Bank One Corp. v. Comm'r

CONTENTS

FINDINGS OF FACT. 183

I. Background. 183

A. Stipulations of Fact. 183

B. Briefs on CD-ROM With Appropriate Hyperlinks . 183

C. Relevant Taxpayers. 183

1. FCC . 183

2. First Chicago NBD Corp. 184

3. FNBC. 184

4. Bank One Corp. 184

II. The Swaps Business . 185

A. Swaps in General . 185

1. Definition of a Swap. 185

2. Swaps Are Derivative Financial Products. 185

3. Types of Swaps in the Marketplace . 186

B. Origin and Growth of the Swaps Market. 186

1. Origin of the Market . 186

2. Growth of the Interest Rate Swaps Market. 187

C. Interest Rate Swaps. 187

1. Terms of an Interest Rate Swap Agreement. 187

2. Notional Principal Amount and Related Terms . 188

3. Different Types of Interest Rates. 188

4. Use of LIBOR as a Floating Interest Rate Index . 189

5. Plain Vanilla Interest Rate Swaps . 190

6. Lack of Payments at Inception. 191

7. Example of an Interest Rate Swap . 191

D. Currency Swaps . 192

E. Participants in the Market. 192

1. End Users . 192

a. Typical End Users . 192

b. End Users’ Uses of Interest Rate Swaps . 193

i. Combat Interest Rate Changes . 193

ii. Prosper From Market Forecast. 194

iii. Reduce Cost of Funding . 194

2. Dealers . 194

a. Typical Dealers . 194

b. Practice as to Swaps. 195

c. Price Quotations . 195

d. Role in the Market . 196

e. Need for Strong Credit . 196

3. Brokers . 196

F. Market for Swaps . 197

1. Types of Markets. 197

a. Primary Market . 197

b. Secondary Market. 197

2. Brokers’ Dissemination of the Dealers’ Quotations . 198

a. Daily Quotations . 198

b. No Dissemination of Actual Swap Prices . 198

c. Spreads Included in Quotations. 199

3. Midmarket Rate . 202

4. Midmarket Swap Curve. 202

5. ISDA Form Agreements. 203

6. Assignments and Buyouts of Swaps . 205

G. Risks Assumed by Dealers . 205

1. Types of Risks. 205

2. Techniques Used To Minimize Credit Risk. 206

3. Techniques Used To Minimize Market Risk. 206

H. Dealer Spreads . 207

1. Bid-Ask Spread. 207

2. Bid-to-Mid Spread . 207

3. Example . 207

4. Significance of Spreads . 207

5. Decline in Interdealer Spreads . 208

III. Valuing Swaps. 209

A. Relevant Valuation Standards . 209

1. Fair Market Value. 209

2. Market Value . 209

3. Fair Value . 209

B. Mark-to-Market Accounting . 209

C. Devon System and the Devon (Midmarket) Value . 210

1. Devon System . 210

2. Devon (Midmarket) Value . 210

3. Yield Curve . 211

a. Overview. 211

b. Constructing the Curve . 211

c. Imprecise Measure . 212

D. Market Value. 212

1. Net Present Value — Forward Rate Pricing . 212

a. Expected Cashflows . 212

b. Discounting Expected Cashflows. 213

2. Floating-Rate Note Method . 213

3. Value at Origination . 214

4. Change in Market Value . 215

E. Primary Financial Reporting Methods . 215

1. Overview . 215

2. Amortized Cost . 215

3. Current Market Value . 216

4. Lower of Cost or Market. 216

F. Relevant Standards of the FASB . 216

1. The FASB and GAAP. 216

2. Initial Role of Market Values in GAAP. 217

3. SFACs. 217

4. Change in Accounting Treatment . 218

5. SFASs . 219

a. SFAS No. 105 . 219

b. SFAS No. 107 . 219

c. SFAS No. 119 . 220

d. SFAS No. 133 . 220

G. Methods of Valuing Swaps . 220

1. Bid-Ask Method . 221

2. Midmarket Method .:.. 221

3. Adjusted Midmarket Method . 221

H. Nontax Purposes for Which Dealers Value Swaps. 222

1. Overview . 222

2. Regulatory Reporting . 222

3. Risk Management . 223

4. Management Reporting . 223

5. Financial Reporting and Pricing. 224

I.The G~30 . 224

1. Overview . 224

2. O-30’s Review of Industry Practices . 224

3. Gt-30 Report. 225

4. BC-277 . 226

IV. Adjustments to Midmarket Value. 227

A. Overview . 227

B. Administrative Costs Adjustment. 228

1. Overview . 228

2. Dealers’ Practice . 228

3. Use of the Dealer’s Own Costs . 228

C. Adjustment for Counterparty Credit Risk . 228

1. Overview . 228

2. Common Method of Calculating Adjustment . 229

a. Counterparty Credit Rating. 229

b. Expected Loss Factor. 229

c. Loan Equivalency. 230

i. Overview . 230

ii. Types of Credit Exposure . 230

A. Current Credit Exposure . 230

B. Potential Credit Exposure . 230

C. Expected Exposure. 231

iii. OCC’s Position . 231

iv. Methods Used To Calculate . 231

3. Market Data for Pricing Credit Risk of Bonds . 232

D. Other Adjustments. 233

1. Investing and Funding Costs . 233

2. Closeout Costs (Liquidity) . 233

3. Dealer Margin . 233

V. Los Alamos Project . 234

VI. FNBC’s Swaps Business . 235

A. Overview . 235

B. Trading Desks . 236

C. Swaps Operations Personnel . 236

1. Overview . 236

2. Traders . 237

a. Function. 237

b. Number Employed in Chicago . 237

c. Practice as to Quotations. 238

d. Risk Management Responsibility . 238

3. Marketers. 239

a. Function. 239

b. Practice as to Quotations . 239

4. Relationship Managers . 239

5. Credit Officers . 240

D. Weak Credit Rating . 240

E. Quoting a Price. 241

F. Buyouts . to 4^ H

G. Swaps Outstanding at Yearend . to ^ tO

H. Swaps in Issue ... bo ^ tO

243 VII. FNBC’s Financial Accounting Practice .

VIII. FNBC’s Practice as to Its Valuation of Its Swaps to £»■

A. Financial Reporting Position. to £»* ^

B. Uses of Valuation . to 4^ ^

C. RAP/GAAP . to 4^ Ox

245 IX. FNBC’s Calculation of Midmarket Value .

245 A. FNBC’s Devon System .

245 1. Overview .

245 2. Role of FNBC’s Devon System .

246 B. Accounting for Devon Value .

247 C. Early Closing Date .

248 X. FNBC’s Administrative Costs Adjustment .

248 A. Overview .

249 B. Calculation of the Adjustment .

250 C. Preparation for the Adjustment.

252 252 D. Expenses Included in the Adjustment. 1. Direct and Indirect Budgeted Costs.

252 2. Amounts From Other Areas of FNBC ..

253 XI. FNBC’s Credit Adjustment.

253 A. Overview ....

253 1. Initial and Subsequent Methods .

253 2. First Method .

253 3. Second Method .

254 a. Methodology .

255 b. Effect of Methodology .

255 B. Swaps in Issue for 1993 .

255 1. Identification of Swaps .

256 2. Duration of Swaps .

256 3. Credit Adjustments Claimed.

257 C. Components of the Second Method.

258 1. CEM Amount.

258 a. Overview.

258 b. Hsieh Model .

259 c. FNBC’s VEP System.

259 i. Evolution of the System .

260 ii. Effect of the System.

260 iii. System’s Operation.

261 2. Credit Risk Ratings.

261 a. System of Risk Classification .....'.

262 b. Credit Procedures .

263 c. Review of Risk Classifications .

264 3. CRESCO Loss Reserve Factors .

264 a. Loss Reserves .

264 b. CRESCO .

265 c. Accuracy of CRESCO Loss Factors.

d. Same Factors Applied to Loans and Swaps . 265

e. FNBC’s Credit and Tenor Enhancements. 266

D. Static Instead of Dynamic Procedure . 266

E. Netting . 267

1. Types of Netting . 267

a. Closeout Netting . 267

b. Single Transaction Netting. 268

c. Multiple Transaction Netting . 268

2. Netting in the Industry . 268

3. Status of Netting Arrangements . 269

4. Practicability of Accounting for Netting. 270

5. Impact of the Failure To Account for Netting . 270

6. FNBC’s Use of Netting Provisions . 270

XII. FNBC’s Adjustments Were Designed To Defer Income . 270

A. Overview . 270

B. FNBC’s Policy Statements. 271

XIII. FNBC Had No Schedule M Adjustments . 271

XTV. Nature and Amount of the Proposed Disallowances. 272

XV. Petitioner’s Facts Set Forth in Its Petition . 272

XVI. Pretrial Order of August 14, 2000 . 273

XVII. Expert Testimony . 274

A. Identity and Qualifications. 274

1. Experts Retained by Petitioner . 274

2. Experts Retained by Respondent . 275

3. Experts Appointed by the Court . 276

B. Procedure Used by the Court To Appoint Our Experts . 276

OPINION. 278

I. Overview . 278

II. Does Section 475 Involve a Method of Accounting? o oo (N

A. Overview . o oo (N

B. Identification of a Method of Accounting . cq oo (M

285 III. Burden of Proof .

IV. Tax Accounting for Methods of Accounting. 287

V. FNBC’s Mark-to-Market Book Method . 291

A. Mark-to-Market Method Acceptable for Section 475 . 291

1. Acceptable in Theory. 291

2. Acceptable in Practice . 293

a. Market Valuation of Inventories . 293

b. Comprehensive Mark-to-Market Accounting. 294

B. Standard of the Mark-to-Market Method Is Not Reasonableness . 297

VI. Application of Fair Market Value . 302

A. Overview . 302

B. History of the Term “Fair Market Value” . 304

C. Determination of Fair Market Value. 306

1. Market Approach. 307

2. Income Approach . 307

3. Asset-Based Approach. 307

D.Fair Market Value Compared With Fair Value . 307

1. Meaning of the Term “Fair Value” . 307

a. GAAP Purposes. 307

b. State Law Purposes. 308

2. Difference Between Fair Market Value and Fair Value . 308

3. Conclusion. 310

VII. Property To Be Valued . 310

VIII. Applicable Valuation Date . 312

IX. Proper Hypothetical Market. 313

X. FNBC Implemented Its Mark-to-Market Method Inconsistently With Section 475 . 316

A. Overview . 316

B. Midmarket Values. 316

C. Adjustments in General. 317

D. Credit Adjustment . 318

1. Need for a Credit Adjustment . 318

2. One-Month Lag in Recording Swaps . 320

3. Credit Ratings of Both Counterparties. 320

4. Midmarket Values Reflected AA Counterparties . 323

5. Credit Enhancements . 323

6. Netting . 324

7. Static or Dynamic Procedure. 324

8. Confidence Levels . 326

9. Mirror and Partially Offsetting Swaps. 326

10. Per-Swap Adjustments . 326

E. Administrative Costs . 327

1. Overview . 327

2. Incremental Costs . 327

3. Use of Own Costs . 328

F. Other . 328

XI. Respondent’s Method of Accounting . 329

XII. Conclusion . 330

XIII. Postscript — Weight Given to Expert Testimony . 331

A. Role of the Experts. 331

B. Court’s Impression of the Experts . 332

Appendix A. 334

Appendix B . 337

Laeo, Judge: These cases were consolidated for purposes of trial, briefing, and opinion. In docket No. 5759-95, First Chicago Corp. (fcc) and its affiliated corporations, one of which was a corporation formerly known as the First National Bank of Chicago (FNBC), petitioned the Court to redetermine respondent’s determination of deficiencies of $1,661,112 and $2,956,794 in the affiliated group’s consolidated Federal income taxes for 1990 and 1991, respectively. In docket No. 5956-97, First Chicago nbd Corp., the successor in interest to FCC and affiliated corporations, petitioned the Court to redetermine respondent’s determination of a $95,156,499 deficiency in the 1993 consolidated Federal income tax of FCC and its affiliated corporations. The latter petition placed in issue a nonnotice year, 1992, by alleging entitlement for that year to adjustments which would affect the notice year 1993.

As relevant herein, the deficiencies stem from FNBC’s claim to “swap fee carve-outs” of $5,468,418 for 1990, $3,543,182 for 1991, $4,294,471 for 1992, and $5,799,724 for 1993. 1 As to swaps (defined infra p. 185) for which it was a party, FNBC valued these swaps at the mid-market values which it computed on its version of a computerized system known as the Devon Derivatives System (Devon system) (as discussed infra, FNBC’s midmarket valuation using the Devon system was based on the midpoint between a swap’s market bid and ask rates, or, in other words, the average of those rates). FNBC’s swap fee carveout as to each of those swaps represented the difference, determined at or about the time of each swap’s initiation, between the swap’s midmarket value and the bid or ask price which it paid or received for the swap. FNBC treated the carved-out amounts as deferred income designed to compensate it for (1) the perceived credit risks of its counterparties (credit adjustments) and (2) the estimated administrative costs which it expected to incur in holding and managing the swaps until maturity (administrative costs adjustments). Respondent determined that the method by which FNBC claimed the carveouts was improper in that the method did not clearly reflect FNBC’s swaps income in accordance with section 446 2 and section 1.446-3, Income Tax Regs. Respondent determined that FNBC was required to report its swaps income by using a method that reported each swap’s midmarket value without any adjustment.

We hold that neither FNBC’s method of accounting as to its swaps income nor respondent’s method of accounting as to that income clearly reflected FNBC’s swaps income. We direct the parties to file with the Court a computation (or computations) under Rule 155 that reflects (or reflect) FNBC’s swaps income in a manner consistent with this Opinion.

FINDINGS OF FACT

I. Background

A. Stipulations of Fact

Many facts were stipulated. We incorporate herein by this reference the parties’ stipulations of fact and the exhibits submitted therewith. We find the stipulated facts accordingly.

B. Briefs on CD-ROM With Appropriate Hyperlinks

The trial of these cases began on October 30, 2000, and (with recesses) concluded on November 28, 2001. The record, which includes a trial transcript of approximately 3,500 pages memorializing the testimony of 21 fact witnesses and 7 expert witnesses, consists of 43 “red” files and more than 10,000 pages of exhibits. For briefing purposes, the Court ordered the parties to file written briefs conforming to Rule 151 with copies on CD-ROM that included Hyperlinks to the relevant part or parts of the exhibits, testimony, pleadings, or stipulations relied upon for each proposed finding of fact. The written briefs, inclusive of their proposed findings of fact and objections to the other party’s proposed findings of fact, totaled more than 3,300 pages. The copies of the briefs on CD-ROM were very helpful to the Court.

C. Relevant Taxpayers

1 .FCC

FCC was a Delaware corporation and registered bank holding company. By virtue of its status as a bank holding company, FCC was regulated during the relevant years by the U.S. Federal Reserve Board (frb). At all relevant times, including at the time of the filing of its petition to this Court, Fee’s principal place of business was in Chicago, Illinois.

For Federal income tax purposes, FCC was an accrual method taxpayer that joined with its affiliates in the filing of consolidated Federal income tax returns. FCC filed those returns timely and on the basis of the calendar year.

2. First Chicago NBD Corp.

First Chicago NBD Corp. was a Delaware corporation and registered bank holding company. First Chicago NBD Corp. was the corporation resulting from the merger, effective December 1, 1995, of FCC with and into NBD Bancorp, Inc., a Delaware corporation and registered bank holding company. At all relevant times, including at the time of the filing of its petition to this Court, the principal place of business of First Chicago NBD Corp. was in Chicago, Illinois.

3. FNBC

FNBC was a national bank organized and existing as a national banking association under the National Bank Act, current version at 12 U.S.C. secs. 21-216 (2000). By virtue of its status as a national bank, FNBC was regulated by the Office of the Comptroller of the Currency (OCC).

During the relevant years, FNBC was Fee’s primary subsidiary. For Federal income tax purposes, FNBC was an accrual method taxpayer, and it joined in the consolidated Federal income tax returns filed by FCC.

4. Bank One Corp.

Bank One Corp. is a multibank holding company registered under the Bank Holding Company Act of 1956, ch. 240, 70 Stat. 133 , currently codified at 12 U.S.C. secs. 1841-1850 (2000). It was incorporated in Delaware on April 9, 1998, to effect the merger of First Chicago NBD Corp. and Banc One Corp., an Ohio corporation and registered bank holding company. The merger was effective October 2, 1998. 3 By virtue of its status as a bank holding company, Bank One Corp. was regulated during the relevant years by the frb. Bank One Corp.’s principal office was in Chicago, Illinois, at all relevant times.

II. The Swaps Business

A. Swaps in General

1. Definition of a Swap

A swap is a bilateral agreement obligating the parties (often referred to as counterparties) to exchange at specified intervals (e.g., monthly, quarterly, semiannually) cashflows ascertained from applying specified financial prices (e.g., interest rates, currency rates) to a specified underlying amount. The specified underlying amount is either a notional principal amount which is not exchanged (as usually occurs when the subject matter of the swap is interest rates) or an amount which may actually be exchanged (as usually occurs when the subject matter of the swap is currency rates). The exchange of cashflows at the periodic intervals is sometimes referred to as “periodic payments” and is usually done on a net settlement basis. Each party to a swap bears the risk that its counterparty will default on its obligation to make a periodic payment, and, thus, that it (the party) will not receive a periodic payment owed to it by the counterparty.

2. Swaps Are Derivative Financial Products

Swaps are derivative financial products (financial derivatives). A financial derivative is a bilateral agreement the value of which is derived (as implied by its name) from the performance of an underlying asset, reference rate, or index.

Other common forms of financial derivatives during the relevant years included: (1) Interest rate guarantees such as caps, floors, and collars; (2) interest rate options; (3) swaptions; and (4) forward rate agreements (FRAs). 4 Interest rate caps, floors, and collars are contracts with notional principal amounts but not necessarily with periodic payments. Interest rate caps and floors require the seller, in exchange for a fee, to make a payment to the purchaser only if, in the case of a cap, a specified market interest rate exceeds the fixed cap rate on specified future dates or, in the case of a floor, the specified market interest rate falls below the fixed floor rate on specified future dates. 5 Interest rate options are contracts that grant one party, for a premium payment, the right to either purchase from or sell to the other party a financial instrument at a specified price within a specified period of time or on a specified date. Swaptions are options to purchase a swap in the future. FRAs are contracts with notional principal amounts that settle in cash at a specified future date on the basis of the difference between a fixed interest rate and a specified market interest rate. 6 FRAs are different from swaps in that FRAs lack periodic payments.

3. Types of Swaps in the Marketplace

Swaps in the marketplace during the relevant years consisted primarily of interest rate swaps (sometimes, IRSWs), currency swaps (sometimes, CYSWs), and commodity swaps (sometimes, COMs). 7 An interest rate swap, the primary swap at issue, is a bilateral agreement calling for the periodic exchange of interest payments ascertained by applying specified interest rates to an agreed-upon notional principal amount. A currency swap is a bilateral agreement to exchange payments denominated in different currencies. A commodity swap is a bilateral agreement to exchange cashflows ascertained by applying commodity prices to a notional quantity of a particular commodity.

B. Origin and Growth of the Swaps Market

1. Origin of the Market

The origin of the swaps market is generally traced to a currency swap negotiated between the World Bank and IBM in 1981. That transaction involved an exchange of payments in Swiss francs for payments in deutschmarks. The first interest rate swap was negotiated with the Student Loan Marketing Association in 1982. The first commodity swap occurred in 1986.

2. Growth of the Interest Rate Swaps Market

Interest rate swaps were the most common swaps during the relevant years. In 1992, dealers generally participated in four to five interest rate swaps daily and one currency swap every 2 days. The corresponding figures for 1987 were three interest rate swaps every 2 days and one currency swap every 4 days. A dealer’s use of commodity swaps during 1987 and 1992 also was less common than the dealer’s use of interest rate swaps during the same years.

The outstanding notional amount of interest rate swaps worldwide totaled approximately $683 billion, $12.8 trillion, and $43 trillion at the end of 1987, 1995, and 1999, respectively. 8 The growth of the outstanding notional amount of interest rate swaps is attributable primarily to the use of interest rate swaps as an effective, inexpensive way in which to manage financial risks from interest rate fluctuations. Those who use financial derivatives in general can identify, isolate, and manage separately the fundamental risks and other characteristics which are bound together in traditional financial instruments. In addition to increasing the range of financial products available, financial derivatives have fostered more precise ways of understanding, quantifying, and managing financial risk. Most institutional borrowers and investors currently use financial derivatives. Many of these entities also act as intermediaries dealing in those financial products.

C. Interest Rate Swaps

1. Terms of an Interest Rate Swap Agreement

Interest rate swaps generally require that the parties thereto negotiate and agree upon several economic terms. These terms generally include (1) a notional amount, (2) a fixed interest rate, (3) a floating interest rate index, (4) a duration (term or tenor) of the contract, (5) an effective date of the contract, and (6) a payment schedule. The parties to an interest rate swap also must negotiate a particular country’s currency (or countries’ currencies) in which a swap is denominated. During the relevant years, the U.S. dollar was overwhelmingly the dominant individual currency for interest rate swaps.

2. Notional Principal Amount and Related Terms

The notional principal amount of an interest rate swap is not actually exchanged but is simply the reference point for the parties’ obligations. 9 The parties to an interest rate swap agree to exchange for a set length of time (term or tenor) and as of specified intervals (payment schedule) streams of interest payments ascertained on the basis of a notional principal amount. At least one of these streams of payments is ascertained on the basis of a floating-rate index. The respective streams of payments are often referred to as “legs”; e.g., a fixed leg and a floating leg.

The party that is paying the fixed rate (i.e., receiving the floating rate) is said to have bought the swap. 10 The party receiving the fixed rate (i.e., paying the floating rate) is said to have sold the swap. The party that is receiving the fixed rate also is said to be “short” the swap, while the party paying the fixed rate is said to be “long” the swap. 11

The trade date is the date on which the swap transaction is agreed. The effective date is the date on which the interest included in the payments begins to accrue. Once interest has begun to accrue, it continues to accrue until the day before the termination date. The termination date is the date on which the last payment is due. The termination date sets the maturity of the contract.

3. Different Types of Interest Rates

Swaps generally involve two types of interest rates. The first rate, a fixed interest rate, is applied for each payment date to ascertain the agreed-upon payment in the fixed leg. By definition, the fixed interest rate is fixed in that it is constant. The second rate, a floating interest rate, is applied for each payment to ascertain the agreed-upon payment in the floating leg. By definition, the floating interest rate floats in accordance with an agreed-upon index and usually changes with time.

The date on which the floating interest rate is changed (i.e., is “reset”) is known as the reset date. Except in the case of the first payment, the floating interest rate applicable to each payment period is generally set at the beginning of the interval, on the basis of the interest rate in effect 2 business days before the most recent reset date. The floating interest rate applicable to the first payment is generally set on the trade date, 2 days before the effective date.

4. Use of LIBOR as a Floating Interest Rate Index

The most common floating interest rate index for interest rate swaps is the London Interbank Offering Rate (LIBOR), the rate of interest at which banks are willing to offer deposits (i.e., lend Eurodollars) to other prime banks, in marketable size, in the London Interbank market. In order to determine the LIBOR rates, the British Bankers’ Association maintains a reference panel of banks with London offices. Each of these banks ascertains the rate at which it could borrow funds, were it to do so by asking for and then accepting interbank offers in reasonable market size just before 11 a.m. that day. The deposits have a zero-coupon structure, meaning that no interest is paid during the life of the deposits but is accrued and paid at maturity. 12 Each LIBOR rate is computed by disregarding the four highest and the four lowest rates offered by these banks and then taking the average of the others.

The LIBOR rates, when determined, are instantly communicated around the world by electronic (on-line) services such as the Associated Press/Dow Jones Telerate Service, Bloomberg, or Reuters Monitor Money Rates Service. Separate LIBOR rates are available and quoted for each standard term (e.g., 1-month, 3-month, 6-month, 12-month), and the parties to a swap may agree on any of these LIBOR rates. In most cases, the floating-rate payor pays no increment or decrement (spread) with respect to the LIBOR rate, and the rate is said to be quoted flat.

In lieu of a LIBOR rate, the parties to an interest rate swap may agree to use a less common floating interest rate index. Other common floating interest rate indices during the relevant years included the T-bill rate (the rate on the most recent issue of U.S. Treasury bills), the commercial paper rate, the bankers acceptance rate, the prime rate, and the tax-exempt rate.

5. Plain Vanilla Interest Rate Swaps

Interest rate swaps may be of the plain vanilla type. A plain vanilla interest rate swap, the simplest and most common type of interest rate swap, is a swap with standard terms and without another financial derivative as part of the agreement. One party to a plain vanilla interest rate swap (first party) agrees to pay to the other party (second party) amounts equal to a fixed rate of interest multiplied by a set notional amount. The second party agrees to pay to the first party amounts equal to a floating rate of interest multiplied by the same notional amount. The fixed and floating amounts are offset against each other as of each payment date, and the party paying the higher rate of interest remits a payment to the counterparty equal to the notional amount multiplied by the difference between the interest rates. An analogy of a plain vanilla interest rate swap is the exchange of a fixed-rate loan for a floating-rate loan. The schedule of payments on a plain vanilla interest rate swap exactly matches the schedule of net payments on an exchange of the fixed- and floating-rate loans.

In contrast to a plain vanilla interest rate swap, a more creative interest rate swap may have nonstandard terms. 13 A combination deal (sometimes, comb) has embedded option features such as a callable or extendable swap or a contract giving one of the parties the option, but not the obligation, to enter into an interest rate or currency swap at prearranged terms. An amortizing or accreting swap has a notional amount that decreases or increases, respectively, during the life of the transaction. 14 A basis swap has two floating legs, instead of a fixed leg and a floating leg, with each party agreeing to exchange payments determined by a different floating-rate index (e.g., one party floats with LIBOR while the other party floats with the commercial paper rate). In some swaps, the payment dates for the counterparties do not coincide, whereas in other swaps the counterparties’ payments are in different currencies. There also are swaps with different fixed rates during different periods.

6. Lack of Payments at Inception

For most interest rate swaps during the relevant years, neither counterparty made a payment at the inception of the swap to effect the transaction. The entire consideration for a party’s promise to make future payments to the counterparty lay in the counterparty’s promise to make its agreed-upon future payments. An initial payment was not generally required to induce the counterparties to enter into the swap agreement.

One exception to the nonpayment rule was off-market swaps which required upfront payments. In an off-market swap, a counterparty agreed to receive or pay an interest rate that was significantly different than the going market rate.

7. Example of an Interest Rate Swap

To illustrate the mechanics of an interest rate swap, assume that a plain vanilla interest rate swap originated on November 29, 1992, the trade date, with the following terms:

Notional principal. $1 million

Fixed rate. 5% per annum

Floating rate . 6-month LIBOR rate

Effective date . Dec. 1, 1992

Termination date. Dec. 1, 1995

Payment dates . June 1 and Dec. 1 of each year

Fixed-rate payor . F

Floating-rate payor. L

Day count conventions 1 Actual/360

1The computations as to swaps are generally based on a 360-day year, a convention that is common in banking.

The table below shows the payments on the swap for a hypothetical scenario of the 6-month LIBOR rate over the life of the swap. In this example, F has promised to pay to L a semiannual interest payment calculated on the basis of a notional principal of $1 million and a fixed 5-percent interest rate as adjusted by a ratio the numerator of which equals the number of days in the payment period and the denominator of which equals 360. L has promised to pay to F a semiannual interest payment calculated on the basis of the same $1 million amount but using, instead of the fixed rate, a floating 6-month LIBOR rate as adjusted by the same ratio. The sixth column, the net of the fixed and floating payments, is the only amount that is actually paid by one party or the other.

Payment dates No. of days in period Fixed payment Hypothetical 6-month LIBOR rate Floating payment Net cashflow to L (to F)

6/1/1993 182 $25,278 4.0% $20,222 ($5,056)

12/1/1993 183 25,417 4.320 21,960 (3,457)

6/1/1994 182 25,278 5.130 25,935 657

12/1/1994 183 25,417 5.901 29,997 4,580

6/1/1995 182 25,278 6.210 31,395 6,117

12/1/1995 183 25,417 6.842 34,780 9,363

D. Currency Swaps

A plain vanilla currency swap involves the exchange of a series of fixed-rate interest payments denominated in a foreign currency for a series of floating-rate interest payments denominated in U.S. dollars. Other currency swaps include exchanging a fixed rate in a foreign currency for a fixed rate in U.S. dollars, exchanging a fixed rate in U.S. dollars for a floating rate in a foreign currency, or exchanging a floating rate in a foreign currency for a floating rate in U.S. dollars.

E. Participants in the Market

The main participants in the interest rate swaps market are end users, dealers, and brokers.

1. End Users

a. Typical End Users

End users are typically major corporations, government or governmental-related entities, investment funds, or other financial institutions. These end users typically use interest rate swaps to combat interest rate movements, express market preferences through position taking, and/or reduce their cost of funding. As to the size of an end user, swaps end-user entities entering into swaps in connection with the conduct of their business must have assets over $10 million or a net worth over $1 million in order to qualify their swaps for a safe-harbor exception from most of the regulatory requirements of the Commodity Futures Trading Commission (CFTC). 15

b. End Users’ Uses of Interest Rate Swaps

i. Combat Interest Rate Changes

End users commonly use interest rate swaps to hedge (minimize) their risk of adverse changes, in interest rates. Interest rate risk is the potential fluctuation in the value of a financial instrument due to a change in the level of interest rates. Whereas the market values of fixed-rate loans are exposed to significant interest rate risk, the market values of floating-rate loans are not. A fall (or rise) in interest rates causes the market value of a fixed-rate loan to increase (or decrease). The fall (or rise) in interest rates leaves the market value of a floating-rate loan unchanged; the interest payments on the floating-rate loan fall (or rise) together with interest rates.

Managing interest rate risk is an important function of financial managers in entities such as corporations and financial institutions, and an interest rate swap is a tool with which financial managers may readily change their exposure to interest rate fluctuations. Through a swap, an institution may change the nature of its liabilities from fixed-rate liabilities to floating-rate liabilities, or vice versa. A company liable on debt paying a floating interest rate, for example, may guard against a rise in interest rates by entering into a swap under which it pays a fixed rate of interest and receives a floating rate. The swap transfers to the counterparty the risk of a rise in interest rates. 16 Likewise, a financial manager may need to increase or decrease the interest rate exposure of an entity’s liabilities. The financial manager of a corporation, for example, that has assets which are positively exposed to interest rate risk (i.e., the value of the assets increases with interest rates) may seek to match this exposure with liabilities that are positively exposed to interest rate risk so as to create zero exposure in the corporation’s net position.

ii. Prosper From Market Forecast

End users also use interest rate swaps to attempt to prosper from their forecast of the movement in interest rates. For example, a company that believes that interest rates will fall may enter into an agreement under which it pays a floating interest rate. In 1992 and 1993, for example, when interest rates were at extremely low levels, many companies elected to issue long-term debt at fixed rates and then enter into shorter-term swap agreements under which the company paid a floating rate. The company, in effect, converted the early years of its financing from a fixed rate to a floating rate.

iii. Reduce Cost of Funding

End users also use interest rate swaps to reduce the transaction costs which are a natural consequence of raising funds. If, for example, a corporation wants to borrow at a fixed rate but has a shelf registration for commercial paper paying a floating interest rate, the corporation may be able to minimize its transaction costs by issuing commercial paper with a floating rate and then swapping the commercial paper for an obligation with a fixed rate.

2. Dealers

a. Typical Dealers

Since at least 1992, the swaps market has been almost entirely intermediated by institutions acting as dealers. Swaps dealers are generally major financial institutions (e.g., securities firms and banks such as FNBC) which hold themselves out as market-makers; i.e., entities ready and willing to take either side of a swap transaction for the purpose of earning a profit by originating new swaps. 17 On some occasions, these institutions enter into swaps in their capacity as swaps dealers. On other occasions, these institutions enter into swaps in their capacity as end users to manage the overall structure of their portfolios to minimize the net exposure to interest rate movements. Swaps dealers trade with both end users and other dealers.

b. Practice as to Swaps

Swaps dealers maintain a portfolio of swaps on their books and usually attempt to maintain a neutral, hedged position in the market. Swaps dealers attempt to maintain a neutral, hedged position either by: (1) Serving as a counterparty to opposite sides of two matching swaps or (2) managing the overall structure of the portfolio so as to minimize the net exposure to interest rate movements.

c. Price Quotations

Prices in the interest rate swaps market, are quoted in the form of interest rates, and major swaps dealers (e.g., FNBC) regularly quote the bid and ask prices at which they stand ready to buy and sell plain vanilla interest rate swaps with standard maturities of 1, 2, 3, 5, 7, and 10 years. The bid price is the fixed interest rate that the dealer is ready to pay in exchange for a specified floating rate. The ask price is the fixed interest rate that the dealer demands to receive in exchange for paying a specified floating rate. The ask rate is greater than the bid rate, and the dealer’s profit when taking the opposite sides on two identical swaps is the difference between the fixed rate it receives and the fixed rate it pays.

Among dealers, it is common to refer to the spread reflected in the pricing of a swap, and the convention is to quote the fixed rate on the assumption that the floating rate is LIBOR flat (i.e., with no spread or premium attached to the floating rate). A swap, however, may be negotiated with the floating payment tied to an index plus or minus a spread; i.e., a margin.

d. Role in the Market

When the swaps market first began, every swap generally was facilitated by a dealer. The dealer was not a party to the transaction but, generally for a fee, arranged the swap by introducing the counterparties to each other and helping them to effect the mechanics of the transaction. With the evolution of the market, dealers became parties to each swap. In the early years of the market’s evolution, a dealer would effect a swap transaction by warehousing the swap (i.e., entering into the swap without having entered into a matching swap but with the expectation of hedging the entered-into swap either through a matching swap or a portfolio of swaps or temporarily in the cash, securities, or futures market) until the dealer could arrange an offsetting swap with another counterparty (i.e., match a book). In the later years of the market’s evolution, the dealer would simply accept a position opposite the counterparty without expecting to locate another counterparty transaction to match the first transaction.

e. Need for Strong Credit

With the evolution of the interest rate swaps market, intermediaries could during the relevant years do far more deals if they were willing to offer themselves as counterparties. Major commercial banks, as compared to investment banks, were more highly capitalized and were more willing to assume the credit risks inherent in acting as a counterparty. The importance of credit risk was a factor during the relevant years in the dominance of commercial banks as dealers; e.g., 16 of the world’s 20 largest swaps dealers in 1993 were commercial banks. A dealer with a weak credit rating in the swaps market was hurt in its ability to enter into swaps.

3. Brokers

Swap brokers do not take a position or act as a principal in a swap transaction, and they do not maintain any exposure with respect to a swap. Swap brokers simply arrange for dealers to enter into interdealer swaps by matching dealers who want to effect a particular swap with other dealers who want to effect a similar swap. The clientele of a swap broker is limited to dealers; e.g., an end user may not use the services of a broker unless the end user is a recognized dealer in the interbank market. A swap broker is paid a standard fee for its services based on a percentage of the notional principal amount.

F. Market for Swaps

1. Types of Markets

a. Primary Market

Interest rate swaps are transacted in the over-the-counter (OTC) market. That market is highly competitive and includes many active dealers. Throughout the relevant years, the primary market for plain vanilla U.S. dollar interest rate swaps between counterparties of relatively good credit quality was liquid and as active, deep, and competitive as almost any other market. The fact that there was an active primary market in benchmark swaps made it possible for potential counterparties to shop around quickly for competitive terms for an interest rate swap and agree on the swap’s value. The appropriate range of terms for a large interest rate swap between high-quality counterparties was at least as transparent and easily determined at a moment’s notice as was the appropriate price for a comparatively large position in the most liquid equities traded on major U.S. stock exchanges.

b. Secondary Market

No active secondary market exists for swaps, other than in the case of buyouts (which occur by number of swap transactions approximately 10 percent of the time in the interbank market) and to a much lesser extent, assignments. Because of contractual restrictions, 18 nonstandardized terms, the requirement of bearing the credit risk of a specific counterparty, and the ability to buy out a swap at the going market rate, a liquid secondary market for the assignment of swaps has never developed. When swaps were sold before maturity, e.g., when a portfolio of swaps was sold by one dealer to another, the terms were not publicly available.

2. Brokers’ Dissemination of the Dealers’ Quotations

a. Daily Quotations

During the course of each business day, swap brokers would contact a large number of swaps dealers (including FNBC) and request their bid and ask quotes on several plain vanilla swaps. These swaps were commonly quoted on the convention of semiannual payments and on the basis of the 6-month LIBOR floating rate and had standard maturities of 1, 2, 3, 5, 7, and 10 years. These quotations (as well as the midmarket swap curve (discussed infra p. 202) assumed that the counterparty was a dealer with a credit rating of AA. 19 No service reported regular and reliable quotes on swaps negotiated with lower rated counterparties.

Upon receiving these quotations from the dealers, the brokers disseminated publicly the best interdealer price quotations by way of electronic broker quotation services such as Bloomberg, Reuters Monitor Money Rates Service, or Associated Press/Dow Jones Telerate Service. These services, to which swaps dealers had access on their “dealer screens”, normally made it unnecessary for a dealer to shop around when the dealer wished to enter into a swap transaction because the dealer knew that the quoted rate was a competitive price. If a dealer wanted to enter into a specific swap, the dealer could contact a broker, and the broker would call one or more dealers and confirm their quotes on the specified swap. The broker then reported back to the first dealer (the one wanting to enter into the particular swap) on the best quote that the broker had obtained. If that dealer ultimately entered into a swap agreement with another dealer supplied by the broker, the broker received a fee for its services based on a percentage of the notional amount.

b. No Dissemination of Actual Swap Prices

The actual prices at which swaps closed during the relevant years were not publicly disclosed. The only publicly available data on swap prices during those years was the quoted bid and ask rates in the interdealer market as to plain vanilla swaps. Those quotations were normally the best indicator of the market price at a particular moment.

c. Spreads Included in Quotations

Swap bid and ask rates in U.S. dollar denominated swaps with maturities exceeding 1 year were commonly quoted in terms of a spread to the corresponding U.S. Treasury yield. The table below lists the U.S. Treasury yield, the bid spreads quoted in the market, and the resulting bid rates as reported by Bloomberg for December 31, 1992, for U.S. dollar denominated swaps with maturities exceeding 1 year.

U.S. Treasury Bid Swap bid Maturity yield spread rate

4.81% 4.57% N <N

5.43 3-year 5.06 I> CO

6.30 5-year 6.00 O CO

6.70 7-year 6.37 CO CO

7.01 10-year 6.69 (M CO

Swap rates reported for U.S. dollar denominated swaps with maturities of 1 year or less were usually taken directly from the libor deposit market. The table below lists the LIBOR deposit rates in the LIBOR deposit market as reported by Bloomberg for December 31, 1992, for U.S. dollar denominated swaps with maturities of 1 year or less.

Maturity LIBOR deposit rate

l-day. 3.125%

1-month ... 3.313

3-month ... 3.438

6-month ... 3.625

9-month ... 3.813

1-year . 4.062

The libor deposit rates for U.S. dollar denominated swaps with maturities of 1 year or less were combined with the swap bid rates for U.S. dollar denominated swaps with maturities exceeding 1 year to obtain a set of bid rates for short and long maturities. The complete set of bid rates for short and long maturities was plotted out on a graph to form the swap bid curve. Swap rates for nonstandard maturities were calculated by interpolating between the rates on the nearby standard maturity contracts. The table below illustrates a combination of the swap bid rates and the LIBOR deposit rates just discussed.

Maturity Swap bid rate LIBOR deposit rate Swap bid curve

1-day 3.125% 3.125%

1-month 3.313 3.313

3-month 3.438 3.438

6-month 3.625 3.625

9-month 3.813 3.813

1-year 4.062 4.062

2-year 4.81% 4.810

3-year 5.43 5.430

5-year 6.30 6.300

7-year 6.70 6.700

10-year 7.01 7.010

The following diagram shows the swap bid curve drawn from these swap bid and LIBOR deposit rates.

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3. Midmarket Rate

The midpoint (average) of the bid and ask rates for a specified maturity is known as that maturity’s midmarket rate. The theoretical midmarket rate is the fixed interest rate for which the present value of the cashflows from the fixed leg of a swap equals the present value of the projected cashflows from the swap’s floating leg. In other words, if a swap was entered into at the midmarket rate, then the present value of the fixed-leg payments would equal the present value of the anticipated floating-leg payments. When any swap with a midmarket rate is valued also using the same midmarket rate, then the swap has a theoretical net present value of zero to both counterparties.

A plain vanilla swap with a fixed rate equal to the current midmarket rate has by definition a market value of zero and is called a “par swap”. It is also said to be “at-market” as opposed to “off-market”. If the fixed interest rate is above the current midmarket rate, the swap is said to be “above-market” and has positive value to the party that sold the swap and is receiving the fixed payments. If the fixed interest rate is below the current midmarket rate, the swap is said to be “below-market” and has negative value to the party that is receiving the fixed payments. A swap is a zero-sum contract, so if it has a positive market value to one counterparty, it has a negative market value to the other counterparty.

4. Midmarket Swap Curve

The set of mid-market rates for various maturities is known as the midmarket swap curve. The midmarket swap curve is drawn from the averages of the bid and ask prices for swaps of standard maturities quoted in the interdealer market. At-market swap rates for all possible maturity dates can be obtained by interpolation from the midpoints between the bid and ask prices of the standard maturities as derived from the dealer quotes and reported by major vendors of financial data.

The midmarket swap curve implies a curve of forward interest rates and a curve of discount factors. 20 One curve implies a second curve if the values on the second curve can be derived mathematically from the values on the first curve. The second curve is said to be implied by the first curve, and, in the case of interest rates or discount factors, the interest rates or discount factors on the second curve are said to be implied interest rates or implied discount factors with respect to the first curve. Consider, for example, a curve of periodic interest rates and a corresponding curve of effective annual yields. Each of these curves is implied by the other. Each point on either curve can be derived by a mathematical formula from the corresponding point on the other curve. This implied concept is different from interpolation. Interpolation is a process by which the gaps between separated points are estimated and filled in to produce a complete curve.

The midmarket value of a swap is calculated using a mathematical model that extracts the market’s forecasts for future interest rates (implied forward interest rates) from the current midmarket swap curve to determine the floating-rate payments that will be due or payable under the swap agreement. 21 The implied forward interest rates are used to project the floating-rate payments into the future. The implied discount factors are used to discount the fixed-rate payments and the projected floating-rate payments to their present value.

5. ISDA Form Agreements

The International Swaps and Derivatives Association, Inc. (ISDA), formerly known as the International Swaps Dealers Association, Inc., is a trade body that comprises swaps dealers and other participants in the OTC derivatives market. The ISDA prescribed customized ISDA form agreements for swap transactions, and these form agreements were in widespread use during the relevant years. The ISDA form agreements generally provided a statement of the general conditions governing all swap contracts between counterparties to the agreements. Customized individual payment terms could be negotiated by the parties to a particular swap, and those terms would be memorialized in the form of a confirmation letter. During the relevant years, many dealers, including FNBC, required that each of their swaps have a confirmation.

The ISDA had two form agreements (collectively, ISDA form agreements); namely, the 1987 ISDA interest rate swap agreement and the 1992 ISDA master agreement (1992 ISDA form agreement). The ISDA form agreements contained a number of standard terms but also allowed the parties a great deal of flexibility in structuring specific transactions. The ISDA form agreements were relied upon in the industry as uniform and accepted contracts with easily understood terms.

Under the ISDA form agreements, a party thereto had the unilateral right to terminate a swap agreement before maturity only in the case of default. The ISDA form agreements also allowed a swap contract to be terminated before maturity in the case of certain events generally not within the control of either party; e.g., if a law was enacted that made it illegal for one or both parties to the contract to perform under the contract. A swap could also be terminated if it contained a credit trigger calling for early termination upon a credit downgrade or other credit event. The 1992 ISDA form agreement also provided that the parties to a swap governed by that agreement could specify any other event as a termination event in the schedule or confirmation. 22

The ISDA form agreements generally prohibited each party thereto from selling or transferring its swap position to a third party without the consent of the counterparty. The swap contract, however, could be transferred to another in the case of an amalgamation, consolidation, merger, or transfer of assets. A nondefaulting party also could transfer any payment owed to it by a defaulting party. The ISDA form agreements also permitted one counterparty to transfer its swap agreement to one of its branches or to an affiliate in order to avoid a termination event. In that case, the other counterparty could not withhold its consent to the transfer if its existing policies would permit it to enter into transactions with the transferee on the terms proposed.

The ISDA form agreements provided that where there was an early termination due to the default of one party, the payment would be ascertained by reference to quotations from leading dealers for the replacement costs of the relevant terminated transactions. Neither of the ISDA form agreements provided specifically for the addition of a surcharge, or discount, for administrative costs adjustments when computing the amount paid on early termination due to the default of one party.

6. Assignments and Buyouts of Swaps

A party to a swap agreement seldom assigned its interest in the swap. In the rare case of an assignment, a third party was substituted for one of the two original counterparties. The third party usually made or received an upfront payment approximately equal to the market value of the swap. In these cases, the market value of the swap generally equaled the difference in the present value of the anticipated net cashflow from each of the swap’s legs.

If a swap counterparty wanted to withdraw from a transaction, it usually terminated the transaction through a buyout. In a buyout, one counterparty terminated the swap by paying the other counterparty a lump-sum amount approximately equal to the swap’s market value. In these cases, the market value of the swap generally equaled the difference in the present value of the anticipated net cashflow from each of the swap’s legs.

Buyouts of swaps were frequent during the relevant years, and they occurred in the case of both interdealer and end-user swaps. The reasons for buyouts were generally that one of the counterparties had a business need to terminate the transaction or was in distress. Swaps were bought out (and initially entered into) on a swap-by-swap (rather than portfolio) basis.

G. Risks Assumed by Dealers

1. Types of Risks

Dealers entering into interest rate swaps assumed at least two types of risk; namely, a credit risk and a market risk. Credit risk was the risk of loss from the possibility that the counterparty would not perform and would default on its payment obligations. Market risk was the risk that changes in the market would affect the value of an instrument. The most common form of market risk was interest rate risk.

2. Techniques Used To Minimize Credit Risk

During the relevant years, the practice of rationing credit risk exposure to specific counterparties through credit enhancements was widespread and was an important part of credit risk management. In addition to placing limitations on the tenor and principal amount of a swap, swaps dealers such as FNBC required counterparties with lower credit quality to post collateral to support the counterparties’ obligations under the contracts. Dealers such as FNBC (and end users) also sometimes inserted provisions in the underlying contracts requiring maintenance of a specified debt-equity ratio, a net worth requirement, or a certain credit rating which, unless met, would trigger an early termination of the contract or the posting of collateral in support of the counterparty’s obligations under the contract. Dealers during the relevant years generally did not adjust interest rates to account for credit risk, nor did they quote different bid and ask rates on the basis of credit rating.

3. Techniques Used To Minimize Market Risk

The market risk of interest rate swaps arose from the high level of volatility in the value of interest rate swaps. A small movement in interest rates, for example, could have a large impact on the value of an interest rate swap. Swaps dealers attempted to reduce or eliminate market risk by hedging their portfolios so that a portfolio’s value would not change significantly with either a rise or fall in interest rates.

In the early days of the swaps market, dealers employed simple hedging strategies. Transactions designed to meet a customer’s requirements were immediately hedged by entering into an offsetting transaction, such as a matched swap. In the later years, many dealers (including FNBC) adopted more sophisticated portfolio strategies for hedging market risks. Under this approach, all of the dealer’s transactions were broken down into their component cashflows to yield a measure of the net (residual) market exposures arising from all of the dealer’s positions. The residual market exposures were then hedged in various ways such as by taking positions in the cash market (e.g., holding or selling short U.S. Treasury securities), by using interest-rate futures (which are traded on public exchanges), or by entering into swaps.

H. Dealer Spreads

I. Bid-Ask Spread

The bid-ask spread is the difference between the bid and ask interest rates which are quoted on the interdealer market. The market bid is typically the highest among a set of dealers surveyed. The market ask is typically the lowest. The market bid and market ask need not come from the same dealer’s bid and ask quotations. A particular dealer’s quoted bid and ask rates .will often deviate from the market bid and ask rates so that the dealer’s mid rate is not necessarily the midmarket rate.

2. Bid-to-Mid Spread

The spread from midmarket (also known as the bid-to-mid spread) is the difference between the fixed interest rate that is quoted on the interbank market and the midmarket rate for a swap. The bid-to-mid spread equals one-half of the bid-ask spread.

3. Example

Assume that the market quotes a bid price of 6.5 percent (the fixed rate it is willing to pay) and an ask price of 6.54 percent (the fixed rate it is willing to receive). The bid-ask spread is four basis points, 23 and the midmarket rate is 6.52 percent. If the dealer’s bid price is accepted and the dealer enters into a swap under which it is paying a fixed interest rate of 6.5 percent, then the spread from midmarket is two basis points.

4. Significance of Spreads

The spread from midmarket that a dealer is able to obtain when it negotiates a swap provides it with the revenue necessary to cover its costs connected with the swap and, it hopes, generate a profit. When a dealer buys a swap, the dealer captures the difference between its bid on the transaction and the midxnarket rate. When a dealer sells a swap, the dealer captures the difference between its ask on the transaction and the midmarket rate.

In general, a dealer did not enter into a swap unless it expected to make a profit. As two exceptions to this rule, dealers entered into swaps without profit to develop a relationship with a particular customer or to hedge their portfolio.

Dealers typically charged smaller spreads to other dealer/ counterparties than to end users. A dealer that entered into an interdealer swap usually contemporaneously entered into a similar swap with an end user. The dealer typically earned a profit on the end-user swap by negotiating a bid or ask rate that was different than the rate that the dealer had negotiated on the interdealer swap.

5. Decline in Interdealer Spreads

For interdealer spreads as of December 20, 1993, the following table shows (in basis points) the bid, ask, and midmarket rates, and the bid-to-mid spreads for nine common swap maturities:

Maturity Bid Ask Midmarket Bid-to-mid spread

2-year 13.000 15.666 14.333 1.333

3-year 22.333 25.000 23.666 1.333

4-year 24.333 27.000 25.666 1.333

5-year 20.000 23.000 21.500 1.500

6-year 26.666 29.666 28.166 1.500

7-year 39.666 43.000 41.333 1.667

8-year 32.000 34.666 33.333 1.333

9-year 32.333 35.000 33.666 1.333

10-year 32.333 35.000 33.366 1.333

By 1993, the swap bid-ask spreads had narrowed from earlier years because in part of competition. Average bid-ask spreads for fixed-for-floating interest rate swaps with 2-, 5-, and 10-year tenors narrowed from 4 to 4.5 basis points in July 1991 to 2.5 to 3 basis points in July 1993.

III. Valuing Swaps

A. Relevant Valuation Standards

The three relevant valuation standards are fair market value, market value, and fair value.

1. Fair Market Value

The term “fair market value” is typically used in the economics and business/tax worlds. The term is generally understood in its simplest form to mean the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy and sell and both having reasonable knowledge of relevant facts.

2. Market Value

The term “market value” is a term of art in the swaps industry. This term is generally understood in its simplest form to mean the present value of the anticipated cashflows, calculated according to a series of generally accepted conventions for using market data and using midmarket swap rates. The market value of a swap is typically calculated the same way for all swaps, without regard for the credit rating of the counterparty and without incorporating an extra adjustment for credit risk or future administrative costs. 24

3. Fair Value

The term “fair value” is typically used in the accounting world and is directed to the needs of financial statement users. 25 The meaning of this term is similar to, but is not necessarily the same as that of, the term “fair market value”. “Fair value” is broader than and may include “fair market value”. The objectives of each of these two concepts also are distinct.

B. Mark-to-Market Accounting

Swaps dealers generally attempted during the relevant years to mark their swap positions to market daily. The concept of mark-to-market accounting requires that the market value of an asset such as a swap be recorded on the balance sheet at each financial reporting date and that any changes in market value from one reporting date to the next be currently reflected in income or loss.

C. Devon System and the Devon (Midmarket) Value

1. Devon System

FNBC and most other dealers used the Devon system in order to ascertain their valuations for their mark-to-market accounting systems. The Devon system was developed and marketed by an independent software company named Devon Systems International, Inc. 26 The Devon system was during the relevant years the most commonly used commercially provided integrated front and back office processing and risk management system for financial derivatives. One of the Devon system’s important functions was to take real time feeds of market rates and provide pricing of various securities and instruments.

2. Devon (Midmarket) Value

The Devon system calculated each swap’s mid-market value by reference to zero-coupon yield curves. The Devon system used the two following types of inputs to calculate the midmarket value of a swap: (1) Transaction information and (2) market information. The transaction information was generally the information set forth in the trade ticket and was typically provided in the confirmation letter. 27 The transaction information included the notional amount, the tenor, the fixed interest rate, the floating interest rate, the payment dates, and the payment formulas. The market information was data on the sets of interest rates prevailing in the financial markets on the valuation date.

The Devon system calculated a swap’s midmarket value in two steps. First, the system used the market data to calculate a set of discount factors and forward rates. Second, the system ascertained the present value of the net cashflows over the life of the swap. The forward rates were used to translate the uncertain future cashflows on the floating side of a swap into expected future cashflows. The discount factors were used to reduce the fixed and expected floating cashflows to their present values. Summing the present values of the various cashflows produced the swap’s total present value.

During the relevant years, midmarket values could be calculated under the Devon system with precision and agreement, and midmarket values were readily agreed upon for those swaps for which sufficient information was provided. The calculation of midmarket value was critically dependent on the assumptions made about future interest rates.

3. Yield Curve

a. Overview

The yield curve defined the yield (interest rate) available in the market for a given maturity on an instrument that met the definitions used in the construction of the yield curve. The yield curve, which was usually a zero-coupon yield curve appropriate to the index on which the swaps were based (e.g., LIBOR-based swaps required LIBOR yield curves), (1) forecast the floating interest rates on each date relevant to a swap agreement and (2) determined the discount rate that should be used to compute the present value of each payment (fixed and floating) due under the swap agreement.

b. Constructing the Curve

In order to construct a yield curve, a user had to make at least three critical decisions. First, the user had to decide among the large amounts of available market information, such as LIBOR deposit rates, Eurodollar futures prices, swap bid and ask quotes, and yields on U.S. Treasury securities. The user had to choose, for example, whether the 1-year point on the yield curve would be based on LIBOR rates, Eurodollar future rates, or some other rate. Because these rates fluctuated during the day, the user then had to decide the time of day at which the rates would be collected, for example, at 11 a.m. or 2 p.m. Because the market data produced only a series of points corresponding to the maturities available in the market, the user then had to decide on a model that connected the dots in order to interpolate where the floating interest rate would be on the particular dates specified in each swap agreement.

c. Imprecise Measure

The midmarket value computed using dealer-constructed yield curves was a constructed, rather than an observed, number and was not absolutely precise. Two dealers could calculate different midmarket values for the same swap, although the differences should not have been that large. Disparities could have resulted, for example, because (1) the dealers relied on different market indicators (e.g., one relied on futures prices while the other relied on LIBOR), (2) the dealers used different software with different interpolation techniques, or (3) the dealers relied on prices quoted at different times during the day. As to the latter, a small movement in interest rates of just one basis point during a day could affect the midmarket values, and the price of a swap could change within a few hours. During the first quarter of 1990, for example, it was not unusual for interest rates to move 10 basis points or more in a single day.

D. Market Value

1. Net Present Value — Forward Rate Pricing

The market value of a swap is equal to the net present value of the expected net cashflows. The forward rate pricing approach calculates this net present value in two steps. First, the expected net cashflows are determined. Second, these expected cashflows are discounted to produce a present value.

a. Expected Cashflows

The table below shows the forecasted future cashflows as of December 1, 1992, on the swap illustrated supra p. 191. The implied forward rate of 4 percent used for the first floating payment is specified when the swap is originated. The remaining implied forward rates are derived from the midmarket swap curve. The forecasted cashflows for the floating side are calculated by multiplying the implied forward rate by the notional principal and then multiplying the product by a ratio that equals the number of days in the payment period divided by 360.

Implied Forecasted Forecasted net No. of days Fixed forward floating cashflow Payment dates in period payment rate payment from (to) FNBC

12/111992

6/1/1993 182 $25,278 4.000% $20,222 ($5,056)

12/1/1993 183 25,417 4.262 21,664 (3,753)

6/1/1994 182 25,278 5.098 25,772 494

12/1/1994 183 25,417 5.813 29,549 4,132

6/1/1995 182 25,278 6.379 32,250 6,972

12/1/1995 183 25,417 6.921 35,180 9,763

b. Discounting Expected Cashflows

The table below shows the calculation of the present value of the forecasted future cashflows of the swap. The second through fourth columns show the forecasted fixed, floating and net cashflows on the swap just discussed. The fifth column shows the discount factors for each cashflow. The total present value of the swap is $10,148 as of December 1, 1992.

Forecasted Present value

Fixed Floating Net Fixed Floating Net payment payment cashflow payment payment cashflow Payment (from (to (to Discount (from (to (to dates FNBC) FNBC) FNBC) factor FNBC) FNBC) FNBC)

6/1/1993 $25,278 $20,222 ($5,056) .9852 $24,903 $19,922 ($4,981)

12/1/1993 25,417 21,664 (3,753) .9643 24,509 20,890 (3,619)

6/1/1994 25,278 25,772 494 .9401 23,762 24,227 465

12/1/1994 25,417 29,549 4,132 .9131 23,207 26,980 3,773

6/1/1995 25,278 32,250 6,972 .8845 22,359 28,526 6,167

12/1/1995 25,417 35,180 9,763 .8545 21,718 30,061 8,343

Total - - - - - - - - - - - - 140,458 150,606 10,148

2. Floating-Rate Note Method

An alternative approach finesses the need to forecast expected cashflows. It works on the analogy between the swap and a pair of bonds, one of which has a fixed rate and the other of which has a floating rate. This method relies on the assumption of which the floating-rate bond is worth its face value on the effective date or on any reset date. Since the market value of the swap is equal to the difference between the value of the floating leg and the value of the fixed leg, and since the value of the floating leg is known, the problem is to determine the value of the fixed leg. This does not require the use of a forward curve.

The floating-rate note method is useful when (1) the terms of the swap are plain vanilla and (2) the valuation date is a reset date. In other cases, a correct implementation of the floating-rate note method requires additional steps which are comparable to those employed in the forward rate pricing approach. The two approaches yield the same result in all events.

3. Value at Origination

Swaps generally originate close to par, at a rate approximately equal to either the prevailing market bid or ask, depending upon which side of the swap the dealer is on. The small initial divergence from par is the dealer’s profit on making the market. When a dealer buys a swap at the prevailing market bid rate, it will have a positive value. The dealer does not typically pay this positive market value to the counterparty but keeps it as the profit on origination. Similarly, when a dealer sells a swap at the prevailing market ask rate, it will also have a positive value which is the dealer’s profit on origination.

Whereas dealers generally originated swaps at prices near the prevailing market bid and ask rates, a particular dealer at any given time could set a higher or lower bid or ask rate for a given maturity swap, thereby producing a higher or lower profit on that swap. The dealer’s ability to set the higher or lower rate depended upon the dealer’s own business situation, on the risk structure of the dealer’s entire portfolio, on the profile of the dealer’s full set of counterparties, and/or upon other commercial considerations. Dealers seldom agreed to a rate on a swap which gave the swap a negative value at origination, unless the dealer was seeking to develop a client relationship and was ready to incur an upfront cost in pursuit of longer term sources of profit.

4. Change in Market Value

A swap may originate at par and become an above-market swap on account of a fall in interest rates. A swap also may originate at par and become an above-market swap without a fall in interest rates. The latter occurs if the term structure is upward sloping so that short-maturity swaps are negotiated with a lower fixed rate than long-maturity swaps. Because the fixed rate is typically constant over the life of the swap, a decline in the swap’s remaining maturity means that the swap’s fixed rate is above the at-market rate for a newly originated swap with the identical remaining maturity. Assume, for example, that the 2-year swap rate is 5 percent, the 3-year swap rate is 6 percent, and the 4-year swap rate is 7 percent. Assume further that a 4-year swap is initiated at par (i.e., at a fixed rate of 7 percent). Assuming that the swap rates remain the same at the end of the first year, at the beginning of the second year, the 7-percent fixed rate on the remaining 3-year swap now exceeds the 6-percent rate for a newly originated 3-year swap. The swap is considered above-market relative to newly originated swaps which have a par rate of 6 percent.

E. Primary Financial Reporting Methods

1. Overview

The primary financial reporting alternatives for valuing nonhedging swaps are amortized cost, current market value, and lower of cost or market value (lower of cost or market). The latter two alternatives use market value information and allow unrealized gains and losses to be either (1) recognized as current income on the income statement or (2) accumulated on the balance sheet in a separate component of shareholders’ equity until realized.

2. Amortized Cost

Under the amortized cost method, the initial cost of a typical interest rate swap is zero; swaps generally have no cashflow at inception. On each financial reporting date, income or loss on the swap is accrued in an amount equal to the portion of the next scheduled cashflow that reflects the elapsed time as of the reporting date. An offsetting entry is made to a receivable or payable, which is the only balance sheet evidence of the swap. On cashflow dates, entries are made to record the cash received or paid, reverse the receivable or payable, and record the balance as income or loss. Income over the life of the swap equals the total cashflows.

3. Current Market Value

Under a current market (or mark-to-market) valuation, entries are made to record the market value of the swap on the balance sheet at each financial reporting date. Changes in market value are reflected in income or loss, as are cashflows. Because the sum of changes in market value over the life of the swap must be zero, the income over the life of the swap again equals total cashflow.

4. Lower of Cost or Market

Entries under the lower of cost or market generally follow the entries made under the amortized cost method, with the added step that, at each financial reporting date, the swap’s amortized cost value (if any) is compared with its market value. If current market value is below the amortized cost value, an entry is made to adjust the recorded value to an amount equal to the market value. All adjustments to or from market value are treated as income or loss. The lower of cost or market method recognizes losses in market value below the amortized cost value, and gains to the extent that they recoup previously recognized losses. The lower of cost or market does not recognize gains in market value above the amortized cost value.

F. Relevant Standards of the FASB

1. The FASB and GAAP

The Financial Accounting Standards Board (fasb) is the professional organization primarily responsible for establishing financial reporting standards in the United States. The fasb’s standards are known as Generally Accepted Accounting Principles (GAAP).

2. Initial Role of Market Values in GAAP

Under GAAP, market values initially played a limited role in shareholder reporting. GAAP uses predominantly transaction-based valuation; i.e., valuation established in an actual transaction by the reporting entity. The primary advantage of transaction-based valuation is reliability; accountants view values established in arm’s-length transactions as less subjective and more easily verified than values produced without such transactions. The primary disadvantage of transaction-based valuation is that values can become outdated, thus rendering the information less relevant to investors. If a company issued a bond at par, for example, transaction-based valuation would report the bond on the company’s financial statements at its issue price. If interest rates fell, the market value of the bond, and thus the market value of the company’s liability, would rise. This rise in value would not be recognized in the company’s transaction-based reports, although it would most likely be an important factor in valuing the company.

3. SFACs

From the late 1970s through the mid-1980s, the FASB issued a series of statements known as “Statements of Financial Accounting Concepts” (SFACs) in an effort to define a conceptual framework within which accounting standards could be developed. These statements did not discuss mark-to-market accounting explicitly. However, SFAC No. 5, issued in December 1984, allowed for the possibility that assets and liabilities could in certain cases be revalued on the basis of current market value in the absence of a new transaction. These cases could occur if the current price information was “sufficiently relevant and reliable to justify the costs involved”.

Though the transaction-based approach remained dominant, the SFAC No. 5 criterion for using current market value allowed a wide range of practice. The FASB listed three examples of valuation at current market value from then-current practice: (1) Some investments in marketable securities, (2) assets expected to be sold at prices less than previous carrying amounts, and (3) some liabilities that involved marketable commodities or securities, such as obligations of writers of options. These examples were limited to circumstances where either (1) shareholders had suffered a decline in value from the historical transaction-based valuation or (2) the item had a ready market in the form of an organized exchange so that the cost of obtaining objective and verifiable pricing information was minimal, as was the uncertainty about whether the reporting entity could find a buyer.

4. Change in Accounting Treatment

Until recently, accounting for non-exchange-traded financial assets had typically been on the basis of amortized cost. For a traditional fixed-rate loan, for example, the amortized cost value of the loan would be (1) the original amount lent, net of any repayments, plus (2) accrued interest at the contractually specified rate. With the exception of actual default, amortized cost valuation was not sensitive to changing market conditions such as changes in interest rates or changes in the asset’s credit risk.

Financial innovation during the 1980s and 1990s created a need for better information than reported by the traditional transaction-based system. With encouragement from the Securities and Exchange Commission (sec), the fasb began in the early 1990s to consider greater use of market values in accounting for financial instruments. 28 One concern with the transaction-based system was that new financial instruments created potentially large risks not reported on the balance sheet. Forward contracts, for example, typically require no exchange at inception, so the transaction-based value would be zero at inception and would remain zero until maturity. At maturity, the cash settlement would determine income or loss, without any value ever appearing on the balance sheet.

A second concern with the transaction-based system was that firms could sell appreciated on-balance-sheet investments to report gains and leave investments that had declined in value reported on the balance sheet at their original cost. A third impetus for increasing the use of market value information in financial reports was the greater acceptance of theoretical models and the wider availability of financial data to support more reliable and informative reports. For example, although models of option pricing existed in the academic finance literature in the 1970s, their acceptance in accounting practice began only in the mid-1980s.

5. SFASs

From in or about March 1990 through June 1998, the FASB worked on its financial instruments project. As part of that project, the FASB issued four statements each known as a “Statement of Financial Accounting Standards” (SFAS).

a. SFAS No. 105

In March 1990, the FASB issued SFAS No. 105, “Disclosures of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk”. SFAS No. 105 required the footnote disclosure of the extent, nature, and terms of financial instruments such as swaps which had off-balance-sheet risk. SFAS No. 105 did not require disclosure of the related market values.

b. SFAS No. 107

In December 1991, the FASB issued SFAS No. 107, “Disclosures about Fair Value of Financial Instruments”, effective for fiscal years ended after December 15, 1992. SFAS No. 107 required footnote disclosure of the fair value of financial instruments for which it was practicable to estimate fair value but did not require formal recognition in the financial statements. SFAS No. 107 defined the fair value of a financial instrument as

the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. If a quoted market price is available for an instrument, the fair value to be disclosed for that instrument is the product of the number of trading units of the instrument times that market price.

SFAS No. 107 stated that the amounts computed as “market value, current value, or mark-to-market” value under the then-existing requirements satisfied the fair value requirements of SFAS No. 107.

As relevant herein, the FASB allowed a variety of methodologies for estimating fair values, including the use of midmarket values if any adjustments thereto were likely to be negligible or not cost effective to estimate reliably. The FASB recognized in SFAS No. 107 that quoted market prices did not exist for custom-tailored instruments such as swaps and recommended that “an estimate of fair value might be based on the quoted market price of a similar financial instrument, adjusted as appropriate”. In illustrating an acceptable disclosure under SFAS No. 107, SFAS No. 107 gives the following description of swap valuation: “The fair value of interest rate swaps * * * is the estimated amount that the Bank would receive or pay to terminate the swap agreements at the reporting date, taking into account current interest rates and the current creditworthiness of the swap counterparties. ”

c. SFAS No. 119

In October 1994, the FASB issued SFAS No. 119, “Disclosures about Derivative Financial Instruments and Fair Value of Financial Instruments”. SFAS No. 119 required footnote disclosure of the nature, terms, and fair values of financial derivative instruments. SFAS No. 119 was not effective for any of the relevant years, and it did not prescribe specific methods for arriving at fair value.

d. SFAS No. 133

In June 1998, the FASB issued SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”. SFAS No. 133 required nonhedging derivative instruments such as swaps to be reported at fair value on the balance sheet, with gains and losses included in current earnings. SFAS No. 133 was not effective for any of the relevant years, and it did not prescribe specific methods for arriving at fair value.

G. Methods of Valuing Swaps

During the relevant years, the three main methods which dealers used to value their swaps portfolios were the bid-ask method, the midmarket method, and the adjusted midmarket method.

1. Bid-Ask Method

The bid-ask method was essentially a market comparables approach to valuation. Some dealers used this method, and it was recognized as a valid method by the Group of Thirty (G-30) (discussed infra p. 224) and the OCC. Under the bid-ask method, each swap generally was valued by (1) identifying the generic swap to which it was most comparable, (2) ascertaining the bid or ask price for that generic swap, and (3) adjusting the ascertained price to reflect any differences between the generic swap and the swap being valued. Bid prices were used to value a long position (swaps where the dealer received the fixed rate), and ask prices were used to value a short position (swaps where the dealer paid the fixed rate). The bid and ask prices were both interdealer published quotes rather than the dealer’s own quotes.

2. Midmarket Method

The industry practice from 1990 through 1993 was to use the midmarket value to value portfolios and to report separately the adjustments described below. 29 As discussed above, the midmarket value was the net present value (positive or negative) of the anticipated cashflows which the parties had agreed to exchange. A positive value meant that the dealer expected to be a net receiver of future payments. A negative value meant that the dealer expected to be a net payer.

3. Adjusted Midmarket Method

During the relevant years, the adjusted midmarket method was a common method used by dealers to value their portfolios, and it was recognized as a valid method by the G-30. Under this method, a dealer calculated the midmarket value of the swaps in its portfolios and then made certain adjustments. The type of these adjustments varied between and among dealers. Depending on the dealer, adjustments were made for factors which included credit risk, future administrative costs, hedging costs, investing and funding costs, closeout costs, and liquidity (each discussed infra p. 225). During the relevant years, there was no standard practice in the market as to the specific adjustments taken by dealers.

H. Nontax Purposes for Which Dealers Value Swaps

I. Overview

Swaps are valued for a number of nontax purposes. These purposes include regulatory reporting, risk management, management reporting, financial reporting, and pricing.

2. Regulatory Reporting

National banks such as FNBC had to value their financial derivative portfolios in reports submitted to their principal regulator, the OCC. During the relevant years, the primary focus of an OCC examination of a bank dealer department was to determine whether the risk management systems employed by the bank assured timely recognition of risk-taking and losses and did not permit an overstatement of income. In contrast with the Commissioner’s audits of a taxpayer’s Federal income tax return, OCC examinations did not focus on understatements of income or of value. OCC examiners were instructed to examine closely the recognition of income associated with financial derivatives positions to ascertain that the bank under examination had not overstated its income. The OCC preferred valuation methodologies and income reporting that resulted in a bank’s taking significant reserves, deferring income recognition, and using conservative carrying values for swaps. The OCC’s role as regulator of the bank was to oversee the risk management systems employed by the bank.

The OCC endorsed valuing financial derivative portfolios at adjusted midmarket values and considered the adjustments “holdbacks” (i.e., reserves) designed to provide for likely future costs and to attribute trading income to the appropriate source of income. This endorsement reflected the OCC’s acceptance of a 1986 recommendation of the Basel Committee on Banking Supervision (Basel Committee) that banks should build a cautious bias into their estimates of the replacement costs of off-balance-sheet instruments. Neither the OCC nor the Basel Committee provided specific guidelines for calculating midmarket value adjustments. The OCC did require banks to take into account changes in counterparty credit quality in swap revaluations. In making credit adjustments to midmarket values, it was the view of the OCC that the credit adjustment was typically calculated by formulas based on the counterparty credit rating, maturity of the transaction, collateral, netting arrangements, and other credit factors.

In 1994, the FRB expressed concerns about the potential for income manipulation by use of midmarket adjustments.

3. Risk Management

Swaps dealers needed to value financial derivatives to measure the performance of their financial derivatives trading operations and to measure and to ascertain how to hedge the market risks in their portfolios. Traders were responsible for maintaining the portfolios they managed within various risk limits. The traders needed to know their exposure to long-term and short-term interest rate movement positions in order to assure that they did not take on unacceptable levels of risk.

Swaps dealers such as FNBC used midmarket values for daily risk management purposes. The purpose of these valuations was to measure the day-to-day change in the value of the portfolio and to quantify the impact that particular interest rate movements would have on the value of the portfolio. These calculations were used to monitor risk positions (i.e., how much unhedged market risk a trader could assume) and to identify where hedging was needed. Swaps dealers such as FNBC did not rely upon their credit adjustments to risk-manage their swaps and did not use their administrative costs adjustments for risk management.

4. Management Reporting

Each month, swaps dealers such as FNBC prepared a management report for the financial derivatives profit center that included interest rate swaps. The monthly management reports contained a profit-and-loss statement and a balance sheet. On its balance sheets, FNBC valued its swaps at midmarket values and reflected its credit and administrative costs adjustments in a reserve account. Copies of these reports were sent to senior management, the OCC, and the FRB.

FNBC’s upper management did not rely upon any of the adjustments used for tax purposes. In making presentations to its Board Examining Committee on the profitability and status of its swaps business, fnbc relied on midmarket values. FNBC reported to its Board Examining Committee that it made a reasonable profit from the difference between the swaps market and the customer. 30

5. Financial Reporting and Pricing

Swaps dealers such as FNBC valued their swaps for financial reporting and pricing purposes. FNBC did not rely upon its credit adjustments in pricing its swaps.

I. The G-30

1. Overview

The G-30 is a private, nonprofit international body that comprises very senior representatives of the private and public sectors and academia. It was organized to deepen understanding of international economic and financial issues and to examine the choices available to market practitioners and policymakers. It is supported by contributions from private sources such as banks and nonbank corporations. During the relevant years, the chairman of the G-30 was Paul Volcker.

2. G-30’s Review of Industry Practices

The G-30 establishes study groups, committees, and subcommittees to study various matters of interest to the international financial community. In 1992, the G-30 commissioned an authoritative review of industry practices and performance with respect to financial derivatives. The G-30 did so in order to define a set of sound risk management practices for dealers, end users, and regulators. Later that year, the G-30 established a Derivatives Project Steering Committee, which, in turn, created a working group of specialists (working group) in the financial derivatives field.

The working group conducted a comprehensive study of financial derivatives and financial derivatives markets drawn from the experience of market participants. In July 1993, the working group issued its report (G-30 report), entitled “Derivatives: Practices and Principles”. The G-30 report focused on bank regulatory concerns and generally defined a set of sound risk management practices for dealers and end users. The working group followed that report with various surveys published in 1994 as to industry practices. These surveys were incorporated into the G-30 report.

3. G — 30 Report

The G-30 report set forth an unofficial but authoritative review of industry practices and performances, mainly for the benefit of the risk management activities of dealers and end users. The G-30 report included a primary section on recommendations and the following additional and integral parts:

Appendix I — Working Papers, dated July 1993

Appendix II — Legal Enforceability, Survey of Nine Jurisdictions, dated July 1993

Appendix III — Survey of Industry Practices, dated March 1994

Follow-up Surveys of Industry Practice, dated December 1994

As to the valuation of financial derivatives, recommendation 3 of the G-30 report stated:

Recommendation 3: Market Valuation Methods

Derivatives portfolios of dealers should be valued based on mid-market levels less specific adjustments, or on appropriate bid or offer levels. Mid-market valuation adjustments should allow for expected future costs such as unearned credit spread, close-out costs, investing and funding costs, and administrative costs.

The G-30 report explained as to this recommendation:

Marking to mid-market less adjustments specifically defines and quantifies adjustments that are implicitly assumed in the bid or offer method. Using the mid-market valuation method without adjustment would overstate the value of a portfolio by not deferring income to meet future costs and to provide a credit spread.

Two adjustments to mid-market are necessary even for a perfectly matched portfolio: the “unearned credit spread adjustment” to reflect the credit risk in the portfolio; and the “administrative costs adjustment” for costs that will be incurred to administer the portfolio. The unearned credit spread adjustment represents amounts set aside to cover expected credit losses and to provide compensation for credit exposure. Expected credit losses should be based upon expected exposure to counterparties (taking into account netting arrangements), expected default experience, and overall portfolio diversification. The unearned credit spread should preferably be adjusted dynamically as these factors change. It can be calculated on a transaction basis, on a portfolio basis, or across all activities with a given client.

Two additional adjustments are necessary for portfolios that are not perfectly matched: the “close-out costs adjustment” which factors in the cost of eliminating their market risk; and the “investing and funding costs adjustment” relating to the cost of funding and investing cash flow mismatches at rates different than the LIBOR rate which models typically assume.

The Survey reveals a wide range of practice concerning the mark-to-market method and the use of adjustments to mid-market value. The most commonly used adjustments are for credit and administrative costs.

The G-30 report does not provide an objective standard as to the calculation, measurement, or testing of either the unearned credit spread (i.e., the credit adjustment) or the administrative costs adjustment.

4. BC-277

Later in 1993, shortly after the G-30 report was issued, the OCC released Banking Circular 277 (BC-277), entitled “Risk Management of Financial Derivatives”. This document addressed the valuation of financial derivatives and was sent to the chief executive officer of every national bank. In relevant part, it stated on the cover page:

PURPOSE

This banking circular provides guidance on risk management practices to national banks and federal branches and agencies engaging in financial derivatives activities. The guidelines in this circular represent prudent practices that will enable a bank to conduct financial derivatives activities in a safe and sound manner. National banks engaged in financial derivatives transactions are expected to follow these guidelines. * * *

ij: # tfi ‡ sj;

SCOPE

Financial derivatives transactions currently represent' a relatively small portion of the total credit, market, liquidity, and operational risk to which most banks are routinely exposed. However, because of their complexity, many banks involved in financial derivatives transactions have developed sophisticated approaches in managing those traditional types of risk. These guidelines reflect such approaches and, therefore, represent sound procedures for risk management generally. Therefore, to the extent possible, they should be applied to all of a bank’s risk-taking activities.

As to the valuation of derivatives, BC-277 stated:

4. Valuation Issues

Banks that engage in financial derivatives activities should ensure that the methods they use to value their derivatives positions are appropriate and that the assumptions underlying those methods are reasonable.

Dealers and active position-takers should have systems that accurately measure the value of their financial derivative portfolios. The pricing procedures and models the bank chooses should be consistently applied and well-documented. Models and supporting statistical analyses should be validated prior to use and as market conditions warrant.

The best approach is to value derivatives portfolios based on mid-market levels less adjustments. Adjustments should reflect expected future costs such as unearned credit spreads, close-out costs, investing and funding costs, and administrative costs. Most limited end-users (and some traders) may find it too costly to establish systems that accurately measure the necessary adjustments for mid-market pricing. In such cases, banks may price derivatives based on bid and offer levels, provided they use the bid side for long positions and the offer side for short positions. This procedure will ensure that financial derivatives positions are not overvalued.

Banks adopting mid-market pricing should recognize' that mid-market prices are not observable for many instruments. In those cases, banks should derive unbiased estimates of market prices from prices in similar markets or from sources that áre independent of the bank’s traders. The bank’s operations staff should develop procedures to verify the reasonableness of all pricing variables or, if that is not possible, should limit the bank’s exposure through position or concentration limits and develop appropriate reporting mechanisms.

Traders may review and comment on prices. When material discrepancies occur, senior management should review them. If, in an extenuating circumstance, senior management overrides a back office estimate, it should prepare a written explanation of the decision.

IV. Adjustments to Midmarket Value

A. Overview

The credit adjustment and the administrative costs adjustment are the primary adjustments in dispute. The total of these adjustments in the industry exceeds $1 billion per year. Dealers during the relevant years also reported adjustments to midmarket value for the following: (1) Provision for current closeout costs of net open positions, (2) provision for future hedging costs (portfolio rebalances), (3) adjustment for odd cashflows, (4) adjustment to reflect borrowing and lending rates for in- or out-of-the-money positions, (5) liquidity, and (6) model risk. We discuss the adjustments recognized by the parties and/or experts.

B. Administrative Costs Adjustment

1. Overview

The adjustment for administrative costs represented those expenses which a dealer expected to incur in the future in holding, managing, and administering its existing swap portfolio to maturity. The adjustment reflected the dealer’s operation, maintenance, and staffing of the support functions and limited trading personnel, including the personnel needed to execute swap transactions to service the existing portfolio, process payments on the swaps, determine and execute the appropriate hedges as to the swaps, and monitor the credit standing of counterparties. The adjustment reflected the appropriate data feeds, software licenses, activities needed to support the trading floor, and associated space costs.

2. Dealers’ Practice

Dealers did not take administrative costs into account for purposes such as pricing and trading. Negotiations among dealers were over the total price of a swap, and dealers did not separately negotiate an administrative costs component of the spread from midmarket value.

3. Use of the Dealer’s Own Costs

Dealers calculated their administrative costs adjustments on the basis of their own internal estimates of future costs. There was neither a market standard for administrative expenses related to swaps, nor a market standard (or market data) for an administrative costs adjustment whether on a swap-by-swap or portfolio basis.

Dealers did not know the level of administrative (or other) costs experienced by other dealers. That information was generally regarded as proprietary and was not public.

C. Adjustment for Counterparty Credit Risk

1. Overview

A party to a swap was exposed to credit risk. The party’s credit risk was the potential change in the market price of the party’s position in the swap due to the credit quality of the counterparty. The event of a default by the counterparty lowered the market price of that position, and the danger of default was the ultimate source of credit risk. Short of an actual default, a downgrade in the counterparty’s credit rating could also affect the market price of the party’s position in the swap. Credit risk included the danger that the market price of the party’s position in a swap would fall because of a downgrade in the credit rating of the counterparty.

Although the notion of midmarket adjustments for credit risk was recognized in the swaps market, there was no publicly available data as to the impact that credit quality had on swap prices. The publicly reported bid and ask rates were commonly considered valid for counterparties rated AA, and counterparties with other ratings that negotiated around these quotes did not publicly report the prices which they negotiated. Those negotiated prices, therefore, could not be distilled into a set of swap curves for different credit qualities.

2. Common Method of Calculating Adjustment

There was no consensus during the relevant years about either the model or the methodology that should be used to calculate a credit adjustment on swaps. Many bank dealers calculated their credit adjustments on the basis of a formula that referenced (1) each counterparty’s credit rating, (2) the bank’s estimate of expected losses for that credit rating, and (3) a loan equivalency amount.

a. Counterparty Credit Rating

Most bank dealers had well-established internal credit risk-rating systems which were developed for purposes other than calculating a credit adjustment on a swap. Many dealers applied these credit ratings to ascertain their credit adjustments for swaps.

b. Expected Loss Factor

On the basis of historical experience, bank dealers generally ascertained a loss factor for each credit rating. The loss factor represented the bank’s estimate of its credit losses for each dollar of credit exposure in that credit rating. The loss factors were generally derived from the bank’s experience with loans to borrowers with the respective credit ratings.

c. Loan Equivalency

i. Overview

A bank would typically establish a credit limit for each customer, and the loan equivalency measurement of credit exposure was used by banks in applying credit limits. The loan equivalency amount focused on the bank dealer’s expected credit exposure from a specific counterparty with which it had entered into one or more swaps. The loan equivalency amount represented the amount of the counterparty’s credit limit, as established by the bank, that was consumed by each swap. In other words, the exposure model determined the number of swaps that the bank could enter into with the counterparty and stay within the prescribed credit limit.

ii. Types of Credit Exposure

The concept of credit exposure was broken into current credit exposure and potential credit exposure. There also is a third type of credit exposure known as “expected exposure”.

A. Current Credit Exposure

A bank dealer’s current credit exposure on any day was the net present value of the amount that the bank expected to receive under a swap agreement as ascertained from current interest rate projections. In other words, a bank’s current credit exposure was the midmarket value of a swap, to the extent that the midmarket value was positive.

B. Potential Credit Exposure

A bank dealer’s potential credit exposure was the most that it could lose on a swap. Although it was possible to ascertain the amount that a bank would lose if interest rates reached unthought-of heights such as 20 percent or higher (or, in other words, a bank’s “maximum exposure”), banks generally did not consider their maximum exposure because they did not believe that interest rates would rise to those unexpected levels. The concept of potential credit exposure was reformulated to measure the most that a bank could lose with a set level of confidence (e.g., a 95-percent certainty). The degree of conservatism increased with an increase in the number used as the confidence level; e.g., the use of a 20-per-cent confidence level was less conservative than the use of a 50-percent confidence level.

The G-30 report recommended that potential credit exposure be calculated using broad confidence intervals (e.g., two standard deviations) over the remaining terms of the transactions. An interval of two standard deviations corresponds to a 95-percent confidence level.

C. Expected Exposure

Expected exposure is the mean exposure which is used for valuing credit risk.

iii. OCC’s Position

BC-277 stated that for risk management purposes every bank should have a system to quantify “current exposure (‘mark-to-market’) as well as potential credit risk due to possible future changes in applicable market rates or prices (‘add-on’).” BC-277 stated further that “This methodology should produce a number representing a reasonable approximation of loan equivalency, that is, the amount of credit exposure inherent in a comparable extension of credit.”

iv. Methods Used To Calculate

Complex models were used to measure credit exposure for interest rate swaps. Initially, some swaps dealers measured potential exposure using a scenario approach. They would analyze a limited number of future interest rate scenarios and track the value of the swap over time to determine the maximum amount at risk if the counterparty were to default. Under this approach, the worst case scenario was regarded as the potential exposure. This approach had many deficiencies, and, by the 1990s, most dealers were trying to develop more sophisticated tools.

One common approach during the relevant years for estimating credit exposure was a Monte Carlo simulation. The basic idea of this approach was to construct a mathematical model to simulate thousands of variations of future movements of a certain interest rate (e.g., 6-month LIBOR rate) and, for each variation, to calculate the credit exposure at numerous points (e.g., every 3 months over the life of the swap). The model generated a probability distribution of exposure amounts for each swap, which was used to calculate maximum exposures for multiple confidence intervals.

3. Market Data for Pricing Credit Risk of Bonds

The credit quality of an issuer of bonds affects the fair market value of the bonds. If a bond is traded, this relationship can be directly observed in the price of the bond.

Data on the market prices of traded bonds can be used to estimate the fair market value of nontraded bonds, inclusive of any premium or discount that should be applied for credit risk. Public databases exist which gather information on the traded prices and yields for bonds with different credit ratings and at different maturities. This information is gathered, and an index of yields is constructed. The value of a nontraded bond is calculated by discounting the promised cashflows at the yield for the index of comparably rated bonds with the same maturity. The observable quality spread in the bond markets makes it possible to calculate an appropriate adjustment for credit quality. Assume, for example, that a U.S. Treasury bond priced at $101.25 would have an estimated fair market value of $99.83 if, instead, it was a like bond issued by an AAA-rated corporation. The $1.42 difference between the two bonds is the credit adjustment for an AAA-rated bond issuer. If the same bond would have had an estimated fair market value of $98.91 if it had been a like bond issued by an A-rated corporation, the $2.34 difference between the prices of the Treasury and A-rated bonds is the credit adjustment for an A-rated bond issuer. The 92-cent difference between the estimated fair market values of the AAA-rated bond and the A-rated bond is the incremental credit adjustment as of the date of valuation. 31

D. Other Adjustments

1. Investing and Funding Costs

The G-30 report recommended an adjustment for investing and funding costs for portfolios that are not “perfectly matched”. This adjustment, the G-30 report stated, relates to “the costs of funding and investing cashflow mismatches at rates different from the LIBOR rate which models typically assume”. This adjustment is also mentioned in BC-277.

2. Closeout Costs (Liquidity)

The G-30 report recommended an adjustment for closeout costs. The closeout costs (liquidity) adjustment reflects the cost to buy out, assign, or otherwise unwind one or all of the reporting entity’s swaps.

The need for a closeout costs adjustment is relatively strong in some cases. Midmarket pricing from models based on the prices of benchmark instruments that are liquid overstates the pricing of assets that are exotic, or infrequently traded, or have a limited set of potential buyers. Such assets should be marked down for their liquidity.

During the relevant years, no sound or implementable approaches existed as to closeout costs adjustments. Nor did many entities (including FNBC) make closeout costs adjustments during those years.

3. Dealer Margin

The fair market value of a swap (inclusive of profit) is not normally zero at inception. Dealers capture profits on the origination of swaps, especially swaps with end users. As a result, the fair market value of a swap between a dealer and an end user is generally positive at origination. The midmarket value of a swap at origination often includes the present value of the dealer’s expected profit on the transaction. The adjusted midmarket method generally did not include an adjustment for the dealer’s profit margin. Nor did FNBC’s implementation of that method include such an adjustment.

V. Los Alamos Project

In 1994, the Commissioner entered into a contract with the Los Alamos National Laboratory under which the Los Alamos scientists (including quantum physicists and mathematicians) were to develop in the form of software a sophisticated model to assist the Commissioner in valuing interest rate swaps, currency swaps, and other financial derivative products for which mark-to-market reporting was required under section 475. This software was intended to produce a narrow range of values for swaps that a revenue agent could use as a litmus test for ascertaining whether a more thorough audit would be necessary as to a dealer’s valuation of its swaps. The Commissioner contemplated that a more detailed audit would be required if the dealer’s valuation fell outside the range of values.

The Los Alamos team was to address during the first 12 months of the project the following nine issues:

1. Address security and disclosure issues. — Some of the data required in the model development must use sensitive unclassified information about taxpayers’ market transactions. Procedures must be put in place to handle these requirements.

2. Determine how the various forms of tax information data are handled and its impact on models. — For example much of the data on transaction is only available in paper format. In this case statistical methods need to be used to account for the transactions; this will need to be allowed for in the models.

3. Many of these models will require historical data on price, interest rates, economic indicators, company reports and analyst estimates. This data is available from several vendors who need to be identified and form of feeds established.

4. Develop pricing models for interest rate and currency swaps, allowing proper determination of zero coupon rates and pricing based on the floating and fixed rate side. Perform benchmarking.

5. Identify list of other significant derivatives for which to begin modeling efforts. — Discuss with the IRS which of the many derivative securities should be focused on. This activity will help set the framework for model development of subsequent securities.

6. Determination of platform to use in the field. It is strongly recommended that this be a windows driven system. Many of the models developed will require a large computing platform. The way to handle this is to have a software package on the field agent’s computer that would remotely log into the larger machines.

7. Non-linear models for interest rate yield curve predictions. — Yield curve models are central to the valuation of these securities, issues associated with these must be addressed early in the game.

8. Credit risk models and their incorporation into swap pricing. — In a similar fashion to yield curve models credit risk or the risk of defaulting on a contract must be addressed.

9. Implement a working system that has a basic set of models with the look and feel of future systems. — Test in house a beta version of system to be implemented.

The Los Alamos team spent the most time for the software project on developing strong foundations for pricing plain vanilla swaps, which were the bulk of instruments traded in the market. The Commissioner believed that strong foundations for building models in these instruments had to be established first before models could be built for the more complicated nongeneric products.

After having spent more than 3 years and at least $2.6 million on the Los Alamos Project, the Commissioner suspended the project in late 1997 primarily because of budgetary constraints. There were internal concerns about computer spending during this time and a particular concern about additional funding for the project because any product that was developed would require subsequent budgeting for costs connected to Los Alamos’s need to fine-tune the product.

VI. FNBC’s Swaps Business

A. Overview

FNBC began dealing in interest rate and currency swaps in 1983 and began dealing in commodity swaps in 1989. To date, FNBC has traded in at least 17 currency markets, including U.S. dollars, Canadian dollars, Australian dollars, deutschmarks, sterling, yen, Swiss francs, ECU’s, and pesetas. FNBC is an innovator of interest rate products and is a leading provider in commodity derivatives including commodities such as oil, zinc, copper, and natural gas.

On the basis of notional principal amounts outstanding, FNBC was the 16th largest swaps dealer in the world in 1993. On a consolidated basis, the notional principal amounts of FNBC’s outstanding swaps at the end of 1990, 1991, 1992, and 1993 totaled $59.4 billion, $78.8 billion, $84.5 billion, and $114.9 billion, respectively. For all of FNBC’s worldwide interest rate derivative business, its return on equity for global derivative products in 1992 and 1993 was 30 percent and 33.9 percent, respectively.

During the relevant years, FNBC entered primarily into interest rate swaps. As of July 31, 1993, approximately 95 percent of the total number of deals in fnbc’s portfolio were plain vanilla swaps and options.

B. Trading Desks

During the relevant years, FNBC had swap trading desks in Chicago, London, Tokyo, and Sydney. The swap traders at the Chicago trading desk handled primarily interest rate swaps denominated in U.S. or Canadian dollars and, to a lesser extent, currency swaps, commodity swaps, and combination swaps. The Chicago office also traded many products other than swaps including, but not limited to, interest rate guarantees, FRAs, Government securities, municipal bonds, high-yield debt, and asset-backed securities.

The Chicago office booked (i.e., held and risk-managed) all swaps the notional principal amounts of which were denominated in U.S. or Canadian dollars. Swaps booked in Chicago but originating outside of fnbc’s Chicago office (e.g., at the London office 32 ) were known as “linked deals”. Linked deals are a type of internal contract that transfers the external exposure on a swap, as well as the responsibility for cashflows and market risk, from one FNBC trading office to another. In order to book in Chicago a deal originating in another office (e.g., London), FNBC entered into a mirror swap with the origination office to transfer the swap from the origination office to Chicago. Carveouts for linked deals were claimed at the linked office; i.e., the office that held and risk-managed the swap.

C. Swaps Operations Personnel

1. Overview

During the relevant years, FNBC’s swap operation was divided into a front office and a back office. The front office consisted of (1) traders, (2) marketers, (3) financial engineers who designed new instruments and structured transactions, and (4) the support staff for the first three categories of employees. The back office (also known as the swaps operations group) ensured the integrity of the paperwork on fnbc’s swaps and other multiple trading products. The back office, among other things, verified that swap master agreements were executed, that confirmations on swap transactions were received, and that periodic payments on swaps were properly transacted.

2. Traders

a. Function

fnbc’s traders were the individuals who on behalf of FNBC negotiated and entered into swap transactions with other dealers or brokers. In order to effect these transactions, FNBC’s traders usually dealt directly with the brokers or with their (fnbc’s traders’) counterparts at the other dealers. In swaps with other dealers, including brokered transactions and those swaps which a dealer entered into for its own use (e.g., to hedge its own books), the FNBC trader usually determined the final price for the swap and was authorized to enter into the transaction without specific credit approval if sufficient credit limits had already been established for the counterparty/dealer. If the counterparty was strictly an end user, as opposed to a dealer acting either as a dealer or as an end user, the FNBC trader would not deal directly with the counterparty. Rather, a marketer would handle negotiations with the counterparty after checking with the trader as to the potential pricing of the transaction.

During the relevant years, FNBC generally required its traders to use ISDA documentation for its swaps, and its swaps were subject to ISDA conventions.

b. Number Employed in Chicago

fnbc’s Chicago swap operation employed three traders of interest rate swaps and one other individual, the head of the trading desk, who supervised these three traders. Two of the three traders traded U.S. dollar denominated interest rate swaps, and the third trader traded Canadian dollar denominated interest rate swaps. One of the two traders of U.S. dollar denominated interest rate swaps traded short-term swaps, and the other traded long-term swaps.

c. Practice as to Quotations

fnbc’s traders typically quoted the same bid and ask rates for all potential counterparties rated A- or better, fnbc’s bid and ask quotes were driven by the market bid and ask quotes and the risk position of fnbc’s portfolio, fnbc’s traders agreed to the terms of a plain vanilla interest swap in a matter of seconds.

In pricing potential swap transactions, fnbc’s traders attempted to determine where the market was at that time and, given their views on interest rate movement, price their swaps on the basis of supply and demand. They gauged the market by looking at various sources (e.g., yields on Treasury securities, broker quotes of swap spreads over relevant Treasury instruments, and Eurodollar futures prices) to determine points on the interest rate yield curve. Some of the requisite information underlying these sources was reflected in fnbc’s Devon system, fnbc’s traders often used the information provided by the Devon system as a starting point in pricing.

d. Risk Management Responsibility

Each FNBC trader was responsible for maintaining his or her aggregate positions within various market risk parameters. The traders risk-managed their portfolios subject to the trading limits set by those market risk parameters. In risk-managing their portfolios, the traders used daily risk profiles and Devon-system-generated daily profit and loss statements for swaps. These profiles and statements listed midmarket values and did not include administrative costs adjustments or credit adjustments. FNBC’s traders were limited on the amount of interest rate exposure that they could assume on behalf of FNBC by a risk point system. That risk point system was based upon the profit/loss estimates that fnbc’s Devon system provided given a certain basis point movement in interest rates.

Whenever FNBC and a counterparty reached agreement on the price of a new swap, the trader would begin the process of attempting to hedge some or all of the market risk taken in the transaction. The trader usually hedged its swaps with other swaps as well as with futures and Government securities such as Treasury securities. In some cases, the trader decided to leave a position unhedged for a period of time or did not enter into a specific hedging transaction. In those cases, the transaction was already adequately balanced, in whole or in part, by other transactions in the trader’s portfolio or was entered into to balance the existing portfolio.

3. Marketers

a. Function

FNBC’s marketers were the individuals who on behalf of FNBC negotiated and entered into swaps with nondealer end users. In order to effect these transactions, FNBC’s marketers dealt directly with the nondealer end users, but only after checking with a trader as to the potential pricing of the transaction. The marketers were assigned groups of customers (e.g., financial institutions) and were responsible for locating nondealer customers that wanted to enter into swaps. The marketers promoted FNBC’s swaps business to its end-user customers and educated potential clients on the products FNBC offered and how the products could help the clients.

b. Practice as to Quotations

FNBC’s marketers negotiated the best price (within the limits set by a trader) for any swap with a nondealer end user but needed the approval of an FNBC trader for any negotiated price as to the swap. The marketer would communicate to an FNBC trader the terms of a proposed swap for a nondealer end-user customer and obtain á price quote. The marketer could build in an additional spread but could not decrease the price quoted by the trader without the trader’s approval. 33 The trader had to sign the trade ticket and, in so doing, took on all responsibility for risk-managing the swap. The marketer had no responsibility for risk management.

4. Relationship Managers

Each customer of FNBC had an assigned FNBC relationship manager who was responsible for generating business from the customer and overseeing FNBC’s dealings with the customer. The relationship manager was not part of the group that included swap traders and marketers. Marketers worked with the relationship managers to explain to customers how they could benefit from using FNBC’s swap products. Relationship managers had overall responsibility for all of the customers’ transactions (e.g., bond issuances, letters of credit, loans, financial derivative transactions).

5. Credit Officers

An FNBC credit officer was assigned to each swap counterparty. Before a swap could be entered into with that counterparty, the credit officer had to approve the counterparty’s credit and give the counterparty a credit exposure limit (credit line). Credit officers did not work in the swap department and were not part of the group that included swap traders and marketers. Nor was the credit approval process a function of the swap traders and marketers.

The credit line for financial derivative products was known as the variable exposure product (vep) limit (vepl). If a VEPL had already been established for a counterparty, and a new swap was within that limit, then no additional credit approval was needed. If the credit exposure of a swap exceeded the available VEPL, or if no VEPL had been approved, then the trader had to obtain credit approval from the credit officer.

D. Weak Credit Rating

FNBC was a major participant in the swaps market during the relevant years but was considered in that market to have weak credit. FNBC’s credit rating was downgraded to A- in or about the fall of 1990. This downgrade was generally viewed poorly among persons or entities dealing with or considering dealing with FNBC, and it hurt FNBC’s ability to enter into new swaps. FNBC’s end-user customers were worried about having periodic payments that would be due to them from a lower rated dealer. Some banks required collateral provisions in their swap agreements with FNBC because they were a better credit risk than FNBC and were not allowed to take on any risk.

E, Quoting a Price

FNBC’s practice at the start of each business day was to announce to brokers its bid and ask quotations on interdealer generic swaps. During the course of the day, FNBC’s traders would receive calls from brokers informing the traders that the brokers had a particular dealer that wanted to enter into a swap at one or more of FNBC’s quoted rates. The broker would not identify the other dealer until FNBC agreed in principle to the terms of the swap. Once FNBC learned the other dealer’s identity, it would decide whether to go forward with the swap, in view of the other party’s credit rating and the credit limit that FNBC had established for the counterparty.

FNBC generally went through two steps in deciding what price to quote on a specific swap (whether with a dealer or an end user). First, FNBC calculated (usually on its Devon system) the midmarket rate that would result in both legs of the swap having the same present value. Second, FNBC added (or subtracted) a spread to arrive at its ask (or bid) price. In pricing a swap, the spreads which FNBC factored into its traders’ bid and ask quotes were constrained by competition. On most transactions, particularly those with other financial institutions and large corporations, the customer obtained quotes from many different dealers, and FNBC was unlikely to get the business if another dealer offered better terms. Where FNBC dealt with an end user on a transaction that was particularly customized, or where the customer was not likely to obtain prices from other sources, FNBC’s marketers sometimes sought to realize additional profit on the transaction by quoting a larger spread. FNBC’s marketers usually were not able to get a larger spread from FNBC’s end users. In the rare cases where they were able to get a larger spread, it was in the nature of a fee for the cost of explaining swaps to the customer or for other services.

F. Buyouts

FNBC’s interest rate swaps were easily terminated during the relevant years by way of buyouts. FNBC regularly and continuously sought to, and did, buy out swap transactions in which it was a party.

Both end users and dealers came to FNBC to buy out their swaps with FNBC. FNBC’s traders and marketers were asked to (and did) quote prices for early termination of swaps by way of buyouts. FNBC marketed its swaps to customers as financial instruments that could be easily bought out or terminated at market value; i.e., the difference in the present value of the anticipated net cashflows from each of the swap’s legs. FNBC required as a matter of practice that the buyout price be at least the midmarket value. FNBC was willing to enter into buyouts at the midmarket value even if there was not a profit to FNBC.

Approximately 12 percent of FNBC’s swaps business in March. 1993 was buyouts. Approximately 23 percent of FNBC’s swaps business in June 1993 was buyouts.

G. Swaps Outstanding at Yearend

Without consideration of any swaps booked in the London branch, FNBC had 1,020 interest rate swaps (without an embedded feature) outstanding at the end of 1991; 1,290 at the end of 1992; and 1,147 at the end of 1993. Without consideration of any swaps booked in the London branch, FNBC had 19 commodity swaps outstanding at the end of 1991; 19 at the end of 1992; and 52 at the end of 1993.

H. Swaps in Issue

The parties have settled all pleaded issues with respect to swaps booked through FNBC’s London branch, and no issues have been raised as to swaps booked through the Tokyo or Sydney office. The swaps at issue originated at the Chicago trading desk or were booked through FNBC’s other desks and linked to the Chicago desk. The disallowed amounts encompass all adjustments on all swaps which were on the books of FNBC’s Chicago office at each yearend and all adjustments used to reduce FNBC’s swaps income.

With respect to all of FNBC’s swaps which it designated as interest rate swaps, 95 percent of them were plain vanilla U.S. dollar denominated interest rate swaps with standardized terms. The remaining 5 percent were mainly exotic swaps that included: (1) Amortizing or accreting swaps; (2) constant maturing swaps (i.e., an interest rate swap in which the floating rate is tied to a long-term constant maturity Treasury bond yield); (3) basis swaps; and (4) forward-start swaps (interest rate swaps that specify a future start date). The remaining 5 percent also included Canadian dollar denominated interest rate swaps, all of which, during the relevant years, were plain vanilla. During 1993, FNBC generally entered into fewer than 10 Canadian dollar denominated interest rate swaps a week.

During 1990 and 1991, the counterparties to FNBC’s interest rate financial derivative products were from the following categories:

1990 1991

Bank dealers 33% 32%

Bank end users 16 21

Corporate end users 30 26

FCC, FNBC and its branches, its affiliates, and its own subsidiaries 21 22

100 100

(rounded)

VII. FNBC’s Financial Accounting Practice

During the relevant years, FNBC’s financial accounting practice with respect to the pricing and valuation of commodity swaps, currency swaps, and combination swaps did not differ significantly from its financial accounting practice with respect to interest rate swaps. FNBC used a three-step process to determine the value of its swaps for financial accounting purposes. First, on a swap-by-swap basis, FNBC generally calculated each swap’s midmarket value (usually from the Devon system but sometimes from the midmarket swap curve) and recalculated these midmarket values daily. Second and third, FNBC calculated credit and administrative costs adjustments as to the swaps. FNBC’s administrative costs adjustments (which were computed on a portfolio basis) included an adjustment for hedging and may have included an adjustment for funding and cost of capital. FNBC did not take an adjustment for the cost to close out (liquidate) its swaps.

VIII. FNBC’s Practice as to Its Valuation of Its Swaps

A. Financial Reporting Position

The 1993 annual report of FNBC and its parent FCC described their accounting policy for financial derivative instruments as follows:

Accounting for Derivative Financial Instruments

Derivative financial instruments used in trading and venture capital activities are valued at prevailing market rates on a present value basis. Realized and unrealized gains and losses are included in noninterest income as trading account profits, foreign exchange trading profits and equities securities gains. Where appropriate, compensation for credit risk and ongoing servicing is deferred and taken into income over the term of the derivatives. Any gain or loss on the early termination of an interest rate swap used in trading activities is recognized currently in trading account profits.

This description related exclusively to the income statements and the balance sheets. It is different from the description used for the fair value disclosure in the footnotes, which omitted any reference to adjustments for administrative costs and/or credit risk. FNBC used midmarket values for SFAS No. 107 footnote disclosure purposes, and it used adjusted midmarket values for other financial reporting purposes.

B. Uses of Valuation

FNBC was required to value its swaps in conformance with regulatory accounting principles (rap), GAAP, and Federal income tax laws. Tax considerations were not a factor when FNBC determined how it would calculate the value of its swaps, and FNBC did not consult with anyone to ascertain whether its adjustments were appropriate for section 475 purposes. Tax considerations were not mentioned when the valuation methodology was presented to FNBC and its parent’s board of directors. Midmarket values were used in the presentation to the board.

There is no line item on any report that FNBC filed with the OCC that set forth, or specifically identified, the amount of administrative costs or credit adjustments FNBC reported for regulatory purposes.

C. RAP I GAAP

In some cases, RAP can differ from GAAP, with RAP/GAAP differences referring to the differences between the reporting required for regulatory purposes and the reporting required for GAAP. FNBC conducted RAP/GAAP reconciliations.

IX. FNBC’s Calculation of Midmarket Value

A. FNBC’s Devon System

1. Overview

FNBC first used the Devon system in 1989. FNBC was one of the first users of the Devon system, and Devon modified its system specifically for FNBC. FNBC’s customization of its Devon system changed repeatedly from 1989 through February 1993. FNBC’s Devon system never took into account the bilateral nature of swaps or FNBC’s relatively weak credit rating for a dealer in the interdealer swaps market.

FNBC needed the Devon system to handle the thousands of transactions it had on its books. FNBC used the Devon system to calculate a midmarket value for each of its swaps. FNBC also used its Devon system to value all of its other financial derivatives. In the relevant years, FNBC’s Devon system used discount factors for entities with the equivalent of AA credit ratings. The Devon system’s use of a discount rate applicable to an AA-rated entity took into account the risk of nonpayment of the cashflows by an AA-rated entity.

2. Role of FNBC’s Devon System

The Devon system had a critical role in FNBC’s risk management and hedging operations. The Devon system was used by FNBC’s Chicago office traders to risk-manage and to hedge their swaps. The Devon system calculated not only the current mid-market value for the book, but also how much the value would change with particular interest rate movements.

B. Accounting for Devon Value

At least monthly, FNBC recorded the change in the midmarket value of a performing swap in two pieces. 34 The first piece, described by FNBC as the accrual, 35 reflected a proportion of the next scheduled net cashflow. This accrual of interest was computed by multiplying the amount of the net interest payment by a fraction. The fraction’s denominator was the number of days in the payment period (the period between the scheduled cashflows or from the start of the swap to the first scheduled cashflow, if that was the first period). The fraction’s numerator was the number of days in the accrual period. If the next scheduled net cashflow was a cash receipt, then FNBC basically recorded an increase in a receivable and a corresponding entry for realized trading income. If the next scheduled net cashflow was a cash payment, then FNBC basically recorded an increase in a payable and a corresponding entry to realized trading loss. FNBC reduced the receivable (or payable) when the scheduled net cashflow was received (or paid).

The second piece, described by FNBC as the revaluation, recorded the change in the midmarket value minus the accrual just discussed. The sum of the two pieces equaled the change in the midmarket value. At the first valuation date after the start of the swap, the change in midmarket value equaled the midmarket value (i.e., the previous value was zero). If the change in the midmarket value minus the accrual was an increase, then FNBC recorded an increase in its asset balance for swaps and a corresponding entry for unrealized trading income. If the change in the midmarket value minus the accrual was a decrease, then FNBC recorded a decrease in its asset balance for swaps and a corresponding entry for unrealized trading loss.

An effect of this manner of accounting for the midmarket value was that no single account recorded the midmarket value of a swap. Rather, the midmarket value was the cumulative sum of accruals plus revaluations which related to the swap.

C. Early Closing Date

FNBC did not value its swap portfolio as of its yearend (or its last business day) but as of a date slightly before yearend (early closing date). Typically, the early closing date was on or about the 20th day of the month; e.g., FNBC determined the value of its portfolio as of December 31, 1993, on the basis of the midmarket values on December 20, 1993. 36 FNBC adjusted its books for periodic payments made during the period between the early closing date and yearend, but did not adjust its books for changes in valuation from the early closing date to yearend. FNBC did not consider those changes in valuation material from the viewpoint of the entire operations of FNBC (and not just from the viewpoint of fnbc’s swaps operation).

FNBC had an internally imposed accounting schedule that dictated its use of the early closing date. FNBC had a rigid deadline under which it would close its books on the second business day after the end of a month. In the early 1990’s, FNBC attempted to value its swaps as of the last day of the month but encountered problems under which it had difficulty meeting its 2-business-day deadline. The Devon system, for example, did not automatically post to the general ledger, and thousands of entries had to be entered manually each month. Because FNBC was unable to enter all of these entries correctly within 2 business days after the close of the year, it established the early closing date.

fnbc’s use of its early closing date was approved by fnbc’s chief accounting officer, and the stub period adjustments (those adjustments for the period extending from the early closing date until the yearend date) were discussed with fnbc’s outside auditors, fnbc’s auditors concluded that fnbc’s financial statements presented fairly, in all material respects, fnbc’s financial position at yearend.

X. FNBC’s Administrative Costs Adjustment

A. Overview

FNBC made an internal forecast of future administrative costs which it expected to incur in administering its existing swap portfolio to maturity. For Federal income tax purposes, FNBC considered the present value of these costs an adjustment to the midmarket value of its swaps. FNBC ascertained its forecast by (1) projecting future costs to manage the current portfolio of swaps and interest rate guarantees; (2) reducing the projected costs in each future year by the proportion of the current portfolio that would mature before the start of the future year, as ascertained from a “rolloff” schedule; (3) discounting the future costs to present value; and (4) assigning 30 percent of future costs to interest rate guarantees and the remaining 70 percent to swaps.

FNBC’s finance department was responsible for computing the administrative costs adjustment. Its objective was to ascertain the costs attributable to administering the existing swaps over their existing life, assuming that there were no new deals. As of the end of the quarter, FNBC (through its finance department) calculated the administrative costs adjustment on a portfolio (rather than swap-by-swap) basis; i.e., FNBC determined the administrative costs for the entire portfolio and did not compute or allocate those costs to individual swaps. FNBC did not calculate a per-swap administrative expense amount.

For the relevant years, the amounts of the administrative costs that FNBC estimated were needed to manage its swaps to maturity were as follows:

Estimated administrative Year costs

1989 . $4,271,337

1990 . 5,253,337

1991 . 3,318,920

1992 . 3,843,770

1993 . 4,832,469

For Federal income tax purposes, FNBC reported the annual increases or decreases to these estimated administrative costs as administrative costs adjustments to its midmarket values. FNBC reported the following amounts for administrative costs adjustments (with the negative amounts decreasing the midmarket values and the positive amounts increasing the midmarket values):

Administrative Year costs adjustment

1990 . ($982,000)

1991 . 1,934,417

1992 . (524,850)

1993 . (988,699)

The administrative costs adjustment’s net effect on income was to decrease (or increase) income per books by the net increase (or decrease) in the aggregate balance of the administrative costs adjustment.

B. Calculation of the Adjustment

FNBC’s administrative costs adjustment reflected FNBC’s estimate of the aggregate of: (1) Its future budgeted costs (both direct and indirect) for its swaps business, (2) its future budgeted costs (both direct and indirect) for the allocable portions of the costs of the back office to manage FNBC’s swaps to maturity, and (3) the allocable future budgeted costs of the nontrading departments of FNBC that FNBC believed would be necessary to support its swaps business in managing the swaps to maturity. For purposes of the administrative costs adjustment, all of these future estimated costs were adjusted upward by an inflation factor and then present valued. The inflation factor for future costs was 3.5 percent for 1992 and the first three quarters of 1993 and 4 percent for the fourth quarter of 1993. These inflation factors were consistent with the inflation factors built into FNBC’s budgeting process. The present values of these estimated expenses, as adjusted by the inflation factor, were computed by using the same zero-coupon yield curve that was used in computing midmarket value.

In order to reflect the fact that its swaps matured, FNBC (through its finance department) prepared a rolloff schedule showing the number of its swaps that matured each year and, going forward, the number of those swaps that would be in place each year until the entire portfolio had matured. The rolloff schedule was used to estimate the number of years that FNBC would be incurring expenses for swaps that had not yet terminated. In the later years, the estimated costs were reduced in proportion to the declining number of swaps that would still be in existence. The maturity estimates did not take into account the percentage of FNBC’s swaps that were bought out each month.

The present values of the expenses, after they had been adjusted for inflation, were then allocated between the swap portfolio and the interest rate guarantee portfolio. FNBC then attributed to the existing swaps the percentage of the resulting estimated expenses, as adjusted, that bore the ratio of the existing swaps to total swaps. The amount of the difference between the administrative costs adjustments for the current quarter and the previous quarter was the amount that FNBC claimed on its books as a portfolio adjustment for the current quarter’s deferral.

C. Preparation for the Adjustment

The starting point in calculating the administrative costs adjustment was the swap department’s annual budget, as approved by the swap department’s senior management. In order to arrive at the amount of salaries, bonuses, and benefits (collectively, personnel costs) to allocate to its administrative costs adjustment calculation, FNBC multiplied its personnel costs by a fraction. The fraction’s numerator equaled the number of full-time equivalent employees (FTEs) estimated to be required to maintain the portfolio to maturity. 37 The fraction’s denominator equaled the total budgeted trading department FTEs. FNBC also allocated to the management of the existing swap portfolio the same percentage of direct costs.

The number of FTEs estimated necessary to maintain the current portfolio to maturity changed during the relevant years as shown below:

FTEs estimated to maintain portfolio FTEs budgeted in trading department Percentage of FTEs used to maintain portfolio Beginning Ending quarter quarter

Unavailable 1/1/1990 3/31/1991

8 12.5% 4/1/1991 9/30/1991

15 10 10/1/1991 12/31/1992 M C7l

26.5 7.5 1/1/1993 9/30/1993 to

24 8.33 10/1/1993 12/31/1993 bO

At the end of 1993, for example, the front office consisted of 24 individuals working as traders, trading assistants, marketers, or managers. Seven of the 24 individuals were traders of interest rate products (more specifically, 1 was the desk head, 2 were traders of U.S. dollar swaps, 1 was a trader of Canadian dollar swaps, 2 were traders of interest rate options, and 1 was engaged solely in modeling). The remaining 17 individuals were financial derivative marketers and trading assistants. For purposes of the fourth quarter of 1993, FNBC’s finance department ascertained that managing the current portfolio of interest rate swaps, commodity swaps, swaptions, and interest rate guarantees would require 2 of the 24 employees (i.e., 8.33 percent). The duties of the FTEs would include making sure that the portfolio remained risk balanced (which would be primarily the responsibility of traders and trading assistants) and attempting to transfer some or all of the portfolio to other swaps dealers (which would primarily require the time of traders and trading assistants, with participation of other trading department personnel as needed), fnbc attributed 8.33 percent of the budgeted front office personnel costs to the management of its portfolio. FNBC also allocated to the management of its portfolio 8.33 percent of the related direct costs.

The swap department’s annual budget included as “indirect costs” amounts that were charged to the swap department by other areas of the bank. The finance department conducted interviews to determine what percentage of each item was attributable to the management of the existing swap portfolio. The percentages used for 1993 were 62 percent of the credit department costs, 25 percent of legal services, 50 percent of audit and finance, 0 percent of R&D, 0 percent of marketing, and 0 percent of corporate utilities. FNBC also charged to the swaps department the indirect costs of additional departments.

The total of all of the expenses attributable to the management of FNBC’s existing swap portfolio represented FNBC’s estimate of the total costs of administering its existing swap portfolio for the upcoming year.

D. Expenses Included in the Adjustment

1. Direct and Indirect Budgeted Costs

The direct and indirect costs of the swap front office used to calculate the administrative costs adjustment included office rent, traders’ salaries and bonuses, all front office expenses, certain miscellaneous costs, costs connected with the Devon system, and retirement and other benefits for front office swap personnel. FNBC did not include the total amounts of these costs but only the portions needed to manage its existing portfolio. FNBC’s administrative costs adjustments for the front office may also have included hedging expenses.

2. Amounts From Other Areas of FNBC

FNBC’s administrative costs adjustment for swaps also included costs from other departments, including: (1) Computer systems; (2) accounting; (3) facilities management; (4) credit process review department; (5) corporate staff from other departments; (6) systems development; (7) general manager; (8) service products group; (9) risk management administration; (10) financial analysis; (11) corporate and institutional banking; and (12) other service charges. These costs, to the extent allocated to swaps and interest rate guarantees, included: (1) Charges from FNBC’s law department, audit department, data processing center, allocable rent (occupancy area), cost to hedge the swaps in existence to maturity, and telephone costs; (2) charges from FNBC’s credit policy group, which set policy on all customer credit transactions, including loans, leasing products and derivatives; (3) charges from management for the credit policy group in addition to other charges from the credit department of FNBC; (4) charges from FNBC’s treasury management group which was responsible for corporate customer cash and other accounts; (5) charges from FNBC’s facilities management section, which maintained the floors, etc., for FNBC’s building, and charges for maintenance of electronic and computer equipment; (6) charges for data processing systems, virtual memory and mainframe computer systems; (7) charges from FNBC’s commercial bank credit area; (8) charges from FNBC’s internal mail and corporate staff; (9) charges from FNBC’s internal audit department and finance department; and (10) charges for high-level expenditures for top-level executives such as, but not necessarily, a corporate jet.

XI. FNBC’s Credit Adjustment

A. Overview

At the inception of each swap, FNBC (through its finance department) determined an initial credit adjustment for that swap. While the midmarket values for each swap were recalculated annually to determine yearend swap values, FNBC never recalculated its credit adjustments for its swaps.

1. Initial and Subsequent Methods

For the relevant years, fnbc used two different methods to calculate its credit adjustments. It used one method from 1990 through the third quarter of 1992. It used a second method for new swaps that arose in the fourth quarter of 1992 through 1993. As to the two methods, FNBC considered the first method to be the more accurate but also believed that the first method was more error prone.

2. First Method

Under the first method, FNBC calculated and recorded a credit adjustment for each swap. FNBC amortized each swap’s credit adjustment over the life of the swap as ascertained by its maturity date. In the event that a swap was terminated or bought out, FNBC included in income all of the remaining credit adjustment attributable to that swap.

3. Second Method

Under the second method, FNBC stopped amortizing the credit adjustments on a per-swap basis over the life of the swap and began applying an aggregate approach of amortization based upon the life of all of the swaps considered initiated in each quarter. For this calculation, FNBC considered each swap to be initiated 1 month after the date when it was actually initiated.

Each quarter, FNBC amortized the credit risk into income on the basis of the life of all the swaps considered initiated during the quarter. FNBC did not make any adjustments in the case of occurrences such as early terminations, changes in mark-to-market amounts, or changes (positive or negative) in the credit rating of a swap counterparty.

a. Methodology

Under the second method, FNBC ascertained its initial credit adjustment through a three-step process. First, as to each swap, FNBC calculated a credit exposure measurement (cem) amount as of the last day of the quarter in which the swap was considered initiated; e.g., if the swap was actually initiated on a day that fell between March 1 and May 31, the initial credit adjustment was calculated on June 30. 38 Second, FNBC assigned the swap counterparty to one of its credit risk rating classes (discussed infra p. 261) and ascertained the corresponding CRESCO 39 loss reserve factor from the credit rating that FNBC had assigned to that CRESCO loss reserve factor. 40 Third, FNBC multiplied the swap’s CEM amount by the counterparty’s CRESCO loss reserve factor to arrive at the swap’s initial credit adjustment. 41

For the period beginning in the fourth quarter of 1992, FNBC accounted for its credit adjustment as follows. First, on the quarterly basis, FNBC reduced income by the credit adjustment for the group of swaps originating in the quarter (with the 1-month lag) 42 and correspondingly reduced the value of assets on the balance sheet. Second, FNBC amortized the credit adjustment back into income on a straight-line basis. FNBC’s stated policy was that, on schedules before June 1993, it would amortize the credit adjustments into income over the average term of deals executed during the quarter for the applicable product. 43 For June 1993 and after, FNBC’s stated policy was that it would amortize the credit adjustments into income over the weighted average term of deals executed during the quarter for the applicable product in the quarter. FNBC actually computed the weighted average term for the applicable product only in the fourth quarter of 1993. For the remaining quarters of 1993, FNBC calculated the weighted average term for all products combined.

b. Effect of Methodology

Under FNBC’s procedure, the credit adjustments for swaps with shorter-than-average lives, relative to others originated in the same quarter, were amortized into income over a longer term than the life of the swap. The converse was true for swaps with longer-than-average lives. For example, as to the first point, FNBC had a swap with an individual amortization period of 4 quarters that FNBC amortized into income over 10 quarters. As to the second point, for example, FNBC had a swap with an individual amortization period of 56 quarters that FNBC amortized into income over 10 quarters.

B. Swaps in Issue for 1993

1. Identification of Swaps

For purposes of its 1993 credit adjustment calculations, FNBC treated 488 swaps as commencing in 1993. These swaps are identified as follows:

No. treated as No. outstanding at commencing Category yearend 1993 in 1993

IRSWs 1,147 t-00 CO

CYSWs unknown l> CO

COMSs 52 oo H

COMBs unknown co H

Total 488

2. Duration of Swaps

The 488 FNBC swaps had specific durations as follows:

Duration in months No. Duration in months No. Duration in months No.

1 17 26 8 54 2

2 3 27 3 57 2

3 8 28 2 59 3

4 3 29 6 60 36 or 37

5 3 30 5 61 1

6 11 31 2 63 2

7 3 32 3 65 1

8 4 33 3 70 4

9 11 35 7 72 1

10 3 36 53 or 54 78 1

11 1 37 3 79 2

12 78 38 3 83 2

13 1 39 1 84 16

15 1 42 5 85 1

17 1 43 1 89 1

18 9 45 5 90 1

19 3 46 1 119 2

20 9 47 1 120 4

21 6 48 16 124 2

22 6 49 1 168 2

23 7 51 1 173 1

24 81 52 1

Total 488

3. Credit Adjustments Claimed

For 1993, FNBC calculated per-swap credit adjustments with respect to 418 of the 488 swaps. The amount of the credit adjustment calculated by type of swap was as follows:

Category Number Credit adjustment

$718,978 IRSW OO CO

100,884 CYSW CD

7,782 COMS OO H

154,351 COMB CD H

Total 488 • 981,995

In 1993, FNBC decreased its swap values reported for 1993 by credit adjustments totaling $981,995. Of the 488 swaps, (1) 9 were a risk class 1 and had a credit adjustment totaling $6,764; of these, 8 were interest rate swaps, with a combined credit carveout of $6,235; (2) 179 were a risk class 2 and had a credit adjustment totaling $257,654; of these, 135 were interest rate swaps, with a combined credit adjustment of $102,311; (3) 26 were currency swaps with a combined credit adjustment of $11,197; (4) 9 were combination swaps with a combined credit adjustment of $141,527; (5) 8 were commodity swaps with a combined credit adjustment of $1,498; and (6) 1 was a swaption with a credit adjustment of $1,121.

As to the total credit adjustment of $981,995: (1) $93,203 arose from transactions that were not in existence on December 31, 1993; 44 (2) $264,418 arose from transactions with counterparties rated AA or better; (3) $94,421 arose from swaps that had a tenor of 9 months or less; 45 (4) $167,109 arose from swaps on which FNBC did not expect to be the net receiver of cash; and (5) at least $6,338 arose from swaps that were known to have the risk of nonpayment of cashflows offset, in full or in part, by other swaps with the same counterparty.

When FNBC reported credit adjustments on swaps where it had more than one swap with the same counterparty, FNBC did not check to see whether the swaps were mirror or partially offsetting swaps. Credit risk credit adjustments should not be taken on mirror swaps. Credit risk also is reduced on partially offsetting swaps. 46

C. Components of the Second Method

The three components that entered into the calculation of FNBC’s initial credit adjustment under the second method were the: (1) CEM amount, (2) credit risk class rating, and (3) CRESCO loss reserve factor. Each of these components was developed separately and independently for purposes other than valuation and was not used in combination with the other two components for any other business purpose. FNBC developed the CEM amount to measure credit exposure for purposes of risk management and banking regulatory requirements. FNBC developed the risk class system for commercial loan purposes to evaluate the creditworthiness of a borrower. FNBC developed the CRESCO loss reserve factors to meet banking regulatory requirements on loss reserves and capital adequacy requirements.

1. CEM Amount

a. Overview

Expected cashflows from an interest rate swap can vary as interest rates change. When the expected cashflows from a swap change, the credit exposure of one counterparty to the other counterparty usually changes, fnbc’s CEM amount statistically measured fnbc’s maximum potential loss (and not expected exposure) on a swap, over its tenor and at a preselected cutoff number (confidence level), if the counterparty to the swap were to default without recovery by FNBC. The CEM amount at the inception of a swap was significantly higher than the current exposure at the inception of the swap; i.e., the CEM amount was a measure of the maximum that FNBC might receive (lose) on the swap in the future, within a certain confidence level, while the current exposure was a measure of the current value of the swap.

During the relevant years, FNBC ascertained its CEM amounts for financial derivatives by using a system called the VEP system, fnbc’s vep system recalculated the CEM amount at least annually. For transactions where the mark-to-market amount exceeded the CEM amount, the CEM amount was recalculated monthly. FNBC calculated the CEM amount for all swaps. A swap that had a negative value (FNBC was the net payor) always had a CEM amount that was greater than zero.

b. Hsieh Model

FNBC’s initial VEP system was developed for it in the late 1980s by David A. Hsieh (Hsieh). Hsieh designed FNBC’s VEP system for risk management purposes to measure credit exposure on interest rate and currency products in a manner consistent with the rules of the FRB. The VEP system was designed specifically for products with a tenor greater than 18 months and had problems calculating the CEM amount for swaps with shorter maturities. FNBC had retained Hsieh in 1987 to develop for it a model to measure credit exposure for interest rate and currency swaps. In 1988, Hsieh produced a paper which described the model (Hsieh Model) that he developed for FNBC. The Hsieh Model used quarterly historical interest and exchange rates, and the resulting volatilities, correlations, and covariance, to perform a Monte Carlo simulation to estimate a distribution of 10,000 possible outcomes for each quarter throughout the term of a given swap. Hsieh developed two programs for FNBC in 1988. The first program used the simulation model on an individual transaction basis. The second program used the same statistical model but did multiple transactions with the same counterparty and took into account the netting of offsetting transactions with the same counterparties. FNBC did not during the relevant years use the second program.

c. FNBC’s VEP System

i. Evolution of the System

FNBC’s VEP system during the relevant years had evolved from the initial version- designed by Hsieh. Each version of FNBC’s VEP system was based upon the Hsieh Model. The first versions were formulated on tables and were not accessible to traders via direct computer link; i.e., on line. The first table version was a table of values at different confidence levels. The second table version was a series of tables by product, maturity, and confidence level. Each of the table versions produced the maximum number within the chosen confidence level.

The next series of versions of the VEP system were on line. The first version of the on-line system allowed traders to pull up information on their screens. Traders input details of trade, and the machine calculated the exposure numbers based upon the tables then in use. The resulting CEM amount was then added to the customer’s existing credit exposure. During 1993, traders could for purposes of discussions have used tables to calculate the CEM amount or they could have gone on line. For actual transactions, FNBC preferred that the traders and marketers use the on-line system.

ii. Effect of the System

FNBC’s VEP system a

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