# UNITED STATES TAX COURT > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3A4b6fee104b1d4963 ## Record - **Collection:** Agency decision - **Document type:** Agency decision ## Text 120 T.C. No. 11 UNITED STATES TAX COURT BANK ONE CORPORATION (SUCCESSOR IN INTEREST TO FIRST CHICAGO NBD CORPORATION, FORMERLY NBD BANCORP, INC., SUCCESSOR IN INTEREST TO FIRST CHICAGO CORPORATION) AND AFFILIATED CORPORATIONS, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket Nos. 5759-95, 5956-97. Filed May 2, 2003. F, a financial institution, enters into bilateral contracts which are a type of derivative financial product known as interest rate swaps. Most of F’s swaps are of the plain vanilla type where one party (first party) agrees to pay to the other party (second party) amounts ascertained as of certain dates by applying a fixed rate of interest to a set notional amount. The second party agrees to pay to the first party amounts ascertained as of the same dates by applying a floating rate of interest (e.g., LIBOR rate) to the same notional amount. For purpose of the mark-to-market rule of sec. 475(a)(2), I.R.C., which applies to taxable years ended after Dec. 30, 1993, F reported that the fair market value of its swaps as of Dec. 31, 1993, equaled their mid-market values; i.e., the values derived through a net cashflow/present value analysis that was based on the average of each swap’s -2market bid and ask rates. In addition, F deferred the recognition of the difference between its valuation and the bid or ask prices which it paid or received for the swaps, treating that difference as deferred income designed to compensate it for (1) the perceived credit risks of its counterparties and (2) the estimated administrative costs to be incurred on holding and managing the swaps until maturity. F used a similar method to report its swaps income for 1990 through 1992. F ascertained the values of its swaps for each of the years 1990 through 1993 as of a date that was approximately 10 days before the last day of F’s taxable year and reported that value as the swaps’ fair market value as of the last day of that year. R determined that F’s method of reporting its swaps income did not clearly reflect F’s swaps income for any of the years from 1990 through 1993. R determined that a proper method values F’s swaps as of the end of each year at the midmarket values and does not take into account any deferral for credit risk or future administrative costs. Pursuant to sec. 446(b), I.R.C., R changed F’s method of accounting for its swaps income to R’s “proper” method. Held: The mark-to-market rule of sec. 475(a)(2), I.R.C., including the valuation requirement subsumed therein, is a method of accounting that is subject to the clear reflection of income standard of sec. 446(b), I.R.C. Held, further, F’s method of accounting for its swaps income does not clearly reflect its swaps income under sec. 475, I.R.C., in that F’s values were not determined at the end of its taxable years and did not properly reflect adjustments to the midmarket values which were necessary to reach the swaps’ fair market value. Held, further, R’s “proper” method of accounting for F’s swaps income does not clearly reflect that income under sec. 475, I.R.C., in that a swap’s mid-market value without adjustment does not reflect the swap’s fair market value. Held, further, to arrive at the fair market value of a swap and other like derivative products, it is acceptable to value each product at its midmarket value as properly adjusted on a dynamic basis for credit risk and administrative costs. A proper credit risk adjustment reflects the creditworthiness of both parties, with due respect to netting and other credit -3enhancements. A proper administrative costs adjustment is limited to incremental costs. Jay H. Zimbler, John L. Snyder, Michael A. Clark, Michael R. Schlessinger, Bradford L. Ferguson, David M. Schiffman, John Wester, Kevin R. Pryor, Michael M. Conway, Marilyn D. Franson, and Hille R. Sheppard, for petitioner.* Marjory A. Gilbert, Marsha A. Sabin, Joseph P. Ferrick, John W. Rogers III, Charles W. Culmer, Michael O’Donnell, and William Merkle, for respondent. CONTENTS FINDINGS OF FACT............................................. 14 I. II. Background....................................... 14 A. Stipulations of Fact........................... 14 B. Briefs on CD-ROM With Appropriate Hyperlinks... 14 C. Relevant Taxpayers............................. 15 1. FCC....................................... 15 2. First Chicago NBD Corp.................... 15 3. FNBC...................................... 15 4. Bank One Corp............................. 16 The Swaps Business............................... 17 A. Swaps in General............................... 17 1. Definition of a Swap...................... 17 * Brief of amici curiae was filed by Leslie B. Samuels and Edward D. Kleinbard as counsel for the American Bankers Association, the Institute of International Bankers, the International Swaps and Derivatives Association, Inc., the Securities Industry Association, the New York Clearing House Association L.L.C., and the Wall Street Tax Association. -42. 3. Swaps Are Derivative Financial Products... 17 Types of Swaps in the Marketplace......... 19 B. Origin and Growth of the Swaps Market.......... 19 1. Origin of the Market...................... 19 2. Growth of the Interest Rate Swaps Market.. 20 C. Interest Rate Swaps............................ 21 1. Terms of an Interest Rate Swap Agreement.. 21 2. Notional Principal Amount and Related Terms..................................... 21 3. Different Types of Interest Rates......... 23 4. Use of LIBOR as a Floating Interest Rate Index..................................... 23 5. Plain Vanilla Interest Rate Swaps......... 25 6. Lack of Payments at Inception............. 27 7. Example of an Interest Rate Swap.......... 27 D. Currency Swaps................................. 28 E. Participants in the Market..................... 29 1. End Users................................. 29 a. Typical End Users.................... 29 b. End Users’ Uses of Interest Rate Swaps................................ 30 i. Combat Interest Rate Changes.. 30 ii. Prosper From Market Forecast.. 31 iii. Reduce Cost of Funding........ 32 2. Dealers................................... 32 a. Typical Dealers...................... 32 b. Practice as to Swaps................. 33 c. Price Quotations..................... 33 d. Role in the Market................... 34 e. Need for Strong Credit .............. 35 3. Brokers................................... 35 F. Market for Swaps............................... 36 1. Types of Markets.......................... 36 a. Primary Market....................... 36 b. Secondary Market..................... 36 2. Brokers’ Dissemination of the Dealers’ Quotations................................ 37 a. Daily Quotations..................... 37 b. No Dissemination of Actual Swap Prices.......................... 39 c. Spreads Included in Quotations....... 39 3. Midmarket Rate............................ 42 4. Midmarket Swap Curve...................... 43 -55. 6. III. ISDA Form Agreements...................... 44 Assignments and Buyouts of Swaps.......... 47 G. Risks Assumed by Dealers....................... 48 1. Types of Risks............................ 48 2. Techniques Used To Minimize Credit Risk... 48 3. Techniques Used To Minimize Market Risk... 49 H. Dealer Spreads................................. 50 1. Bid-Ask Spread............................ 50 2. Bid-to-Mid Spread......................... 50 3. Example................................... 50 4. Significance of Spreads................... 51 5. Decline in Interdealer Spreads............ 52 Valuing Swaps.................................... 52 A. Relevant Valuation Standards................... 52 1. Fair Market Value......................... 53 2. Market Value.............................. 53 3. Fair Value................................ 53 B. Mark-to-Market Accounting...................... 54 C. Devon System and the Devon (Midmarket) Value... 54 1. Devon System.............................. 54 2. Devon (Midmarket) Value................... 55 3. Yield Curve............................... 56 a. Overview............................. 56 b. Constructing the Curve............... 57 c. Imprecise Measure.................... 58 D. Market Value................................... 58 1. Net Present Value–-Forward Rate Pricing... 58 a. Expected Cashflows................... 59 b. Discounting Expected Cashflows....... 59 2. Floating-Rate Note Method................. 60 3. Value at Origination...................... 61 4. Change in Market Value.................... 62 E. Primary Financial Reporting Methods............ 63 1. Overview.................................. 63 2. Amortized Cost............................ 63 3. Current Market Value...................... 64 4. Lower of Cost or Market................... 64 F. Relevant Standards of the FASB................. 65 1. The FASB and GAAP......................... 65 -62. 3. 4. 5. IV. Initial Role of Market Values in GAAP..... 65 SFACs..................................... 66 Change in Accounting Treatment............ 67 SFASs..................................... 68 a. SFAS No. 105......................... 69 b. SFAS No. 107......................... 69 c. SFAS No. 119......................... 70 d. SFAS No. 133......................... 71 G. Methods of Valuing Swaps....................... 71 1. Bid-Ask Method............................ 71 2. Midmarket Method.......................... 72 3. Adjusted Midmarket Method................. 72 H. Nontax Purposes for Which Dealers Value Swaps.. 73 1. Overview.................................. 73 2. Regulatory Reporting...................... 73 3. Risk Management........................... 75 4. Management Reporting...................... 75 5. Financial Reporting and Pricing........... 76 I. The G-30....................................... 76 1. Overview.................................. 76 2. G-30’s Review of Industry Practices....... 77 3. G-30 Report............................... 78 4. BC-277.................................... 79 Adjustments to Midmarket Value................... 81 A. Overview....................................... 81 B. Administrative Costs Adjustment................ 82 1. Overview.................................. 82 2. Dealers’ Practice......................... 82 3. Use of the Dealer’s Own Costs............. 83 C. Adjustment for Counterparty Credit Risk........ 83 1. Overview.................................. 83 2. Common Method of Calculating Adjustment... 84 a. Counterparty Credit Rating........... 84 b. Expected Loss Factor................. 85 c. Loan Equivalency..................... 85 i. Overview...................... 85 ii. Types of Credit Exposure...... 85 A. Current Credit Exposure.... 86 B. Potential Credit Exposure.. 86 C. Expected Exposure.......... 87 -7- 3. D. iii. OCC’s Position................ 87 iv. Methods Used To Calculate...... 87 Market Data for Pricing Credit Risk of Bonds..................................... 88 Other Adjustments.............................. 89 1. Investing and Funding Costs............... 89 2. Closeout Costs (Liquidity)................ 90 3. Dealer Margin............................. 90 V. Los Alamos Project............................... 91 VI. FNBC’s Swaps Business............................ 93 A. Overview....................................... 93 B. Trading Desks.................................. 94 C. Swaps Operations Personnel..................... 95 1. Overview.................................. 95 2. Traders................................... 96 a. Function............................. 96 b. Number Employed in Chicago........... 97 c. Practice as to Quotations............ 97 d. Risk Management Responsibility....... 98 3. Marketers................................. 99 a. Function............................. 99 b. Practice as to Quotations............100 4. Relationship Managers.....................100 5. Credit Officers...........................101 D. Weak Credit Rating.............................101 E. Quoting a Price................................102 F. Buyouts........................................103 G. Swaps Outstanding at Yearend...................104 H. Swaps in Issue.................................104 VII. FNBC’s Financial Accounting Practice.............106 VIII. FNBC’s Practice as to Its Valuation of Its Swaps.106 A. Financial Reporting Position...................106 B. Uses of Valuation..............................107 -8C. IX. X. XI. RAP/GAAP.......................................108 FNBC’s Calculation of Midmarket Value............108 A. FNBC’s Devon System............................108 1. Overview..................................108 2. Role of FNBC’s Devon System...............109 B. Accounting for Devon Value.....................109 C. Early Closing Date.............................111 FNBC’s Administrative Costs Adjustment...........112 A. Overview.......................................112 B. Calculation of the Adjustment..................114 C. Preparation for the Adjustment.................116 D. Expenses Included in the Adjustment............118 1. Direct and Indirect Budgeted Costs........118 2. Amounts From Other Areas of FNBC..........119 FNBC’s Credit Adjustment.........................120 A. Overview.......................................120 1. Initial and Subsequent Methods............120 2. First Method..............................121 3. Second Method.............................121 a. Methodology..........................121 b. Effect of Methodology................123 B. Swaps in Issue for 1993........................124 1. Identification of Swaps...................124 2. Duration of Swaps.........................124 3. Credit Adjustments Claimed................125 C. Components of the Second Method................127 1. CEM Amount................................127 a. Overview.............................127 b. Hsieh Model..........................128 c. FNBC’s VEP System....................129 i. Evolution of the System.......129 ii. Effect of the System..........130 iii. System’s Operation............131 2. Credit Risk Ratings.......................133 a. System of Risk Classification........133 -9- 3. XII. b. Credit Procedures....................134 c. Review of Risk Classifications ......136 CRESCO Loss Reserve Factors...............137 a. Loss Reserves........................137 b. CRESCO...............................137 c. Accuracy of CRESCO Loss Factors......138 d. Same Factors Applied to Loans an Swaps................................139 e. FNBC’s Credit and Tenor Enhancements.139 D. Static Instead of Dynamic Procedure............141 E. Netting........................................142 1. Types of Netting..........................142 a. Closeout Netting.....................142 b. Single Transaction Netting...........143 c. Multiple Transaction Netting.........143 2. Netting in the Industry...................143 3. Status of Netting Arrangements............144 4. Practicability of Accounting for Netting..146 5. Impact of the Failure To Account for Netting...................................146 6. FNBC’s Use of Netting Provisions..........147 FNBC’s Adjustments Were Designed To Defer Income.147 A. Overview.......................................147 B. FNBC’s Policy Statements.......................147 XIII. FNBC Had No Schedule M Adjustments...............148 XIV. Nature and Amount of the Proposed Disallowances..148 XV. Petitioner’s Facts Set Forth in Its Petition.....149 XVI. Pretrial Order of August 14, 2000................151 XVII. Expert Testimony.................................152 A. Identity and Qualifications....................152 1. Experts Retained by Petitioner............152 2. Experts Retained by Respondent............153 3. Experts Appointed by the Court............155 B. Procedure Used by the Court To Appoint Our Experts........................................156 -10OPINION......................................................159 I. Overview.........................................159 II. Does Section 475 Involve a Method of Accounting?.162 A. Overview.......................................162 B. Identification of a Method of Accounting.......164 III. Burden of Proof..................................169 IV. Tax Accounting for Methods of Accounting.........172 V. FNBC’s Mark-to-Market Book Method................179 VI. VII. A. Mark-to-Market Method Acceptable for Section 475............................................179 1. Acceptable in Theory......................180 2. Acceptable In Practice....................183 a. Market Valuation of Inventories......183 b. Comprehensive Mark-to-Market Accounting...........................184 B. Standard of the Mark-to-Market Method Is Not Reasonableness.................................189 Application of Fair Market Value.................198 A. Overview.......................................198 B. History of the Term “Fair Market Value”........200 C. Determination of Fair Market Value.............204 1. Market Approach...........................205 2. Income Approach...........................205 3. Asset-Based Approach......................206 D. Fair Market Value Compared With Fair Value.....206 1. Meaning of the Term “Fair Value”..........206 a. GAAP Purposes........................206 b. State Law Purposes...................206 2. Difference Between Fair Market Value and Fair Value................................207 3. Conclusion................................211 Property To Be Valued............................211 -11VIII. Applicable Valuation Date........................214 IX. Proper Hypothetical Market.......................215 X. FNBC Implemented Its Mark-to-Market Method Inconsistently With Section 475..................219 A. Overview.......................................219 B. Midmarket Values...............................220 C. Adjustments in General.........................221 D. Credit Adjustment..............................223 1. Need for a Credit Adjustment..............223 2. One-Month Lag in Reporting Swaps..........226 3. Credit Ratings of Both Counterparties.....227 4. Midmarket Values Reflected AA Counterparties............................230 5. Credit Enhancements.......................231 6. Netting...................................232 7. Static or Dynamic Procedure...............233 8. Confidence Levels.........................235 9. Mirror and Partially Offsetting Swaps.....236 10. Per-Swap Adjustments......................236 E. Administrative Costs...........................237 1. Overview..................................237 2. Incremental Costs.........................238 3. Use of Own Costs..........................239 F. Other..........................................239 XI. Respondent’s Method of Accounting................240 XII. Conclusion.......................................242 XIII. Postscript–-Weight Given to Expert Testimony.....244 A. Role of the Experts............................244 B. Court’s Impression of the Experts..............246 Appendix A...................................................249 Appendix B...................................................254 -12LARO, 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. 17) 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 1 Whereas the parties sometimes use the term “adjustment” to refer to the carveouts discussed herein, so do we. -13using 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 4462 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) 2 Unless otherwise indicated, section references are to the applicable versions of the Internal Revenue Code, and Rule references are to the Tax Court Rules of Practice and Procedure. -14under 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. B. We find the stipulated facts accordingly. 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. -15C. 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, FCC’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 -16version 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 FCC’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. effective October 2, 1998.3 The merger was 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. 3 Shortly thereafter, the Court, pursuant to an unopposed motion by petitioner, ordered that the caption be changed to the present caption. -17II. 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. -18Other 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. future. Swaptions are options to purchase a swap in the 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 4 During the relevant years, FNBC was a party to swaps as well as to one or more of these financial derivatives. 5 An interest rate collar is essentially an interest rate cap combined with an interest rate floor. -19interest 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 agreedupon 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. 6 A forward rate is a rate that the parties to a forward contract agree will be applied at a future date. Assume, for example, that a person agrees to borrow money 1 year from today and repay it with 6-percent interest at the end of the second year. The 6-percent interest rate is a forward rate, and the contract is a forward contract. 7 During the relevant years, FNBC was a party to each type of these swaps. The specific swaps in dispute are FNBC’s interest rate swaps, currency swaps, and commodity swaps. -20That 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 8 The outstanding notional principal of currency swaps at the end of 1999 is estimated at approximately $2 trillion. -21are 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 -22parties’ 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 9 Nor is the notional amount shown on either party’s balance sheet. 10 The negotiated fixed rate is sometimes called the price of the swap. 11 Assume, for example, that C agrees to pay to B a fixed interest rate in return for B’s agreeing to pay to C an interest rate that floats in accordance with a certain floating interest rate index. C is the buyer of the swap (and is long on the swap). B is the seller of the swap (and is short on the swap). -23termination 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 -24rate 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, 3month, 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. 12 A zero rate means that interest, if paid, is paid only at maturity. -25In 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 -26exactly 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. 13 The expression “structured swap” is used to capture any swap with specially tailored features. Relatively new and unfamiliar types of swaps are called “exotics”. 14 An amortizing swap mimics the fixed and floating interest rate schedules on regular amortizing loans. -276. 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 Fixed rate Floating rate Effective date Termination date Payment dates Fixed-rate payor Floating-rate payor Day count conventions 1 $1 million 5 percent per annum 6-month LIBOR rate Dec. 1, 1992 Dec. 1, 1995 June 1 and Dec. 1 of each year F L Actual/3601 The computations as to swaps are generally based on a 360-day year, a convention that is common in banking. -28The 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 6/1/1993 12/1/1993 6/1/1994 12/1/1994 6/1/1995 12/1/1995 D. Number of Days in Fixed Period Payment 182 183 182 183 182 183 Hypothetical 6-Month LIBOR Rate Floating Payment Net Cashflow To L (To F) 4.0% 4.320 5.130 5.901 6.210 6.842 $20,222 21,960 25,935 29,997 31,395 34,780 ($5,056) (3,457) 657 4,580 6,117 9,363 $25,278 25,417 25,278 25,417 25,278 25,417 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 -29floating 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 15 A swap must also meet three other requirements in order to qualify for such an exception. First, the swap may not be part of a fungible class of agreements which are standardized as to their material economic terms. Second, the creditworthiness of any party having an actual or potential obligation under the swap agreement must be a material consideration in entering into or determining the terms of the swap agreement. Third, the swap agreement may not be entered into or traded on a physical or electronic transaction execution facility in which participants can simultaneously effect transactions and bind both parties. -30b. 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 -31rate. 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. 16 An entity that borrows at a floating rate and then buys a fixed-for-floating swap of matching maturity and notional principal is said to have synthetically created a fixed-rate loan; i.e., the net of the payments on the floating-rate loan and the swap mirror the payments on a fixed-rate loan. -32iii. 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 17 In performing this market-making function, dealers act more as principals than as agents in transactions. -33movements. 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. -34Among 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. -35e. 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. -36F. 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 -37restrictions,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. 43) assumed that the counterparty was a dealer with a credit 18 For example, a swap may be assigned only upon the consent of both parties thereto. -38rating 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. 19 Participants in the swaps market generally rated counterparties using standard credit ratings obtained from private credit rating agencies such as Moody’s and Standard & Poor’s (S&P). Each agency had its own set of ratings. The ratings offered by S&P for long-term debt were (from best to worst) AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, BB+, BB, BB-, B+, B, and B-. (For clarity, we refer only to the S&P ratings.) In 1992, most swaps dealers had a credit rating of A or better, and many of those dealers had ratings of AA or AAA. -39b. 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. Maturity U.S. Treasury Yield Bid Spread Swap Bid Rate 2-year 3-year 5-year 7-year 10-year 4.57% 5.06 6.00 6.37 6.69 .24 .37 .30 .33 .32 4.81% 5.43 6.30 6.70 7.01 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 -40December 31, 1992, for U.S. dollar denominated swaps with maturities of 1 year or less. Maturity LIBOR Deposit Rate 1-day 1-month 3-month 6-month 9-month 1-year 3.125% 3.313 3.438 3.625 3.813 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 1-month 3-month 6-month 9-month 1-year 2-year 3-year 5-year 7-year 10-year ------------4.81% 5.43 6.30 6.70 7.01 3.125% 3.313 3.438 3.625 3.813 4.062 ----------- 3.125% 3.313 3.438 3.625 3.813 4.062 4.810 5.430 6.300 6.700 7.010 -41The diagram below shows the swap bid curve drawn from these swap bid and LIBOR deposit rates. -423. 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. -434. 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. of these curves is implied by the other. Each Each point on either curve can be derived by a mathematical formula from the corresponding point on the other curve. 20 This implied concept is A discount factor states the value today of $1 to be received on a future date. -44different 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. 21 The ISDA form agreements generally provided a As discussed infra p. 60, the midmarket value of a swap also can be calculated as the difference between the value of two specific bonds, both of which have a principal amount equal to the notional amount of the swap. The first bond is a floating-rate bond. The second bond is a fixed-rate bond paying a fixed interest rate equal to the fixed interest rate of the swap. -45statement 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 -46credit 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 22 Notwithstanding the terms of a particular swap, a party thereto could synthetically terminate any swap by entering into an offsetting or mirror swap; i.e., a new swap with terms identical to those in the remainder of an existing swap, but with the payments reversed. The parties also could mutually agree to terminate a swap with one party paying the other in a buyout. -47dealers 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 -48swaps. 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 -49requirement, 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 -50various 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 1. 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 -51spread is 4 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 2 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 midmarket 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 23 A basis point is 0.01 percent. -52was 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 3-year 4-year 5-year 6-year 7-year 8-year 9-year 10-year 13.000 22.333 24.333 20.000 26.666 39.666 32.000 32.333 32.333 15.666 25.000 27.000 23.000 29.666 43.000 34.666 35.000 35.000 14.333 23.666 25.666 21.500 28.166 41.333 33.333 33.666 33.366 1.333 1.333 1.333 1.500 1.500 1.667 1.333 1.333 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. -531. 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 24 The common industry practice of valuing swaps does not consider differences in the credit ratings of investment grade counterparties. -54users.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 25 Most State statutes also usually define the term for purposes of valuing dissenting stockholders’ appraisal rights and, sometimes, for purposes of valuing property in cases of marital dissolution. As discussed below, that definition is not applicable here. 26 SunGard Systems International, Inc., a subsidiary of SunGard Data Systems, Inc., acquired Devon Systems International, (continued...) -55commonly 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 26 (...continued) Inc., in 1987. Devon Systems International, Inc., changed its name to SunGard Capital Markets, Inc., in 1992. On Jan. 2, 1998, SunGard Data Systems, Inc., acquired Infinity Financial Technology, Inc. (IFT), a financial derivatives trading and risk management company. SunGard Data Systems, Inc., merged IFT and its existing related Renaissance Software and SunGard Capital Markets to form a new operating group named Infinity, A SunGard Company. Infinity now maintains and licenses the Devon software. 27 Each FNBC trader filled out a “trade ticket” for each transaction in which he or she had responsibility. This ticket, which listed all of the essential facts of the transaction, was then transmitted to the back office to input those facts into FNBC’s Devon system and to prepare the related confirmation letter. -56market 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. yield curve, which was usually a zero-coupon yield curve The -57appropriate 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. -58c. 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. expected net cashflows are determined. First, the Second, these expected cashflows are discounted to produce a present value. -59a. Expected Cashflows The table below shows the forecasted future cashflows as of December 1, 1992, on the swap illustrated supra p. 27. 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. Payment Dates Number of Days in Period Fixed Payment 12/1/1992 6/1/1993 12/1/1993 6/1/1994 12/1/1994 6/1/1995 12/1/1995 182 183 182 183 182 183 $25,278 25,417 25,278 25,417 25,278 25,417 b. Forecasted Forecasted Net Cash Implied Forward Floating Flow Rate Payment From (To) FNBC 4.000% 4.262 5.098 5.813 6.379 6.921 $20,222 21,664 25,772 29,549 32,250 35,180 ($5,056) (3,753) 494 4,132 6,972 9,763 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 discount factors for each cashflow. The fifth column shows The total present value of the swap is $10,148 as of December 1, 1992. -60Forecasted Net Cash Payment Fixed Payment Floating Payment Flow Discount Dates (from FNBC) (to FNBC) (to FNBC) Factor 6/1/1993 12/1/1993 6/1/1994 12/1/1994 6/1/1995 12/1/1995 Total $25,278 25,417 25,278 25,417 25,278 25,417 —-- 2. $20,222 21,664 25,772 29,549 32,250 35,180 --- ($5,056) (3,753) 494 4,132 6,972 9,763 --- .9852 .9643 .9401 .9131 .8845 .8545 --- Present Value Floating Net Cash Fixed Payment Payment Flow (from FNBC) (to FNBC) (to FNBC) $24,903 24,509 23,762 23,207 22,359 21,718 140,458 $19,922 20,890 24,227 26,980 28,526 30,061 150,606 ($4,981) (3,619) 465 3,773 6,167 8,343 10,148 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. events. The two approaches yield the same result in all -613. 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 -62ready 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. -63E. 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. the swap equals the total cashflows. Income over the life of -643. 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. -65F. 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 -66company’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 -67historical 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 28 One concern with the transaction-based Before 1990, financial accounting standards mentioned swaps only in the context of hedging. Statement of Financial Accounting Standards (SFAS) No. 52 mentions currency swaps used as hedges to reduce risk from currency fluctuations and discusses (continued...) -68system 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. 28 As part of that (...continued) the appropriate accounting for such hedges. SFAS No. 52 does not discuss the appropriate accounting for nonhedging swaps such as those at issue. -69project, 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 -70requirements 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 -71of 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 non-hedging 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. 76) 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 -72long 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 29 Most people in the industry during the relevant years referred to the midmarket value of a swap as its “market value”. -73risk, future administrative costs, hedging costs, investing and funding costs, closeout costs, and liquidity (each discussed infra p. 81). 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 1. 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 -74and 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. -753. 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 -76sheets, 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. 30 It FNBC also did not rely upon its credit adjustments to set employee bonuses. -77is 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. incorporated into the G-30 report. These surveys were -783. 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 Appendix II Working Papers, dated July 1993 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 midmarket 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 -79portfolio. 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. stated on the cover page: In relevant part, it -80PURPOSE 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. * * * * * * * * * * 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. -81Adjustments 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 are 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 -82cashflows, (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. -833. Use of 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. -84Although 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. -85b. 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 [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3A4b6fee104b1d4963. Public record. Not legal advice.