risk management practices.

In the United States, risk managers have already responded to similar requirements for the Financial Accounting Standards Board's FAS 133. Some have implemented derivatives processing systems with hedge accounting capabilities in order to gain favorable accounting treatment. The systems provide mark-to-market valuation, hedge effectiveness testing, hedge relationship tracking and derivatives accounting. This option is most conducive to continuing pre-FAS 133 risk management techniques.

Others have continued to use derivatives without applying for favorable hedge accounting treatment. Essentially, all derivative activity is marked to market, potentially causing dramatic swings in reported earnings.

Or, risk managers have eliminated or reduced the use of derivatives and other instruments with embedded optionality, which may lead to an undesirable risk/reward profile with large exposures to interest rate and currency risks.

Although IAS 39 is often compared to FAS 133, it is wider ranging in its coverage of financial assets and associated accounting treatments. Because customized financial structures and techniques as well as sophisticated legal characteristics continue to evolve to maintain business development and investor appeal, IAS 39 implementation must also be designed to assimilate these new products.

Institutions active in asset securitization now move through the various phases of market development more rapidly than ever. Rapid engineering of new structures and risk practices is crucial to maintaining profitability while providing investors with opportunities for investment in diverse, collateralized and high credit quality assets. To appreciate the striking changes that have affected this marketplace, compare the cashflow collateralized loan obligations market of the mid-1990s to the market value synthetic collateralized structures of today. Asset composition, portfolio management techniques and risk measures have become dramatically more complex. The newer structures are subject to more intense legal, rating agency, accounting and financial scrutiny.

Asset securitizations are set up to accommodate the legal isolation of the structures in their different forms. By definition, these structures have protections for investors in the event of the erosion of the credit quality of the underlying collateral, default or other nonperformance from the sellers or ultimate obligors on a credit-enhanced obligation. The complexity of the operating environment and the lack of standardized legal documentation, servicing and reporting, however, means that each structure demands significant effort to assess and adopt the varying accounting standards on measurement, disclosure and derecognition. When adopting the IAS 39 framework, market-specific structures must be taken into consideration, as each will be subject to detailed analysis to validate the interpretation and determine required accounting treatment.

Outstanding Questions

The implementation of new regulatory, capital and accounting standards, combined with the emergence of standardized documentation and origination terms for frequently securitized asset classes will support the development of a mature and cost-effective securitization market outside of the United States. IAS 39 implementation is one of the critical components that needs to be successfully achieved for a framework as complex as that required by a securitization process to be realizable. But there are still areas of the standard where concerns have not been answered.

The June 2002 exposure draft of proposed amendments to IAS 39 introduces the concept of continued involvement as a basis for determination of when assets used in origination of a securitization can be derecognized (i.e., treated as sold for accounting purposes) and the rules for partial derecognition. (Continued involvement is defined as some degree of retained contractual rights or control of an asset's cash flows subsequent to its transference.) This is a mixture of the control/components model (FAS 140) and the risk/ rewards model that has been adopted in other accounting standards. Both the IASB and market practitioners continue to test and validate the standard against diverse structures. Through this process, they will identify and eliminate any inconsistencies in valuation and recognition that may be enforced by the current proposed standard.

For example, an entity can derecognize financial assets from its balance sheet when it can demonstrate no continued involvement. This condition is satisfied by reli\nquishing all contractual rights to the asset's cash flows and the absence of any contractual provisions that may entitle a transferor to reacquire control of the assets (e.g., a repurchase agreement).

For this, some origination techniques are clear-cut. For example, entering into a total return swap in conjunction with the transference of assets will mean that the transferor will still recognize these assets. If the transferor remains the obligor for subordinated debt used as enhancement, then it cannot derecognize the fair value of the risk still assessed on this debt.

But if the credit risk is separately retained, the transferor retains a call option or the transferee is granted a put option on the assets, then careful assessment of the securitization terms and the derecognition rules, under varying market scenarios, is required.

This area has been debated extensively with the IASB as the exposure drafts have been discussed.

One thing is clear: each and every deal that has currently been originated or pending must be assessed to determine the valuation and measurement for both the transferor and the transferee. The ability to audit and manage financial transaction life cycles becomes a significant component of the IAS 39 solution.

Mobilizing for IAS 39

Planning and implementation of an IAS 39 compliance solution requires the combined efforts of operations, accounting and risk management. Once the accounting implications are widely understood, adaptation of risk management practices to IAS 39 guidelines will be instrumental to the project.

The risk management team will be tasked to produce the documentation and management reports that provide internal transparency for all hedging activities. They must identify highly effective hedge strategies that ensure the highest rate of continued compliance. This requires extensive analysis of all existing financial instruments and associated hedges in order to determine effectiveness and proper hedge accounting. (The treasury system should provide basic methods of calculating hedge effectiveness.)

Prior to implementation, risk managers will have to evaluate the costs and impact on the organization, and present a process road map and business impact analysis to senior management and the IAS 39 committee. Meticulous documentation and frequent communication will keep the project moving and resolve issues that affect multiple functional units (e.g., trading, back office, accounting and finance).

The IAS 39 standard's guideline for documentation of hedge strategies imposes more stringent controls on hedging practices, and consequently managers will have to pay more attention to operational risk management techniques. Risk officers may choose to limit the types of hedge strategies employed or specify different effectiveness assessment methods for different structures. But in general, the typical risk oversight responsibilities of identification, control, mitigation and monitoring risk remain the same.

Systems for IAS 39 Implementation

For risk managers, the implementation of an IAS 39 system to manage derivatives is no simple task, as it requires a highly coordinated effort with accounting, trading and information technology. In building or selecting a system to manage this, it is important that the team considers a platform that allows continuation and growth of existing risk management techniques as the standard itself matures. The solution should first and foremost not discourage the use of hedging and other risk management practices. And from a functionality standpoint, it should also provide:

* Mark to market of assets, liabilities and derivatives using consistent valuation models and data

* Documentation to reference hedge strategies and objectives

* Ability to designate hedge types (cashflow, fair value)

* Comprehensive reporting capability for retrospective as well as prospective measurement of hedge effectiveness and sensitivity analysis

* Management of hedge linkage possibilities (one-to-one, many-to- many) incorporating changes such as redesignation of hedges over time

* Accounting ledger balances required for effectiveness tests, including the generation of adjusting entries required for proper hedge accounting (e.g., journal from OCI to income)

Systems and Process Considerations

IAS 39 is a critical and complex standard to be implemented. Institutions must seek to implement IAS solutions that meet diverse business objectives. Some important factors in determining the appropriate solution for securitization include:

* Implement an adaptive infrastructure with the flexibility to allow for adjustments to the accounting and processing required to meet the needs of evolving guidelines and practices.

* Consistent modeling of the securitization flow and terms is fundamental to assessment of compliance and accounting changes. This will also be supported by a move to standardize the terms for origination and credit enhancement.

* Advanced modeling ensures that the hedging and risk management techniques truly report, monitor and act upon changes in portfolio performance. This must include analysis of default and simulation of default scenarios into the portfolio risk analysis.

* To reduce the cost and potential capital charges on liquidity support, adopt more advanced portfolio cash analysis techniques that will allow retention of rating on the liability issuance without the cost of full structured liquidity support.

* Consistent valuation across the assets, derivatives and liabilities ensures accurate retrospective and prospective hedge effectiveness testing.

* The ability to audit all transactions and business flows provides the required transparency for investors, regulators and rating agencies. This key concept of IAS 39 has universal application.

Securitization Glossary

available-for-sale assets-one of four categories as defined by international accounting standards: held for trading, held-to- maturity, loans and receivables originated by the enterprise or loans and receivables available for sale. Available-for-sale assets must be carried at fair value.

call option-an agreement that gives an investor the right but not the obligation to buy a stock, bond, commodity or other instrument at a specified price within a specific time period

cashflow hedges-a hedge of the exposure to the volatilities in future cash flows that might affect future income statements. Often used for transactions that are foreign currency denominated or floating interest rates.

collateralized loan obligations-a special purpose vehicle with securitization payments in the form of different tranches

consolidation-in securitization, the integration of the assets, liabilities and results of the activity of a special purpose vehicle into the financial statements of the enterprise that has a controlling financial interest in it

credit-enhanced obligation-financial assets or liabilities that have been secured by bond insurance or some form of credit support

derecognition of assets-when an entity transfers an asset and relinquishes all contractual rights, risks and benefits to the asset. The entity does not have to record its derecognized assets.

derivative-a security, such as an option or futures contract, whose value depends on the performance of an underlying security

effectiveness tests-measurements to determine that hedges and hedged items have offsetting changes in fair value. Highly correlated offsets are considered effective.

embedded options-an option that is an inseparable part of another instrument as opposed to a normal (or bare) option, which trades separately from the underlying security

hedge-making an investment to reduce the risk of adverse price movements in an asset

hedge accounting-designating a derivative financial instrument as an offset in net profit or loss, in whole or in part, to the change in fair value or cash flows of the hedged item

held-when a security is temporarily unavailable for trading

held-to-maturity assets-debt securities that a firm has the ability and intent to hold until maturity. These are reported at amortized cost, therefore, they are not affected by swings in the financial markets.

fair value-the estimated value of all assets and liabilities of an acquired company used to consolidate the financial statements of both companies

fair value hedges-a hedge of the exposure to changes in the fair value of an asset or liability that is already recognized in the balance sheet. The gain or loss from the change in fair value of the hedging instrument is recognized immediately in net profit or loss.

impaired asset-an asset with a market value that is worth less than its book value. If the sum of all estimated future cash flows is less than the carrying value of the asset, then the asset would be considered impaired and would have to be written down to its fair value.

internal contracts-derivatives contracts within an organization used to transfer risk positions (e.g., a swap between an operating division and a treasury division that deals with external counter- party on financial markets)

many-to-many linkage-relationship where multiple financial assets are hedged by a combination of hedge instruments

mark-to-market valuation-(1) recording the price or value of a security, portfolio or account to reflect the current market value; (2) an accounting method that relates to how a trader calculates trading gains and losses, and how these gains and losses are reported on the trader's income tax returns

obligor-an entity that has an obligation to pay all principal and interest payments on a debt (or debtor)

one-to-one hedge linkage-hedge relationship between one financial instrument and one hedging instrument

option-a privilege sold by one party to another that offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security at an agreed-upon price during a certain period of time or on a specific date

originated loans-financial assets that are created by an entity, providing money, goods or services directly to the debtor

other comprehensive income (OCI)-a financial statement item used in recording portions of derivatives or hedges that are deemed effective and hence not booked to the income statement. The ineffective portion of a derivative's change in fair value is recognized in earnings.

prospective measurement-projected hedge effectiveness testing on a hedge-hedged item relationship(s)

put option-an option contract giving the owner the right but not the obligation to sell a specified amount of an underlying security at a specified price within a specified time

realized losses-a loss recognized when assets are sold for a price lower than the original purchase price

retrospective measurement-historical hedge effectiveness testing on a hedge-hedged item relationship(s)

securitization-the process of creating a financial instrument by combining other financial assets and then marketing them to investors

synthetic collateralized debt obligation-an artificial collateralized debt obligation that is backed by a pool of credit derivatives such as credit default swaps, forward contracts and options

timing of earning recognition-accounting term on determination of profits or loss impact on a financial statement for a specific accounting period where a transaction is started in one period but will be completed in a future period

total return swap-any swap in which the nonfloating rate side is based on the total return of an equity or fixed income instrument with a life longer than the swap

unrealized losses-a loss that results from holding on to an asset rather than cashing it in and officially taking the loss

Sean Togher is director of product management, at Principia Partners in Jersey City, New Jersey.
Copyright Risk Management Society Publishing, Inc. Aug 2003

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