Saturday, June 20, 2009

Standardizing OTC derivatives destroys "hedge accounting"

As an echo of our post in early June called Derivatives, the WRONG war, Chatham Financial, a risk management advisor to corporations has shot a letter to the U.S. Congress regarding the proposed regulation of the OTC derivatives market.

Here is a quote from PR Newswire:
The letter lists concerns over regulations that might limit access to customized derivatives or impose onerous collateral requirements on the American businesses that use OTC derivatives responsibly to hedge fluctuations in interest rates, foreign currency exchange rates, and commodity prices. These concerns are directed at certain proposals mandating clearing and exchange-trading for all OTC derivatives. "Forcing all derivatives onto exchanges or into central clearing is not the answer," says Bontrager.

The letter cautions that companies forced to use standardized derivatives could "face significantly increased earnings volatility and accounting complexity and may be unable to qualify for hedge accounting treatment" under FAS 133. Discussing the letter, Clark Maxwell, director of Chatham's accounting consultancy, commented that, "We're concerned that the accounting for derivatives could become even more complicated and may discourage prudent risk management. The benefits of customizable derivative contracts that precisely hedge a company's risks are significant for the vast majority of end users."

They are making a reference here to an accounting rule called "hedge accounting" (FAS133 or IAS39). Under this rule corporations who hedge their risks precisely do not have to show losses (or gains) on a derivatives contract because whatever it is they are hedging would have the offsetting gain (loss). To qualify for this rule the hedge must be shown to be "effective" - that is it must be proven to closely mirror the asset or liability being hedged.

However the push to standardize OTC derivatives and move them to a clearing house will cause havoc for corporations because the standard contracts will rarely match precisely the hedged item. That means corporations will rarely qualify for hedge accounting and will either not hedge at all or have imprecise hedges that need to be marked to market without marking the item being hedged (marking only one side of a risk neutral position). Either scenario will make earnings extremely volatile for many firms (from power companies to cereal manufacturers).

At the risk of sounding repetitive, the knee-jerk reaction to blindly regulate OTC derivatives is imprudent. It will help some politicians and bureaucrats with their careers and CNBC with their ratings. But it will force US corporations to take more risk, not less.

Don't buy what the mainstream media and populist blogs are feeding you. Think for yourself.

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