Accounting for Interest Rate Derivatives FAS ASC 815 Presented by Douglas Winn September 23, 2014

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• Describe hedge accounting and provide examples • Address hedge effectiveness testing • Define hedge ineffectiveness – testing vs. bookkeeping • Provide alternative to hedge accounting • We will briefly discuss the NCUA rule itself – see our Insights and Resources page

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NCUA authorizes credit unions to use only the following derivatives: •

Interest Rate Swaps An agreement to exchange future payments of interest on a notional amount at specific times and for a specific time period

•

Interest Rate Caps A contract, based on a reference interest rate, for payment to the purchaser when the reference interest rate rises above the level specified in the contract

•

Interest Rate Floors A contract, based on a reference interest rate, for payment to the purchaser when the reference interest rate falls below the level specified in the contract 3

•

Basis Swaps An agreement between two parties in which the parties make periodic payments to each other based on floating rate indices multiplied by a notional amount

•

Treasury Note futures A U.S. Treasury note financial contract that obligates the buyer to take delivery of Treasury notes (or the seller to deliver Treasury notes) at a predetermined future date and price. Futures contracts are standardized to facilitate trading on an exchange

Note:

Wilary Winn Risk Management believes all of the derivatives permitted by the NCUA meet the definition of a derivative under GAAP. 4

• OTC swaps pricing varies considerably – Consider engaging independent third party advisor that can obtain multiple bids – We also recommend having an advisor help with the purchase of interest rate caps and floors

• Treasury futures are exchange traded – Pricing is the same for everyone – Must post collateral

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• Notional Amount o Takes into account type of derivative, time to maturity and net worth

• Fair Value Loss Limit o Loss limit does not include hedge benefit – measures the derivatives only o Limit is based on net aggregate loss of derivatives and net worth Entry Standard Total fair value Weighted average remaining maturity - notional

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Limits 15 65

Limits 25 100

Cannot net offsetting transaction – calculation is cumulative Step #1 Gross Product National Options (Caps) Current notional Options (Floors) Current notional Swaps Current notional Futures Contract size

Adjust Factor (Percent) 33 33 100 100

Step #2 Adjusted Notional 33% of current notional 33% of current notional 100% of current notional 100% of contract size Sum = Total adjusted notional

WARMN = Adjusted notional * (WARM/10)

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Step #3 WARM Time remaining to maturity Time remaining to maturity Time remaining to maturity Underlying contract Sum = Overall WARM

Balance Sheet & 2 Year Net Interest Income Projection Balance Sheet Assets Cash Investments Loans Other Assets

Liabilities Non‐maturity Time

Net

2 Year Net Interest Income Position $ MM ‐100 Base +100 +200 +300 0.05 0.15 0.61 1.08 1.54 3.70 4.34 5.12 5.85 6.58 27.28 29.14 31.00 33.48 35.34           ‐                 ‐                  ‐                 ‐                 ‐ 31.03 33.63 36.74 40.41 43.46

$ MM 30 140 310 20 500

‐200 0.01 2.44 24.49           ‐ 26.94

300 150 450

0.15 1.80 1.95

0.30 2.10 2.40

1.05 3.75 4.80

3.27 5.55 8.82

5.52 7.05 12.57

7.77 8.85 16.62

50

24.99

28.63

28.83

27.92 ‐0.91

27.84 ‐0.99

26.84 ‐1.99

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2-Year Interest Rate Swap – Pay Fixed, Receive Floating Entry Limit Calculations Fair Value Limit Net Worth Fair Value Limit Limit $

$ MM 50.0 15% 7.5

Notional Amount Limit Net Worth Notional Limit Maximum Maximum Notional Adjustment Factor Time to Maturity Time Factor Verification 9

$ MM 50.0 65% 32.5 162.5 100%          2.00 20% 32.5

5-Year Interest Rate Swap – Pay Fixed, Receive Floating Entry Limit Calculations Fair Value Limit Net Worth Fair Value Limit Limit $

Notional Amount Limit

$ MM 50.0 15% 7.5

Net Worth Notional Limit Maximum Maximum Notional Adjustment Factor Time to Maturity Time Factor Verification 10

$ MM 50.0 65% 32.5 65.0 100%          5.00 50% 32.5

2-Year Interest Rate Swap – Pay Fixed, Receive Floating Base Case Swap Cash Flows on $50 MM Notional $50 MM Interest Rate Swap - Base Case Cash Flow Pay Date Pmts (Rcv) Rate (Rcv) Pmts (Pay) Rate (Pay) Q2 2014 29,106 0.23 (69,706) 0.56 Q3 2014 32,739 0.26 (69,706) 0.56 Q4 2014 38,641 0.30 (72,804) 0.56 Q1 2015 43,702 0.37 (66,608) 0.56 Q2 2015 61,569 0.49 (69,706) 0.56 Q3 2015 85,779 0.69 (69,706) 0.56 Q4 2015 120,688 0.92 (72,804) 0.56 Q1 2016 149,682 1.20 (69,706) 0.56 Total / Avg. 561,905 0.56 -560,748 0.56

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Net Pmts Discount (40,600) 0.9994 (36,967) 0.9987 (34,164) 0.9980 (22,907) 0.9971 (8,138) 0.9958 16,073 0.9941 47,884 0.9917 79,975 0.9887 1,156

PV (40,576) (36,921) (34,094) (22,840) (8,104) 15,978 47,486 79,071 0

2 Year Net Interest Income Projection with Swap

Interest Income Interest Expense Net Change from Base Swap Impact * Change from Base w/ Swap

2 Year Net Interest Income Position $ MM ‐200 ‐100 Base +100 +200 +300 26.94 31.03 33.63 36.74 40.41 43.46 1.95 2.40 4.80 8.82 12.57 16.62 24.99 28.63 28.83 27.92 27.84 26.84 (3.84) (0.20)       (0.56)       (0.54)       (4.40)       (0.74)

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(0.91) 1.01 0.09

(0.99) (1.99) 2.01        3.02 1.02        1.03

Derivatives must be accounted for and reported at fair value Three options to decrease resulting income statement volatility: 1. Fair Value Hedge Accounting 2. Fair Value Accounting 3. Cash Flow Hedge Accounting

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Two types of hedge accounting 1. Fair value hedge Change in fair value of the hedging instrument runs through the income statement, along with the change in the fair value of the item being hedged – used for existing financial assets and liabilities 2. Cash flow hedge “Effective” portion of the hedge is reported in Other Comprehensive Income, while the ineffective portion is reported in current earnings – used for forecasted transactions or variable payments on existing financial assets and liabilities 14

Type of accounting depends on the item being hedged – Credit Union enters into a Pay Fixed, Receive Floating Interest Rate Swap Fair Value Hedge Example: CU wants to hedge against the decrease in fair value of a fixed rate loan portfolio defines hedge as change in benchmark interest rate If benchmark interest rate increases, fair value of the loans will decrease, and the fair value of the swap will increase. Change in each runs through the income statement

Cash Flow Hedge Example: CU wants to hedge against increase in dividend payments on CD accounts as they renew Defines hedge as risk of an increase in the forecasted payments to its members. Effective portion will run through OCI 15

Formal designation and documentation required at inception The CU’s objective and strategy for the hedge must include (815-20-25-3b 2): • The hedging instrument – the derivative (interest rate swap, interest rate floor, interest rate cap, etc.) • The hedged item or transaction – the asset or liability being hedged • The nature of the risk being hedged – interest rate risk • The method that will be used to retrospectively and prospectively measure the hedge’s effectiveness

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•

The method that will be used to measure hedge ineffectiveness

•

Benchmark interest rate being hedged Eligible benchmark rates are (815-20-25-6A): Treasury rates Federal funds effective swap rate LIBOR

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Fair Value Hedge: •

Can hedge the change in fair value of an entire or a portion of an asset or liability (815-20-25-11)

Cash Flow Hedge - Variability in Expected Future Cash Flows related to: •

An existing recognized asset or liability (such as all or certain future interest payments on variable rate debt

•

A forecasted transaction (such as a forecasted purchase or sale) (815-20-25-13)

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To qualify for hedge accounting, the hedging relationship (both at inception of the hedge and on an ongoing basis), shall be expected to be highly effective in achieving either of the following (815-20-25-75): • Offsetting changes in fair value attributable to the hedged risk during the period that the hedge is designated - a fair value hedge • Offsetting cash flows attributable to the hedged risk during the term of the hedge - a cash flow hedge

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Hedge Effectiveness can be measured in two ways: 1. Dollar-offset approach (815-20-35-5a) • Compares changes in fair value or cash flow of the hedged item and the derivative •

Can be applied period by period (cannot be less than 3 months) or cumulatively

•

Most believe a dollar offset range of 80%-125% would be considered highly effective

2. Statistical methodologies • May permit a CU to continue to use hedge accounting for the current period even though the dollar-offset approach appears ineffective (815-20-55-68) • Complex to implement and requires multiple observation periods 20

Dollar-Offset Approach Example $50 MM pay fixed / receive floating 5-year interest rate swap Hedged item – a group of fixed rate investments held AFS

Month

Market Rate Net Change From Swap Inception Payment

Swap Fair Value

Change in Swap Fair Value

Change in Investments Fair Value

Dollar Effective Offset % (y / n)

Mo. 0

0 bps

Mo. 1

-10 bps

(68,950)

(166,293)

(166,293)

140,579

118.3%

yes

Mo. 2

-15 bps

(71,327)

(214,920)

(48,627)

65,425

74.3%

no

Mo. 3

-25 bps

(73,705)

(371,804)

(156,884)

150,257

104.4%

yes

Mo. 4

-20 bps

(71,488)

(181,349)

190,455

(140,757)

135.3%

no

Mo. 5

+5 bps

(62,835)

437,189

618,538

(625,865)

98.8%

yes

437,189

(410,361)

106.5%

yes

Total

0

(348,305)

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Statistical Approaches – Regression Analysis •

Minimum of 30 observations

•

Must consider changes in the value of the derivative and the hedged item

•

Time horizon must coincide or be less than the time horizon of the hedge relationship

•

Must consider whether to regress value changes or value levels

•

Must review distribution of error terms

EY Derivatives and Hedging, October 2013 4.9.2.4

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Statistical Approaches – Regression Analysis Continued •

R-squared result must exceed a pre-specified level (e.g. 0.80)

•

Hedge relationship must correspond to beta (the slope of the regression line)

•

Standard error must be used to calculate the reliability using the t statistic

•

T-test must be passed at a 95% confidence level

•

Must consider y-intercept

•

Must compare results to dollar offset results

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Statistical Approach Example – R-squared Analysis Hedged item – floating dividend rate on money market shares 1 Mo LIBOR Line Fit  Plot 1.60

Dividend  Rate

1.40 1.20 1.00 0.80 0.60

Div. Rate

0.40

Predicted Div. Rate

0.20 0.00 0.00

1.00

2.00

3.00

1 Mo LIBOR

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4.00

5.00

6.00

A credit union shall consider hedge effectiveness in two different ways: 1. Prospective Considerations 2. Retrospective Evaluations

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Prospective Considerations (815-20-25-79a) •

Can be based on regression or other statistical analysis of past changes in fair values or cash flows as well as on other relevant information

•

Shall consider all reasonably possible changes in fair value (if a fair value hedge) or in fair value or cash flows (if a cash flow hedge) of the derivative instrument and the hedged items for the period used to assess whether the requirement for expectation of highly effective offset is satisfied

•

Not be limited only to the likely or expected changes in fair value (if a fair value hedge) or in fair value or cash flow (if a cash flow hedge)

•

Generally involves a probability-weighted analysis – consistent with FASB Concepts Statement No. 7 26

Retrospective Considerations (815-20-25-79b) •

• • •

An assessment of effectiveness shall be performed whenever financial statements or earnings are reported, and at least every three months Can be based on dollar offset or statistical approaches Dollar-offset measurement can be for period or cumulative Statistical methods must be similar period to period (e.g. same number of data points)

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Other Considerations for Cash Flow Hedges Effectiveness testing for a cash flow hedge involving an interest rate swap can be done using one of three methods: • Change in variable cash flows method (815-30-35-16 through 24) • Hypothetical derivative method (815-30-35-25 through 30) • Change in fair value method (815-30-35-31 through 32) We will show an examples of the change in variable cash flows method 28

What if the hedge is not or no longer effective? The hedge accounting is discontinued prospectively, resulting in potential income statement volatility as the derivative is marked to market with no offset to the hedged item (fair value hedge 815-25-40-1 and cash flow hedge 815-30-40-1)

Fair value adjustments for fixed rate financial instruments related to fair value hedges are recognized prospectively using the effective interest rate method when hedge accounting is discontinued (815-2535-9)

Cash flow hedge - the net gain or loss remains in AOCI unless it is probable that the forecasted transaction will not occur by the end of the originally specified time period plus a 2 month extension (815-3040-4) 29

Hedge ineffectiveness is measured by the Dollar-offset method Fair Value Hedge: Hedge ineffectiveness flows through the income statement based on any difference between the change in the value of the derivative and the change in value of the hedged item (815-20-35-1b)

Cash Flow Hedge: Ineffectiveness must be separately measured and recorded on the income statement. If the fair value of the derivative changes by more than the present value of hedged cash flows, the difference is the ineffective amount. If the fair value of the hedged cash flows changes by more than the change in the fair value of the derivative then no ineffectiveness (815-20-35-1c) 30

Entities can assume no ineffectiveness in an interest rate swap in two instances: 1. A private company that enters into a pay fixed, receive floating interest rate swap (this exemption does not apply to financial institutions) (815-20-25-131B) 2. A swap can be examined to determine if it can be accounted for under the Short-Cut Method (this applies to all companies, including financial institutions)

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To conclude no hedge ineffectiveness in a hedge with an interest rate swap, all of the following conditions must be met (815-20-25-104): a) Notional amount of swap matches principal amount of item being hedged b) Fair value of the swap is zero at inception Note: For the purposed of determining zero: can ignore bid/ask spread at inception, commissions, and other transaction costs

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c) Formula for computing net settlements remains the same throughout the swap − −

Fixed rate remains the same Variable rate index does not change

d) Interest bearing asset or liability is not pre-payable −

−

Unless the prepayment is due to an embedded call (put) option and the swap has a mirror option call (put) option - options must mach exactly Because the NCUA does not allow a credit union to enter into a swap with this feature, we believe a swap involving loans that can be prepaid will not qualify for the short-cut method

e) Index on which the variable rate leg is based matches the benchmark interest rate designated as the interest rate being hedged 33

WW Risk Management does not recommend the short-cut method, because if you fail, you cannot reassess. We recommend that a credit union account for the swap using the long-haul method, recognizing that swaps that would qualify for the short-cut method will easily pass the effectiveness testing

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As asset or liability is eligible for designation as a hedged item in a fair value hedge if all of the following criteria are met: •

The hedged item is specifically identified as either all or a specific portion of a recognized asset or liability or of an unrecognized firm commitment (815-20-25-12a)

•

The hedged item presents an exposure to changes in fair value attributable to the hedged risk that could affect reported earnings (815-20-25-12c)

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•

The hedged item is a single asset or liability (or a specific portion thereof) or is a portfolio of similar assets or similar liabilities (or a specific portion thereof) (815-20-25-12b) o If similar assets or similar liabilities are aggregated and hedged as a portfolio, the individual assets or liabilities shall share the risk exposure – generally proportionate change in fair value o If the specific portion of an asset or liability then one or more selected contractual cash flows, including one or more individual interest payments during a selected portion of the term of a debt instrument (such as the portion of the asset or liability representing the present value of the interest payments in the first two years of a four-year debt instrument). o A put option or call option (including an interest rate cap or price cap or an interest rate floor or price floor) embedded in an existing asset or liability that is not an embedded derivative accounted for separately

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•

If the hedged item is a financial asset or liability or a recognized loan servicing right, the designated risk being hedged is any of the following (815-20-25-12f): o The risk of changes in the overall fair value of the entire hedged item o The risk of changes in its fair value attributable to changes in the designated benchmark interest rate (referred to as interest rate risk) o The risk of changes in its fair value attributable to both of the following (referred to as credit risk): • Changes in the obligor’s creditworthiness • Changes in the spread over the benchmark interest rate with respect to the hedged item’s credit sector at inception of the hedge

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Change in fair value for each item in the portfolio must be within a fairly narrow range – such as 9 to 11%. On the other hand, a range of 7 to 13% would not meet the similar portfolio requirement (815-20-55-14)

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In aggregating loans in a portfolio to be hedged, an entity may choose to consider some of the following characteristics, as appropriate (815-20-55-15): a. Loan type b. Loan size c. Nature and location of collateral d. Interest rate type (fixed or variable) e. Coupon interest rate (if fixed) f. Scheduled maturity g. Prepayment history of the loans (if seasoned) h. Expected prepayment performance in varying interest rate scenarios

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Non-performance risk Credit valuation adjustments (CVAs) Counterparty risk (815-20-35-16) Credit union non-performance risk – implied EY 4.11.1

For derivatives such as swaps the CVAs adjustments can swing from party to party as each entity comes into / goes out of the money

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Credit unions considering a fair value hedge should be aware of the following: • •

•

Fair value hedge cannot be used to hedge interest rate risk on heldto-maturity securities (815-20-43c 2) If a fair value hedge is used to hedge interest rate risk on availablefor- sale securities then the change in the value of the hedged item runs through the income statement and not through OCI A partial-term hedge of a fixed rate financial instrument using a shorter-term, notionally matched swap will generally not "be effective" (e.g. hedging a 30-year loan with a 3-year swap)

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Fair value hedge accounting is restrictive and complex, and a CU could elect to account for the financial instrument at fair value in order to avoid these complications and limitations. However, fair value election has several disadvantages: • •

•

Hedge-accounting election can be terminated at any time, while the fair value election is irrevocable Nearly all of the change in value of an interest rate derivative over time will be due to changes in the market interest rates, while fair value of the loans will be affected by changes in interest rate and credit conditions The CU will need to develop systems to estimate the fair value of loans over their entire lives 42

We recommend that if a credit union elects to account for loans at fair value, that it: •

Select high credit borrowers to minimize the change in value arising from deterioration of the borrower’s credit or the widening out of credit spreads

We note that we have systems in place to estimate the fair value of loans over their entire lives

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Fixed Rate Mortgage Fair Value Example Fixed Rate Mortgage FICO Score Range

LTV Range

Principal Balance

Avg FICO

Avg LTV

WAC

CPR %

CRR %

CDR % Severity%

Discount Rate

Fair Value %

780+ 780+ 780+ 780+

under 50% 50% - 75% 75% - 100%

1,000,000 1,000,000 1,000,000 3,000,000

821 809 780 815

32% 60% 79% 42%

4.6% 4.4% 4.5% 4.6%

11.5% 10.1% 8.8% 11.0%

11.5% 9.5% 6.6% 10.7%

0.0% 0.0% 0.0% 0.0%

0.0% 10.0% 15.0% 12.2%

4.2% 4.3% 4.3% 4.2%

101.4% 100.1% 100.6% 100.9%

720 - 779 720 - 779 720 - 779 720 - 779

under 50% 50% - 75% 75% - 100%

1,000,000 1,000,000 1,000,000 3,000,000

762 757 747 756

25% 59% 77% 54%

4.4% 4.5% 4.4% 4.5%

10.7% 11.1% 8.7% 10.6%

10.7% 11.1% 8.6% 10.5%

0.1% 0.1% 0.1% 0.1%

0.0% 10.0% 15.0% 9.1%

4.2% 4.3% 4.3% 4.2%

100.4% 100.9% 101.0% 100.8%

660 - 719 660 - 719 660 - 719 660 - 719

under 50% 50% - 75% 75% - 100%

1,000,000 1,000,000 1,000,000 3,000,000

687 688 687 688

15% 60% 79% 63%

4.7% 4.4% 4.2% 4.4%

8.6% 8.6% 6.9% 7.8%

8.4% 8.4% 6.6% 7.6%

0.2% 0.2% 0.3% 0.3%

0.0% 10.0% 15.0% 12.6%

4.4% 4.6% 5.4% 5.0%

101.1% 98.9% 92.5% 96.2%

620 - 659 620 - 659 620 - 659 620 - 659

under 50% 50% - 75% 75% - 100%

1,000,000 1,000,000 1,000,000 3,000,000

648 630 630 632

42% 66% 78% 67%

5.0% 4.6% 4.3% 4.6%

8.3% 8.5% 8.0% 8.4%

7.3% 7.3% 6.0% 6.9%

1.0% 1.3% 2.1% 1.5%

0.0% 10.0% 15.0% 11.4%

4.6% 4.9% 6.3% 5.2%

102.2% 97.0% 86.1% 94.6%

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An entity may designate a derivative instrument as hedging the exposure to variability in expected future cash flows that is attributable to a particular risk. That exposure may be associated with either of the following (815-20-25-13): •

Payments on an existing recognized asset or liability (such as all or certain future interest payments on variable-rate debt or variable rate liabilities – share accounts)

•

A forecasted transaction (such as a forecasted purchase or sale)

45

A forecasted transaction is eligible for designation as a hedged transaction in a cash flow hedge if all of the following criteria are met (815-20-25-15): a) A forecasted transaction is specifically identified as either: 1. A single transaction 2. A group of individual transactions that share the same risk exposure for which they are designated as being hedged. A forecasted purchase and a forecasted sale shall not both be included in the same group of individual transactions that constitute the hedged transaction.

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b) The occurrence of the forecasted transaction is probable. c) The forecasted transactions meets both of the following conditions: 1. It is a transaction with a party external to the reporting entity 2. It presents an exposure to variations in cash flows for the hedged risk that could affect reported earnings

d) The forecasted transaction is not the acquisition of an asset or incurrence of a liability that will subsequently be re-measured with changes in fair value attributable to the hedged risk reported currently in earnings. e) If the forecasted transaction relates to a recognized asset or liability, the asset or liability is not re-measured with changes in fair value attributable to the hedged risk reported currently in earnings. 47

f)

If the hedged transaction is the variable cash inflow or outflow of an existing financial asset or liability, the designated risk being hedged is any of the following: 1. The risk of overall changes in the hedged cash flows related to the asset or liability, such as those relating to all changes in the purchase price or sales price 2. The risk of changes in its cash flows attributable to changes in the designated benchmark interest rate (referred to as interest rate risk) 3. The risk of changes in its cash flows attributable to all of the following (referred to as credit risk): i. Default ii. Changes in the obligor’s creditworthiness iii. Changes in the spread over the benchmark interest rate with respect to the related financial asset’s or liability’s credit sector at inception of the hedge. 48

Accounting for cash flows AOCI reclassified into earnings in the same period that the in which the forecasted transaction affects earnings

49

Fair value of the derivative • •

Interest rate swap Interest rate cap

Cash Flow Hedges •

Rollover of Share CDs – change in variable cash flows method (815-20-05-10)

Fair value hedge •

Loan Portfolio

Forgo Hedge Accounting •

Fair Value Option for loan portfolio 50

$50 MM 3-year pay fixed / receive floating interest rate swap Quarter

Total

Days

Pay Fixed

Receive Floating

Net Payments

Present Value

1

90

(153,706)

29,311

(124,395)

(124,318)

2

91

(155,414)

32,702

(122,713)

(122,556)

3

89

(151,998)

46,322

(105,676)

(105,442)

4

90

(153,706)

72,157

(81,549)

(81,248)

5

90

(153,706)

101,353

(52,353)

(52,053)

6

90

(153,706)

131,620

(22,086)

(21,901)

7

90

(153,706)

162,603

8,896

8,793

8

90

(153,706)

195,117

41,411

40,766

9

90

(153,706)

227,693

73,987

72,500

10

90

(153,706)

261,209

107,503

104,796

11

90

(153,706)

287,054

133,347

129,231

12

90

(153,706)

310,982

157,276

151,433

(1,844,475)

1,858,124

13,649

-

At inception and without the credit valuation adjustment (CVA), the fair value of the swap is zero. 51

$50 MM 3-year pay fixed / receive floating interest rate swap Quarter 1 2 3 4 5 6 7 8 9 10 11 12 Total

Pay Fixed

Days 90 91 89 90 90 90 90 90 90 90 90 90

(153,706) (155,414) (151,998) (153,706) (153,706) (153,706) (153,706) (153,706) (153,706) (153,706) (153,706) (153,706) (1,844,475)

Discount Discounted w/ 2% CVA Pay Fixed Leg 0.9944 0.9888 0.9830 0.9767 0.9699 0.9626 0.9547 0.9463 0.9373 0.9278 0.9180 0.9078

(152,852) (153,673) (149,419) (150,130) (149,083) (147,953) (146,742) (145,448) (144,071) (142,613) (141,098) (139,532) (1,762,615)

Receive Floating 29,311 32,702 46,322 72,157 101,353 131,620 162,603 195,117 227,693 261,209 287,054 310,982 1,858,124

Discount w/ 1% CVA

Discounted Rcv Float Leg

0.9969 0.9938 0.9904 0.9865 0.9821 0.9770 0.9715 0.9653 0.9585 0.9512 0.9434 0.9352

29,221 32,498 45,877 71,184 99,535 128,599 157,961 188,342 218,247 248,454 270,805 290,843 1,781,566

Fair Value with CVA (123,631) (121,176) (103,541) (78,947) (49,548) (19,354) 11,219 42,895 74,176 105,841 129,707 151,311 18,951

Credit valuation adjustment (CVA) is applied to the discount rate on both legs of the swap to determine fair value 52

$50 MM 3-year pay fixed / receive floating interest rate swap

Time Inception 1 Year Out 2 Years Out

-100

Base

(1,494,219) (758,735) (111,723)

353,620 506,549

100 1,445,935 1,443,606 1,118,512

200 2,845,187 2,511,784 1,724,262

300 4,199,400 3,558,698 2,323,891

Fair value of the swap changes as interest rates move and with the passage of time

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$25 MM 5-year interest rate swap with a 3.50% strike price Quarter 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Total

Cap 3.50% 3.50% 3.50% 3.50% 3.50% 3.50% 3.50% 3.50% 3.50% 3.50% 3.50% 3.50% 3.50% 3.50% 3.50% 3.50% 3.50% 3.50% 3.50% 3.50%

Reset Rate Discount 0.23% 0.26% 0.37% 0.58% 0.81% 1.05% 1.30% 1.56% 1.82% 2.08% 2.30% 2.48% 2.46% 2.62% 2.79% 2.94% 2.84% 2.96% 3.09% 3.20%

Intrinsic PV

0.9994 0.9987 0.9978 0.9963 0.9943 0.9916 0.9884 0.9844 0.9799 0.9748 0.9691 0.9630 0.9571 0.9509 0.9441 0.9370 0.9303 0.9236 0.9162 0.9089

-

Time PV 0 38 58 582 2,345 5,916 6,007 11,170 17,170 23,154 19,463 24,590 31,310 38,087 32,029 35,915 43,603 46,751 338,186

Cap Cost 0 38 58 582 2,345 5,916 6,007 11,170 17,170 23,154 19,463 24,590 31,310 38,087 32,029 35,915 43,603 46,751 338,186

Since the cap strike price of 3.50% exceeds the anticipated forward rate in all periods, this cap is out-of-the-money at inception. 54

$25 MM 5-year interest rate swap with a 3.50% strike price Time Inception 1 Year Out 2 Years Out 3 Years Out 4 Years Out

-300

-200 0 0 0 0 0

5,946 4,401 3,533 3,730 1,757

-100

0

81,174 71,131 62,564 50,556 23,375

338,186 315,122 279,964 206,421 89,439

100 799,566 756,148 666,519 494,152 269,609

200

300

1,435,252 1,347,453 1,192,560 985,180 557,555

2,197,990 2,056,018 1,880,248 1,515,716 860,821

Fair value of the interest rate cap changes as interest rates move and with the passage of time

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Cash Flow Hedge Example: Rollover of Existing Debt A pay fixed, receive floating interest rate swap is used to hedge against the risk of increases in interest raterelated cash flows on reissuances of the credit union's share certificates • • •

Hedging item used - pay fixed, receive floating interest rate swap with a fair value of zero at inception Hedged item – forecasted quarterly re-issuances of fixed rate share certificates Nature of the risk being hedged - variability in cash flows arising from reissuances of share certificates

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Cash Flow Hedge Example: Rollover of Existing Debt Critical terms • • • • •

Notional amount of the swap and share certificates match at $50 MM Fixed rate on the swap is the same throughout the term and the variable rate equals LIBOR No interest payments beyond the term of the swap are designated as hedged Swap and CDs re-price on the same day Determination that the it is probable that the swap counterparty will not default on its obligations

57

Cash Flow Hedge Example: Change in Variables Cash Flow Method Credit Union must perform effectiveness testing. To be effective, changes in certificates of deposit must closely track changes in LIBOR. Effectiveness testing could be based on the changes in LIBOR only – as a benchmark interest rate. In this example, we will test using the rate on the CDs. Ineffectiveness will measured using the change in variable cash flows method.

58

Change in Variables Cash Flow Method • • • • •

Hedge ineffectiveness is based on a comparison of: Variable leg of the interest rate swap Hedged variable-rate cash flows on the share certificates Based on the premise that only the floating-rate component of the interest rate swap provides the cash flow hedge The interest rate swap is recorded at fair value on the balance sheet. The calculation of ineffectiveness involves a comparison of the following amounts: a. The present value of the cumulative change in the expected future cash flows on the variable leg of the interest rate swap b. The present value of the cumulative change in the expected future interest cash flows on the CDs

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Change in Variables Cash Flow Method •

Hedge ineffectiveness results when the present value of the cumulative cash flows on the swap exceed the present value of the cumulative cash flows of the designated share certificate accounts. Conversely, there is no ineffectiveness if the PV of the designated share certificate payments exceed the PV of the swap (FAS ASC 815-3035-3(b))

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Hedge Accounting Examples

•

•

Non-performance Risk for Cash Flow Hedges Using Interest Rate Swaps The discount rate used for the change in variable cash flows method and the hypothetical derivative method is the rate applicable to determining the fair value of the swap (815-30-35-20). This means that the non-performance risk of the swap counterparty would be applied to the swap and the hedged item cash flows so it would not in itself result in effectiveness. Issue arises if default of counterparty is “probable”. Non-performance risk can result in effectiveness using the change in fair value method (815-30-35-17)

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Change in Variables Cash Flow Method A $50 MM 3-year pay fixed, receive floating interest rate swap is used to hedge against the risk of increases in interest rate-related cash flows on rollovers the credit union's share certificates Qtr 2 3 4 5 6 7 8 9 10 11 12 Total

Fair Value of the Swap Pay Receive Net Fixed Floating Payments (155,414) 64,299 (151,998) 77,225 (153,706) 103,408 (153,706) 132,604 (153,706) 162,870 (153,706) 193,853 (153,706) 226,368 (153,706) 258,943 (153,706) 292,459 (153,706) 318,304 (153,706) 342,233 (1,690,769) 2,172,563

(91,115) (74,774) (50,299) (21,103) 9,164 40,146 72,661 105,236 138,753 164,598 188,526 481,794

Present Value (90,998) (74,562) (50,053) (20,944) 9,065 39,562 71,281 102,705 134,628 158,694 180,529 459,906

At inception hedge value is $0. LIBOR rates increase 25 basis points after 1 quarter, and the credit union paid $124,395 at the end of first quarter. 62

Change in Variables Cash Flow Method A $50 MM 3-year pay fixed, receive floating interest rate swap is used to hedge against the risk of increases in interest rate-related cash flows on rollovers the credit union's share certificates Change in Cash Flows on the Variable Leg of the Swap Projected Updated Increase Discount Present at Inception Projection (Decrease) Factor Value 32,702 46,322 72,158 101,354 131,620 162,603 195,118 227,693 261,209 287,054 310,983 1,828,813

64,299 77,225 103,408 132,604 162,870 193,853 226,368 258,943 292,459 318,304 342,233 2,172,563

31,597 30,903 31,250 31,250 31,250 31,250 31,250 31,250 31,250 31,250 31,250 343,750

0.9987 0.9972 0.9951 0.9925 0.9893 0.9854 0.9810 0.9759 0.9703 0.9641 0.9576

Change in Cash Flows on the Future Share Certificates Projected Updated Increase Discount Present at Inception Projection (Decrease) Factor Value

31,557 30,815 31,097 31,015 30,914 30,795 30,656 30,498 30,321 30,129 29,924 337,723

32,740 46,371 72,195 101,416 131,658 162,653 195,180 227,730 261,296 287,079 311,008 1,829,325

61,809 74,802 100,945 130,166 160,408 191,403 223,930 256,480 290,046 315,829 339,758 2,145,575

29,069 28,431 28,750 28,750 28,750 28,750 28,750 28,750 28,750 28,750 28,750 316,250

$310,706 is the effective portion of the hedge. $27,017 is ineffective. 63

0.9987 0.9972 0.9951 0.9925 0.9893 0.9854 0.9810 0.9759 0.9703 0.9641 0.9576

29,032 28,350 28,610 28,534 28,441 28,331 28,204 28,058 27,895 27,719 27,530 310,706

Change in Variables Cash Flow Method

64

Fair Value Hedge • Portfolio Method using an interest rate swap Forgo Hedge Accounting • Loan portfolio – fair value option

65

Fair Value Hedge Example: Portfolio Method A pay fixed, receive floating interest rate swap is used to hedge against the change in the fair value of a portfolio of fixed rate single family mortgages • • •

•

Hedging item used - pay fixed, receive floating interest rate swap with a fair value of zero at inception Hedged item - portfolio of fixed rate single family mortgage loans Nature of the risk being hedged - interest rate risk defined as the change in the fair value of the mortgage loan portfolio in relation to the change in benchmark interest rate (LIBOR) The portfolio of loans meets the similar assets criteria

66

Fair Value Hedge Example: Portfolio Method A pay fixed, receive floating interest rate swap is used to hedge against the change in the fair value of a portfolio of fixed rate single family mortgages • •

Stated maturity of swap is consistent with the stated maturities of the loans Swap amortizes on a schedule that equates to scheduled amortization of the loans

67

Fair Value Hedge Example: Portfolio Method As part of its documented risk management strategy associated with this hedging relationship, on a quarterly basis, the credit union intends to do both of the following: • Assess effectiveness of the existing hedging relationship for the past three-month period. • Consider possible changes in value of the hedging derivative and the hedged item over the next three months in deciding whether it has an expectation that the hedging relationship will continue to be highly effective at achieving offsetting changes in fair value.

Loans can prepay – credit union considers prepayment risk of the portfolio in its prospective testing If loans prepay faster than expected resulting in an over-hedge – credit union de-designates a portion of the swap for the next three month period 68

Fair Value Hedge Example: Portfolio Method $50 MM amortizing 15 year pay fixed / receive floating interest rate swap Hedged item – a pool of 15-year fixed rate loans Amortizing Hedge Notional Amt Month Mo. 0 Mo. 1 Mo. 2 Mo. 3 Total

  50,000,000   49,796,823   49,592,968   49,388,434

Market Rate Change From Inception 0 bps ‐10 bps +5bps +10 bps

Net Swap Payment

Change in Change in Swap Swap 15 Year Loan De-designation Fair Fair Loan Pool Portfolio Dollar Effective Notional Value Value Unpaid Bal. Value Offset % (y / n) Amount

0   50,000,000 (104,527) (251,261)    (251,261)   49,571,823      257,100    (97,316)   372,325     623,586   49,017,968     (508,479)    (94,853)   639,043     266,718   48,632,600     (301,068)

97.7% 122.6% 88.6%

yes yes yes

               755,834

(296,696)

115.7%

yes

               755,834

    639,043

69

    (552,447)

Fair Value Hedge Example: Portfolio Method

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Fair Value Election Accounting Fixed Rate Mortgage Fair Value Example Fixed Rate Mortgage FICO Score Range

LTV Range

Principal Balance

Avg FICO

Avg LTV

WAC

CPR %

CRR %

CDR % Severity%

Discount Rate

Fair Value %

780+ 780+ 780+ 780+

under 50% 50% - 75% 75% - 100%

1,000,000 1,000,000 1,000,000 3,000,000

821 809 780 815

32% 60% 79% 42%

4.6% 4.4% 4.5% 4.6%

11.5% 10.1% 8.8% 11.0%

11.5% 9.5% 6.6% 10.7%

0.0% 0.0% 0.0% 0.0%

0.0% 10.0% 15.0% 12.2%

4.2% 4.3% 4.3% 4.2%

101.4% 100.1% 100.6% 100.9%

720 - 779 720 - 779 720 - 779 720 - 779

under 50% 50% - 75% 75% - 100%

1,000,000 1,000,000 1,000,000 3,000,000

762 757 747 756

25% 59% 77% 54%

4.4% 4.5% 4.4% 4.5%

10.7% 11.1% 8.7% 10.6%

10.7% 11.1% 8.6% 10.5%

0.1% 0.1% 0.1% 0.1%

0.0% 10.0% 15.0% 9.1%

4.2% 4.3% 4.3% 4.2%

100.4% 100.9% 101.0% 100.8%

660 - 719 660 - 719 660 - 719 660 - 719

under 50% 50% - 75% 75% - 100%

1,000,000 1,000,000 1,000,000 3,000,000

687 688 687 688

15% 60% 79% 63%

4.7% 4.4% 4.2% 4.4%

8.6% 8.6% 6.9% 7.8%

8.4% 8.4% 6.6% 7.6%

0.2% 0.2% 0.3% 0.3%

0.0% 10.0% 15.0% 12.6%

4.4% 4.6% 5.4% 5.0%

101.1% 98.9% 92.5% 96.2%

620 - 659 620 - 659 620 - 659 620 - 659

under 50% 50% - 75% 75% - 100%

1,000,000 1,000,000 1,000,000 3,000,000

648 630 630 632

42% 66% 78% 67%

5.0% 4.6% 4.3% 4.6%

8.3% 8.5% 8.0% 8.4%

7.3% 7.3% 6.0% 6.9%

1.0% 1.3% 2.1% 1.5%

0.0% 10.0% 15.0% 11.4%

4.6% 4.9% 6.3% 5.2%

102.2% 97.0% 86.1% 94.6%

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Fair Value Election Accounting Example with Default and Interest Rate Shock Fixed Rate Mortgage FICO Score Range

LTV Range

Avg FICO

Avg LTV

Base CDR %

Shock CDR %

Change in Fair Value%

Base Discount Rate

Shock Discount Rate

Change in Fair Value%

Total Change in Fair Value%

780+ 780+ 780+ 780+

under 50% 50% - 75% 75% - 100%

821 809 780 815

32% 60% 79% 42%

0.0% 0.0% 0.0% 0.0%

0.1% 0.1% 0.1% 0.1%

0.0% 0.0% 0.0% 0.0%

4.2% 4.3% 4.3% 4.2%

6.2% 6.3% 6.3% 6.2%

-7.1% -9.6% -11.1% -8.0%

-7.1% -9.6% -11.1% -8.0%

720 - 779 720 - 779 720 - 779 720 - 779

under 50% 50% - 75% 75% - 100%

762 757 747 756

25% 59% 77% 54%

0.1% 0.1% 0.1% 0.1%

0.2% 0.2% 0.2% 0.2%

0.0% -0.1% -0.1% -0.1%

4.2% 4.3% 4.3% 4.2%

6.2% 6.3% 6.3% 6.2%

-7.5% -9.2% -10.6% -9.0%

-7.6% -9.2% -10.8% -9.1%

660 - 719 660 - 719 660 - 719 660 - 719

under 50% 50% - 75% 75% - 100%

687 688 687 688

15% 60% 79% 63%

0.2% 0.2% 0.3% 0.3%

0.4% 0.4% 0.6% 0.5%

-0.1% -0.2% -0.3% -0.2%

4.4% 4.6% 5.4% 5.0%

6.4% 6.6% 7.4% 7.0%

-5.6% -9.6% -9.9% -9.2%

-5.7% -9.8% -10.2% -9.5%

620 - 659 620 - 659 620 - 659 620 - 659

under 50% 50% - 75% 75% - 100%

648 630 630 632

42% 66% 78% 67%

1.0% 1.3% 2.1% 1.5%

2.0% 2.5% 4.1% 2.9%

-0.5% -1.1% -1.6% -1.2%

4.6% 4.9% 6.3% 5.2%

6.6% 6.9% 8.3% 7.2%

-9.3% -9.5% -8.9% -9.3%

-9.9% -10.6% -10.5% -10.5%

72

Fair Value Election

73

Call Report References • • •

Other Assets,32–d Liabilities, 7 Schedule D:

Non-Trading Derivatives Assets, net Non-Trading Derivative Liabilities, net Pages 20-24

Risk Based Capital •

AOCI not included in capital so no regulatory benefit for cash flow hedge

74

• • •

•

Identify the optimal derivative(s) to be used given your credit union's ALM profile Work with you to amend your ALM policies to allow for the use of derivatives Work with you to draft derivatives policies and procedures that ensure you have the proper internal controls in place and that you meet all of the NCUA requirements regarding the use of derivatives We can provide estimates of ongoing fair value for loans, investments, and liabilities which you have elected to account for at fair value. We can also help you with the initial selection of the items

75

• For those electing hedge accounting we can: – Develop the appropriate interest rate hedge and hedging item(s) to be used given your credit union's ALM profile – Work with you to identify the item(s) to be hedged and the nature of the risk being hedged – Ensure you are able to achieve hedge accounting - including prospective and retrospective effectiveness testing on a dollar offset or statistical basis – Provide you with the journal entries needed to report hedging activities

76

Wilary Winn LLC First National Bank Building 332 Minnesota Street, Suite W1750 Saint Paul, MN 55101 651-224-1200 www.wilwinn.com

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Services and Contact Information Private Label MBS/CMOs and Asset Liability Management: Frank Wilary [email protected] Mergers and Acquisitions, Fair Value Footnotes, ASC 310-30, and TDRs: Brenda Lidke [email protected] Mortgage Servicing Rights and Mortgage Banking Derivatives: Eric Nokken [email protected]

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