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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

II.

Background....................................... 14

Stipulations of Fact........................... 14

Briefs on CD-ROM With Appropriate Hyperlinks... 14

Relevant Taxpayers............................. 15

1. FCC....................................... 15

2. First Chicago NBD Corp.................... 15

3. FNBC...................................... 15

4. Bank One Corp............................. 16

The Swaps Business............................... 17

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.

Swaps Are Derivative Financial Products... 17

Types of Swaps in the Marketplace......... 19

Origin and Growth of the Swaps Market.......... 19

1. Origin of the Market...................... 19

2. Growth of the Interest Rate Swaps Market.. 20

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

Currency Swaps................................. 28

Participants in the Market..................... 29

1. End Users................................. 29

a. Typical End Users.................... 29

b. End Users’ Uses of Interest Rate

Swaps................................ 30

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

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.

III.

ISDA Form Agreements...................... 44

Assignments and Buyouts of Swaps.......... 47

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

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

Relevant Valuation Standards................... 52

1. Fair Market Value......................... 53

2. Market Value.............................. 53

3. Fair Value................................ 53

Mark-to-Market Accounting...................... 54

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

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

Primary Financial Reporting Methods............ 63

1. Overview.................................. 63

2. Amortized Cost............................ 63

3. Current Market Value...................... 64

4. Lower of Cost or Market................... 64

Relevant Standards of the FASB................. 65

1. The FASB and GAAP......................... 65

-62.

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

Methods of Valuing Swaps....................... 71

1. Bid-Ask Method............................ 71

2. Midmarket Method.......................... 72

3. Adjusted Midmarket Method................. 72

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

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

Overview....................................... 81

Administrative Costs Adjustment................ 82

1. Overview.................................. 82

2. Dealers’ Practice......................... 82

3. Use of the Dealer’s Own Costs............. 83

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

Overview...................... 85

ii.

Types of Credit Exposure...... 85

A. Current Credit Exposure.... 86

B. Potential Credit Exposure.. 86

C. Expected Exposure.......... 87

-7-

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

Los Alamos Project............................... 91

VI.

FNBC’s Swaps Business............................ 93

Overview....................................... 93

Trading Desks.................................. 94

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

Weak Credit Rating.............................101

Quoting a Price................................102

Buyouts........................................103

Swaps Outstanding at Yearend...................104

Swaps in Issue.................................104

VII.

FNBC’s Financial Accounting Practice.............106

VIII.

FNBC’s Practice as to Its Valuation of Its Swaps.106

Financial Reporting Position...................106

Uses of Valuation..............................107

-8C.

IX.

XI.

RAP/GAAP.......................................108

FNBC’s Calculation of Midmarket Value............108

FNBC’s Devon System............................108

1. Overview..................................108

2. Role of FNBC’s Devon System...............109

Accounting for Devon Value.....................109

Early Closing Date.............................111

FNBC’s Administrative Costs Adjustment...........112

Overview.......................................112

Calculation of the Adjustment..................114

Preparation for the Adjustment.................116

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

Overview.......................................120

1. Initial and Subsequent Methods............120

2. First Method..............................121

3. Second Method.............................121

a. Methodology..........................121

b. Effect of Methodology................123

Swaps in Issue for 1993........................124

1. Identification of Swaps...................124

2. Duration of Swaps.........................124

3. Credit Adjustments Claimed................125

Components of the Second Method................127

1. CEM Amount................................127

a. Overview.............................127

b. Hsieh Model..........................128

c. FNBC’s VEP System....................129

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-

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

Static Instead of Dynamic Procedure............141

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

Overview.......................................147

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

Identity and Qualifications....................152

1. Experts Retained by Petitioner............152

2. Experts Retained by Respondent............153

3. Experts Appointed by the Court............155

Procedure Used by the Court To Appoint Our

Experts........................................156

-10OPINION......................................................159

Overview.........................................159

II.

Does Section 475 Involve a Method of Accounting?.162

Overview.......................................162

Identification of a Method of Accounting.......164

III.

Burden of Proof..................................169

IV.

Tax Accounting for Methods of Accounting.........172

FNBC’s Mark-to-Market Book Method................179

VI.

VII.

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

Standard of the Mark-to-Market Method Is Not

Reasonableness.................................189

Application of Fair Market Value.................198

Overview.......................................198

History of the Term “Fair Market Value”........200

Determination of Fair Market Value.............204

1. Market Approach...........................205

2. Income Approach...........................205

3. Asset-Based Approach......................206

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

FNBC Implemented Its Mark-to-Market Method

Inconsistently With Section 475..................219

Overview.......................................219

Midmarket Values...............................220

Adjustments in General.........................221

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

Administrative Costs...........................237

1. Overview..................................237

2. Incremental Costs.........................238

3. Use of Own Costs..........................239

Other..........................................239

XI.

Respondent’s Method of Accounting................240

XII.

Conclusion.......................................242

XIII.

Postscript–-Weight Given to Expert Testimony.....244

Role of the Experts............................244

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

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)

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

Background

Stipulations of Fact

Many facts were stipulated.

We incorporate herein by this

reference the parties’ stipulations of fact and the exhibits

submitted therewith.

We find the stipulated facts accordingly.

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

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.

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.

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.

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).

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.

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

Swaps in General

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.

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

During the relevant years, FNBC was a party to swaps as

well as to one or more of these financial derivatives.

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.

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.

Origin and Growth of the Swaps Market

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.

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.

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.

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.

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

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.

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.

Interest Rate Swaps

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.

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

Nor is the notional amount shown on either party’s balance

sheet.

The negotiated fixed rate is sometimes called the price

of the swap.

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.

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.

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.

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.

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.

Plain Vanilla Interest Rate Swaps

Interest rate swaps may be of the plain vanilla type.

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

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.

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.

The expression “structured swap” is used to capture any

swap with specially tailored features. Relatively new and

unfamiliar types of swaps are called “exotics”.

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.

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 million

5 percent per annum

6-month LIBOR rate

Dec. 1, 1992

Dec. 1, 1995

June 1 and Dec. 1 of each year

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.

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

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.

Participants in the Market

The main participants in the interest rate swaps market are

end users, dealers, and brokers.

End Users

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

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

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.

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.

Dealers

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

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.

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.

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.

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.

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

Types of Markets

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.

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.

Brokers’ Dissemination of the Dealers’ Quotations

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

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.

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.

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.

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.

ISDA Form Agreements

The International Swaps and Derivatives Association, Inc.

(ISDA), formerly known as the International Swaps Dealers

Association, Inc., is a trade body that comprises swaps dealers

and other participants in the OTC derivatives market.

The ISDA

prescribed customized ISDA form agreements for swap transactions,

and these form agreements were in widespread use during the

relevant years.

The ISDA form agreements generally provided a

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.

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.

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

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.

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.

Risks Assumed by Dealers

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.

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.

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.

Dealer Spreads

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.

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.

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.

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

A basis point is 0.01 percent.

-52was different than the rate that the dealer had negotiated on the

interdealer swap.

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

15.666

25.000

27.000

23.000

29.666

43.000

34.666

35.000

14.333

23.666

25.666

21.500

28.166

41.333

33.333

33.666

33.366

1.333

1.500

1.667

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

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.

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

Fair Value

The term “fair value” is typically used in the accounting

world and is directed to the needs of financial statement

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.

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.

Devon System and the Devon (Midmarket) Value

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

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.

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.

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

(...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.

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.

Yield Curve

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.

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.

Market Value

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

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

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

—--

$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.

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

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.

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.

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.

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

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).

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.

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.

Change in Accounting Treatment

Until recently, accounting for non-exchange-traded financial

assets had typically been on the basis of amortized cost.

For a

traditional fixed-rate loan, for example, the amortized cost

value of the loan would be (1) the original amount lent, net of

any repayments, plus (2) accrued interest at the contractually

specified rate.

With the exception of actual default, amortized

cost valuation was not sensitive to changing market conditions

such as changes in interest rates or changes in the asset’s

credit risk.

Financial innovation during the 1980s and 1990s created a

need for better information than reported by the traditional

transaction-based system.

With encouragement from the Securities

and Exchange Commission (SEC), the FASB began in the early 1990s

to consider greater use of market values in accounting for

financial instruments.28

One concern with the transaction-based

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.

SFASs

From in or about March 1990 through June 1998, the FASB

worked on its financial instruments project.

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).

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.

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.”

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.

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.

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.

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.

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.

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

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.

Nontax Purposes for Which Dealers Value Swaps

Overview

Swaps are valued for a number of nontax purposes.

These

purposes include regulatory reporting, risk management,

management reporting, financial reporting, and pricing.

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.

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

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.

The G-30

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.

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.

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.

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:

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

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.

Administrative Costs Adjustment

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.

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.

Adjustment for Counterparty Credit Risk

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.

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.

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.

Loan Equivalency

Overview

A bank would typically establish a credit limit for each

customer, and the loan equivalency measurement of credit exposure

was used by banks in applying credit limits.

The loan

equivalency amount focused on the bank dealer’s expected credit

exposure from a specific counterparty with which it had entered

into one or more swaps.

The loan equivalency amount represented

the amount of the counterparty’s credit limit, as established by

the bank, that was consumed by each swap.

In other words, the

exposure model determined the number of swaps that the bank could

enter into with the counterparty and stay within the prescribed

credit limit.

ii.

Types of Credit Exposure

The concept of credit exposure was broken into current

credit exposure and potential credit exposure.

There also is a

third type of credit exposure known as “expected exposure”.

-86A.

Current Credit Exposure

A bank dealer’s current credit exposure on any day was the

net present value of the amount that the bank expected to receive

under a swap agreement as ascertained from current interest rate

projections.

In other words, a bank’s current credit exposure

was the midmarket value of a swap, to the extent that the

midmarket value was positive.

Potential Credit Exposure

A bank dealer’s potential credit exposure was the most that

it could lose on a swap.

Although it was possible to ascertain

the amount that a bank would lose if interest rates reached

unthought-of heights such as 20 percent or higher (or, in other

words, a bank’s “maximum exposure”), banks generally did not

consider their maximum exposure because they did not believe that

interest rates would rise to those unexpected levels.

The

concept of potential credit exposure was reformulated to measure

the most that a bank could lose with a set level of confidence

(e.g., a 95-percent certainty).

The degree of conservatism

increased with an increase in the number used as the confidence

level; e.g., the use of a 20-percent confidence level was less

conservative than the use of a 50-percent confidence level.

The G-30 report recommended that potential credit exposure

be calculated using broad confidence intervals (e.g., two

standard deviations) over the remaining terms of the

-87transactions.

An interval of two standard deviations corresponds

to a 95-percent confidence level.

Expected Exposure

Expected exposure is the mean exposure which is used for

valuing credit risk.

iii.

OCC’s Position

BC-277 stated that for risk management purposes every bank

should have a system to quantify “current exposure (‘mark-tomarket’) as well as potential credit risk due to possible future

changes in applicable market rates or prices (‘add-on’).”

BC-277

stated further that “This methodology should produce a number

representing a reasonable approximation of loan equivalency, that

is, the amount of credit exposure inherent in a comparable

extension of credit.”

iv.

Methods Used To Calculate

Complex models were used to measure credit exposure for

interest rate swaps.

Initially, some swaps dealers measured

potential exposure using a scenario approach.

They would analyze

a limited number of future interest rate scenarios and track the

value of the swap over time to determine the maximum amount at

risk if the counterparty were to default.

Under this approach,

the worst case scenario was regarded as the potential exposure.

This approach had many deficiencies, and, by the 1990s, most

dealers were trying to develop more sophisticated tools.

-88One common approach during the relevant years for estimating

credit exposure was a Monte Carlo simulation.

The basic idea of

this approach was to construct a mathematical model to simulate

thousands of variations of future movements of a certain interest

rate (e.g., 6-month LIBOR rate) and, for each variation, to

calculate the credit exposure at numerous points (e.g., every 3

months over the life of the swap).

The model generated a

probability distribution of exposure amounts for each swap, which

was used to calculate maximum exposures for multiple confidence

intervals.

Market Data for Pricing Credit Risk of Bonds

The credit quality of an issuer of bonds affects the fair

market value of the bonds.

If a bond is traded, this

relationship can be directly observed in the price of the bond.

Data on the market prices of traded bonds can be used to

estimate the fair market value of nontraded bonds, inclusive of

any premium or discount that should be applied for credit risk.

Public databases exist which gather information on the traded

prices and yields for bonds with different credit ratings and at

different maturities.

This information is gathered, and an index

of yields is constructed.

The value of a nontraded bond is

calculated by discounting the promised cashflows at the yield for

the index of comparably rated bonds with the same maturity.

-89The observable quality spread in the bond markets makes it

possible to calculate an appropriate adjustment for credit

quality.

Assume, for example, that a U.S. Treasury bond priced

at $101.25 would have an estimated fair market value of $99.83

if, instead, it was a like bond issued by an AAA-rated

corporation.

The $1.42 difference between the two bonds is the

credit adjustment for an AAA-rated bond issuer.

If the same bond

would have had an estimated fair market value of $98.91 if it had

been a like bond issued by an A-rated corporation, the $2.34

difference between the price of the Treasury and A-rated bonds is

the credit adjustment for an A-rated bond issuer.

The 92-cent

difference between the estimated fair market values of the

AAA-rated bond and the A-rated bond is the incremental credit

adjustment as of the date of valuation.31

Other Adjustments

Investing and Funding Costs

The G-30 report recommended an adjustment for investing and

funding costs for portfolios that are not “perfectly matched”.

This adjustment, the G-30 report stated, relates to “the costs of

funding and investing cashflow mismatches at rates different from

the LIBOR rate which models typically assume”.

This adjustment

is also mentioned in BC-277.

The market price of credit risk fluctuates over time.

-902.

Closeout Costs (Liquidity)

The G-30 report recommended an adjustment for closeout

costs.

The closeout costs (liquidity) adjustment reflects the

cost to buy out, assign, or otherwise unwind one or all of the

reporting entity’s swaps.

The need for a closeout costs adjustment is relatively

strong in some cases.

Midmarket pricing from models based on the

prices of benchmark instruments that are liquid overstates the

pricing of assets that are exotic, or infrequently traded, or

have a limited set of potential buyers.

Such assets should be

marked down for their liquidity.

During the relevant years, no sound or implementable

approaches existed as to close out costs adjustments.

Nor did

many entities (including FNBC) make closeout costs adjustments

during those years.

Dealer Margin

The fair market value of a swap (inclusive of profit) is not

normally zero at inception.

Dealers capture profits on the

origination of swaps, especially swaps with end users.

As a

result, the fair market value of a swap between a dealer and an

end user is generally positive at origination.

The midmarket

value of a swap at origination often includes the present value

of the dealer’s expected profit on the transaction.

-91The adjusted midmarket method generally did not include an

adjustment for the dealer’s profit margin.

Nor did FNBC’s

implementation of that method include such an adjustment.

Los Alamos Project

In 1994, the Commissioner entered into a contract with the

Los Alamos National Laboratory under which the Los Alamos

scientists (including quantum physicists and mathematicians) were

to develop in the form of software a sophisticated model to

assist the Commissioner in valuing interest rate swaps, currency

swaps, and other financial derivative products for which mark-tomarket reporting was required under section 475.

This software

was intended to produce a narrow range of values for swaps that a

revenue agent could use as a litmus test for ascertaining whether

a more thorough audit would be necessary as to a dealer’s

valuation of its swaps.

The Commissioner contemplated that a

more detailed audit would be required if the dealer’s valuation

fell outside the range of values.

The Los Alamos team was to address during the first 12

months of the project the following nine issues:

Address security and disclosure issues. –- Some of

the data required in the model development must

use sensitive unclassified information about

taxpayers’ market transactions. Procedures must

be put in place to handle these requirements.

Determine how the various forms of tax information

data are handled and its impact on models. –- For

example much of the data on transaction is only

available in paper format. In this case

-92statistical methods need to be used to account for

the transactions; this will need to be allowed for

in the models.

Many of these models will require historical data

on price, interest rates, economic indicators,

company reports and analyst estimates. This data

is available from several vendors who need to be

identified and form of feeds established.

Develop pricing models for interest rate and

currency swaps, allowing proper determination of

zero coupon rates and pricing based on the

floating and fixed rate side. Perform

benchmarking.

Identify list of other significant derivatives for

which to begin modeling efforts. –- Discuss with

the IRS which of the many derivative securities

should be focused on. This activity will help set

the framework for model development of subsequent

securities.

Determination of platform to use in the field. It

is strongly recommended that this be a windows

driven system. Many of the models developed will

require a large computing platform. The way to

handle this is to have a software package on the

field agent’s computer that would remotely log

into the larger machines.

Non-linear models for interest rate yield curve

predictions. –- Yield curve models are central to

the valuation of these securities, issues

associated with these must be addressed early in

the game.

Credit risk models and their incorporation into

swap pricing. -- In a similar fashion to yield

curve models credit risk or the risk of defaulting

on a contract must be addressed.

Implement a working system that has a basic set of

models with the look and feel of future systems.

-- Test in house a beta version of system to be

implemented.

-93The Los Alamos team spent the most time for the software

project on developing strong foundations for pricing plain

vanilla swaps, which were the bulk of instruments traded in the

market.

The Commissioner believed that strong foundations for

building models in these instruments had to be established first

before models could be built for the more complicated nongeneric

products.

After having spent more than 3 years and at least $2.6

million on the Los Alamos Project, the Commissioner suspended the

project in late 1997 primarily because of budgetary constraints.

There were internal concerns about computer spending during this

time and a particular concern about additional funding for the

project because any product that was developed would require

subsequent budgeting for costs connected to Los Alamos’s need to

fine-tune the product.

VI.

FNBC’s Swaps Business

Overview

FNBC began dealing in interest rate and currency swaps in

1983 and began dealing in commodity swaps in 1989.

To date, FNBC

has traded in at least 17 currency markets, including U.S.

dollars, Canadian dollars, Australian dollars, deutschmarks,

sterling, yen, Swiss francs, ECU’s, and pesetas.

FNBC is an

innovator of interest rate products and is a leading provider in

-94commodity derivatives including commodities such as oil, zinc,

copper, and natural gas.

On the basis of notional principal amounts outstanding, FNBC

was the 16th largest swaps dealer in the world in 1993.

On a

consolidated basis, the notional principal amounts of FNBC’s

outstanding swaps at the end of 1990, 1991, 1992, and 1993

totaled $59.4 billion, $78.8 billion, $84.5 billion, and $114.9

billion, respectively.

For all of FNBC’s worldwide interest rate

derivative business, its return on equity for global derivative

products in 1992 and 1993 was 30 percent and 33.9 percent,

respectively.

During the relevant years, FNBC entered primarily into

interest rate swaps.

As of July 31, 1993, approximately 95

percent of the total number of deals in FNBC’s portfolio were

plain vanilla swaps and options.

Trading Desks

During the relevant years, FNBC had swap trading desks in

Chicago, London, Tokyo, and Sydney.

The swap traders at the

Chicago trading desk handled primarily interest rate swaps

denominated in U.S. or Canadian dollars and, to a lesser extent,

currency swaps, commodity swaps, and combination swaps.

The

Chicago office also traded many products other than swaps

including, but not limited to, interest rate guarantees, FRAs,

-95Government securities, municipal bonds, high yield debt, and

asset-backed securities.

The Chicago office booked (i.e., held and risk-managed) all

swaps the notional principal amounts of which were denominated in

U.S. or Canadian dollars.

Swaps booked in Chicago but

originating outside of FNBC’s Chicago office (e.g., at the London

office32) were known as “linked deals”.

Linked deals are a type

of internal contract that transfers the external exposure on a

swap, as well as the responsibility for cashflows and market

risk, from one FNBC trading office to another.

In order to book

in Chicago a deal originating in another office (e.g., London),

FNBC entered into a mirror swap with the origination office to

transfer the swap from the origination office to Chicago.

Carveouts for linked deals were claimed at the linked office;

i.e., the office that held and risk-managed the swap.

Swaps Operations Personnel

Overview

During the relevant years, FNBC’s swap operation was divided

into a front office and a back office.

The front office

consisted of (1) traders, (2) marketers, (3) financial engineers

who designed new instruments and structured transactions, and

(4) the support staff for the first three categories of

The London office specialized in the trading of European

and Asian currencies.

-96employees.

The back office (also known as the swaps operations

group) ensured the integrity of the paperwork on FNBC’s swaps and

other multiple trading products.

The back office, among other

things, verified that swap master agreements were executed, that

confirmations on swap transactions were received, and that

periodic payments on swaps were properly transacted.

Traders

Function

FNBC’s traders were the individuals who on behalf of FNBC

negotiated and entered into swap transactions with other dealers

or brokers.

In order to effect these transactions, FNBC’s

traders usually dealt directly with the brokers or with their

(FNBC’s traders’) counterparts at the other dealers.

In swaps

with other dealers, including brokered transactions and those

swaps which a dealer entered into for its own use (e.g., to hedge

its own books), the FNBC trader usually determined the final

price for the swap and was authorized to enter into the

transaction without specific credit approval if sufficient credit

limits had already been established for the counterparty/dealer.

If the counterparty was strictly an end-user, as opposed to a

dealer acting either as a dealer or as an end user, the FNBC

trader would not deal directly with the counterparty.

Rather, a

marketer would handle negotiations with the counterparty after

-97checking with the trader as to the potential pricing of the

transaction.

During the relevant years, FNBC generally required its

traders to use ISDA documentation for its swaps, and its swaps

were subject to ISDA conventions.

Number Employed in Chicago

FNBC’s Chicago swap operation employed three traders of

interest rate swaps and one other individual, the head of the

trading desk, who supervised these three traders.

Two of the

three traders traded U.S. dollar denominated interest rate swaps,

and the third trader traded Canadian dollar denominated interest

rate swaps.

One of the two traders of U.S. dollar denominated

interest rate swaps traded short-term swaps, and the other traded

long-term swaps.

Practice as to Quotations

FNBC’s traders typically quoted the same bid and ask rates

for all potential counterparties rated A- or better.

FNBC’s bid

and ask quotes were driven by the market bid and ask quotes and

the risk position of FNBC’s portfolio.

FNBC’s traders agreed to

the terms of a plain vanilla interest swap in a matter of

seconds.

In pricing potential swap transactions, FNBC’s traders

attempted to determine where the market was at that time and,

given their views on interest rate movement, price their swaps on

-98the basis of supply and demand.

They gauged the market by

looking at various sources (e.g., yields on Treasury securities,

broker quotes of swap spreads over relevant Treasury instruments,

and Eurodollar futures prices) to determine points on the

interest rate yield curve.

Some of the requisite information

underlying these sources was reflected in FNBC’s Devon system.

FNBC’s traders often used the information provided by the Devon

system as a starting point in pricing.

Risk Management Responsibility

Each FNBC trader was responsible for maintaining his or her

aggregate positions within various market risk parameters.

The

traders risk-managed their portfolios subject to the trading

limits set by those market risk parameters.

In risk-managing

their portfolios, the traders used daily risk profiles and

Devon-system-generated daily profit and loss statements for

swaps.

These profiles and statements listed midmarket values and

did not include administrative costs adjustments or credit

adjustments.

FNBC’s traders were limited on the amount of

interest rate exposure that they could assume on behalf of FNBC

by a risk point system.

That risk point system was based upon

the profit/loss estimates that FNBC’s Devon system provided given

a certain basis point movement in interest rates.

Whenever FNBC and a counterparty reached agreement on the

price of a new swap, the trader would begin the process of

-99attempting to hedge some or all of the market risk taken in the

transaction.

The trader usually hedged its swaps with other

swaps as well as with futures and Government securities such as

Treasury securities.

In some cases, the trader decided to leave

a position unhedged for a period of time or did not enter into a

specific hedging transaction.

In those cases, the transaction

was already adequately balanced, in whole or in part, by other

transactions in the trader’s portfolio or was entered into to

balance the existing portfolio.

Marketers

Function

FNBC’s marketers were the individuals who on behalf of FNBC

negotiated and entered into swaps with nondealer end users.

order to effect these transactions, FNBC’s marketers dealt

directly with the nondealer end users, but only after checking

with a trader as to the potential pricing of the transaction.

The marketers were assigned groups of customers (e.g., financial

institutions) and were responsible for locating nondealer

customers that wanted to enter into swaps.

The marketers

promoted FNBC’s swaps business to its end-user customers and

educated potential clients on the products FNBC offered and how

the products could help the clients.

-100b.

Practice as to Quotations

FNBC’s marketers negotiated the best price (within the

limits set by a trader) for any swap with a nondealer end-user

but needed the approval of an FNBC trader for any negotiated

price as to the swap.

The marketer would communicate to an FNBC

trader the terms of a proposed swap for a nondealer end-user

customer and obtain a price quote.

The marketer could build in

an additional spread but could not decrease the price quoted by

the trader without the trader’s approval.33

The trader had to

sign the trade ticket and, in so doing, took on all

responsibility for risk-managing the swap.

The marketer had no

responsibility for risk management.

Relationship Managers

Each customer of FNBC had an assigned FNBC relationship

manager who was responsible for generating business from the

customer and overseeing FNBC’s dealings with the customer.

The

relationship manager was not part of the group that included swap

traders and marketers.

Marketers worked with the relationship

managers to explain to customers how they could benefit from

using FNBC’s swap products.

Relationship managers had overall

responsibility for all of the customers’ transactions (e.g., bond

A client that received many services from an FNBC

marketer might allow the marketer to add to the spread to pay for

the services.

-101issuances, letters of credit, loans, financial derivative

transactions).

Credit Officers

An FNBC credit officer was assigned to each swap

counterparty.

Before a swap could be entered into with that

counterparty, the credit officer had to approve the

counterparty’s credit and give the counterparty a credit exposure

limit (credit line).

Credit officers did not work in the swap

department and were not part of the group that included swap

traders and marketers.

Nor was the credit approval process a

function of the swap traders and marketers.

The credit line for financial derivative products was known

as the variable exposure product (VEP) limit (VEPL).

If a VEPL

had already been established for a counterparty, and a new swap

was within that limit, then no additional credit approval was

needed.

If the credit exposure of a swap exceeded the available

VEPL, or if no VEPL had been approved, then the trader had to

obtain credit approval from the credit officer.

Weak Credit Rating

FNBC was a major participant in the swaps market during the

relevant years but was considered in that market to have weak

credit.

FNBC’s credit rating was downgraded to A- in or about

the fall of 1990.

This downgrade was generally viewed poorly

among persons or entities dealing with or considering dealing

-102with FNBC, and it hurt FNBC’s ability to enter into new swaps.

FNBC’s end-user customers were worried about having periodic

payments that would be due to them from a lower rated dealer.

Some banks required collateral provisions in their swap

agreements with FNBC because they were a better credit risk than

FNBC and were not allowed to take on any risk.

Quoting a Price

FNBC’s practice at the start of each business day was to

announce to brokers its bid and ask quotations on interdealer

generic swaps.

During the course of the day, FNBC’s traders

would receive calls from brokers informing the traders that the

brokers had a particular dealer that wanted to enter into a swap

at one or more of FNBC’s quoted rates.

The broker would not

identify the other dealer until FNBC agreed in principle to the

terms of the swap.

Once FNBC learned the other dealer’s

identity, it would decide whether to go forward with the swap, in

view of the other party’s credit rating and the credit limit that

FNBC had established for the counterparty.

FNBC generally went through two steps in deciding what price

to quote on a specific swap (whether with a dealer or an end

user).

First, FNBC calculated (usually on its Devon system) the

midmarket rate that would result in both legs of the swap having

the same present value.

Second, FNBC added (or subtracted) a

spread to arrive at its ask (or bid) price.

In pricing a swap,

-103the spreads which FNBC factored into its traders’ bid and ask

quotes were constrained by competition.

On most transactions,

particularly those with other financial institutions and large

corporations, the customer obtained quotes from many different

dealers, and FNBC was unlikely to get the business if another

dealer offered better terms.

Where FNBC dealt with an end user

on a transaction that was particularly customized, or where the

customer was not likely to obtain prices from other sources,

FNBC’s marketers sometimes sought to realize additional profit on

the transaction by quoting a larger spread.

FNBC’s marketers

usually were not able to get a larger spread from FNBC’s end

users.

In the rare cases where they were able to get a larger

spread, it was in the nature of a fee for the cost of explaining

swaps to the customer or for other services.

Buyouts

FNBC’s interest rate swaps were easily terminated during the

relevant years by way of buyouts.

FNBC regularly and

continuously sought to, and did, buy out swap transactions in

which it was a party.

Both end users and dealers came to FNBC to buy out their

swaps with FNBC.

FNBC’s traders and marketers were asked to (and

did) quote prices for early termination of swaps by way of

buyouts.

FNBC marketed its swaps to customers as financial

instruments that could be easily bought out or terminated at

-104market value; i.e., the difference in the present value of the

anticipated net cashflows from each of the swap’s legs.

FNBC

required as a matter of practice that the buyout price be at

least the midmarket value.

FNBC was willing to enter into

buyouts at the midmarket value even if there was not a profit to

FNBC.

Approximately 12 percent of FNBC’s swaps business in March

1993 was buyouts.

Approximately 23 percent of FNBC’s swaps

business in June 1993 was buyouts.

Swaps Outstanding at Yearend

Without consideration of any swaps booked in the London

branch, FNBC had 1,020 interest rate swaps (without an embedded

feature) outstanding at the end of 1991; 1,290 at the end of

1992; and 1,147 at the end of 1993.

Without consideration of any

swaps booked in the London branch, FNBC had 19 commodity swaps

outstanding at the end of 1991; 19 at the end of 1992; and 52 at

the end of 1993.

Swaps in Issue

The parties have settled all pleaded issues with respect to

swaps booked through FNBC’s London branch, and no issues have

been raised as to swaps booked through the Tokyo or Sydney

office.

The swaps at issue originated at the Chicago trading

desk or were booked through FNBC’s other desks and linked to the

Chicago desk.

The disallowed amounts encompass all adjustments

-105on all swaps which were on the books of FNBC’s Chicago office at

each yearend and all adjustments used to reduce FNBC’s swaps

income.

With respect to all of FNBC’s swaps which it designated as

interest rate swaps, 95 percent of them were plain vanilla U.S.

dollar denominated interest rate swaps with standardized terms.

The remaining 5 percent were mainly exotic swaps that included:

(1) Amortizing or accreting swaps; (2) constant maturing swaps

(i.e., an interest rate swap in which the floating rate is tied

to a long-term constant maturity Treasury bond yield); (3) basis

swaps; and (4) forward-start swaps (interest rate swaps that

specify a future start date).

The remaining 5 percent also

included Canadian dollar denominated interest rate swaps, all of

which, during the relevant years, were plain vanilla.

During

1993, FNBC generally entered into fewer than 10 Canadian dollar

denominated interest rate swaps a week.

During 1990 and 1991, the counterparties to FNBC’s interest

rate financial derivative products were from the following

categories:

Bank dealers

Bank end users

Corporate end users

FCC, FNBC and its branches,

its affiliates, and its own

subsidiaries

1990

1991

33%

32%

100

100 (rounded)

-106VII.

FNBC’s Financial Accounting Practice

During the relevant years, FNBC’s financial accounting

practice with respect to the pricing and valuation of commodity

swaps, currency swaps, and combination swaps did not differ

significantly from its financial accounting practice with respect

to interest rate swaps.

FNBC used a three-step process to

determine the value of its swaps for financial accounting

purposes.

First, on a swap-by-swap basis, FNBC generally

calculated each swap’s midmarket value (usually from the Devon

system but sometimes from the midmarket swap curve) and

recalculated these midmarket values daily.

Second and third,

FNBC calculated credit and administrative costs adjustments as to

the swaps.

FNBC’s administrative costs adjustments (which were

computed on a portfolio basis) included an adjustment for hedging

and may have included an adjustment for funding and cost of

capital.

FNBC did not take an adjustment for the cost to close

out (liquidate) its swaps.

VIII.

FNBC’s Practice as to Its Valuation of Its Swaps

Financial Reporting Position

The 1993 Annual Report of FNBC and its parent FCC described

their accounting policy for financial derivative instruments as

follows:

Accounting for Derivative Financial Instruments

Derivative financial instruments used in trading and

venture capital activities are valued at prevailing

-107market rates on a present value basis. Realized and

unrealized gains and losses are included in noninterest

income as trading account profits, foreign exchange

trading profits and equities securities gains. Where

appropriate, compensation for credit risk and ongoing

servicing is deferred and taken into income over the

term of the derivatives. Any gain or loss on the early

termination of an interest rate swap used in trading

activities is recognized currently in trading account

profits.

This description related exclusively to the income

statements and the balance sheets.

It is different from the

description used for the fair value disclosure in the footnotes,

which omitted any reference to adjustments for administrative

costs and/or credit risk.

FNBC used midmarket values for SFAS

No. 107 footnote disclosure purposes, and it used adjusted

midmarket values for other financial reporting purposes.

Uses of Valuation

FNBC was required to value its swaps in conformance with

regulatory accounting principles (RAP), GAAP, and Federal income

tax laws.

Tax considerations were not a factor when FNBC

determined how it would calculate the value of its swaps, and

FNBC did not consult with anyone to ascertain whether its

adjustments were appropriate for section 475 purposes.

Tax

considerations were not mentioned when the valuation methodology

was presented to FNBC and its parent’s board of directors.

Midmarket values were used in the presentation to the board.

There is no line item on any report that FNBC filed with the

OCC that set forth, or specifically identified, the amount of

-108administrative costs or credit adjustments FNBC reported for

regulatory purposes.

RAP/GAAP

In some cases, RAP can differ from GAAP, with RAP/GAAP

differences referring to the differences between the reporting

required for regulatory purposes and the reporting required for

GAAP.

IX.

FNBC conducted RAP/GAAP reconciliations.

FNBC’s Calculation of Midmarket Value

FNBC’s Devon System

Overview

FNBC first used the Devon system in 1989.

FNBC was one of

the first users of the Devon system, and Devon modified its

system specifically for FNBC.

FNBC’s customization of its Devon

system changed repeatedly from 1989 through February 1993.

FNBC’s Devon system never took into account the bilateral nature

of swaps or FNBC’s relatively weak credit rating for a dealer in

the interdealer swaps market.

FNBC needed the Devon system to handle the thousands of

transactions it had on its books.

FNBC used the Devon system to

calculate a midmarket value for each of its swaps.

FNBC also

used its Devon system to value all of its other financial

derivatives.

In the relevant years, FNBC’s Devon system used

discount factors for entities with the equivalent of AA credit

ratings.

The Devon system’s use of a discount rate applicable to

-109an AA-rated entity took into account the risk of nonpayment of

the cashflows by an AA-rated entity.

Role of FNBC’s Devon System

The Devon system had a critical role in FNBC’s risk

management and hedging operations.

The Devon system was used by

FNBC’s Chicago office traders to risk-manage and to hedge their

swaps.

The Devon system calculated not only the current

mid-market value for the book, but also how much the value would

change with particular interest rate movements.

Accounting for Devon Value

At least monthly, FNBC recorded the change in the midmarket

value of a performing swap in two pieces.34

The first piece,

described by FNBC as the accrual,35 reflected a proportion of the

next scheduled net cashflow.

This accrual of interest was

computed by multiplying the amount of the net interest payment by

a fraction.

The fraction’s denominator was the number of days in

the payment period (the period between the scheduled cashflows or

FNBC removed “nonperforming VEP transactions” (discussed

infra p. 148) from its trading portfolio and valued these swaps

at a “modified lower of cost or market”.

In the accounting sense, an “accrual” is the process of

recognizing noncash events or circumstances as they occur, not

necessarily when cash is paid or received. Accrued assets or

liabilities and the related revenues, expenses, gains, or losses

represent amounts expected to be received or paid in the future.

Common examples of accruals include (1) purchases and sales of

goods or services on account and (2) unpaid but incurred amounts

of interest, rent, wages, salaries, and taxes.

-110from the start of the swap to the first scheduled cashflow, if

that was the first period).

The fraction’s numerator was the

number of days in the accrual period.

If the next scheduled net

cashflow was a cash receipt, then FNBC basically recorded an

increase in a receivable and a corresponding entry for realized

trading income.

If the next scheduled net cashflow was a cash

payment, then FNBC basically recorded an increase in a payable

and a corresponding entry to realized trading loss.

FNBC reduced

the receivable (or payable) when the scheduled net cashflow was

received (or paid).

The second piece, described by FNBC as the revaluation,

recorded the change in the midmarket value minus the accrual just

discussed.

The sum of the two pieces equaled the change in the

midmarket value.

At the first valuation date after the start of

the swap, the change in midmarket value equaled the midmarket

value (i.e., the previous value was zero).

If the change in the

midmarket value minus the accrual was an increase, then FNBC

recorded an increase in its asset balance for swaps and a

corresponding entry for unrealized trading income.

If the change

in the midmarket value minus the accrual was a decrease, then

FNBC recorded a decrease in its asset balance for swaps and a

corresponding entry for unrealized trading loss.

An effect of this manner of accounting for the midmarket

value was that no single account recorded the midmarket value of

-111a swap.

Rather, the midmarket value was the cumulative sum of

accruals plus revaluations which related to the swap.

Early Closing Date

FNBC did not value its swap portfolio as of its yearend (or

its last business day) but as of a date slightly before yearend

(early closing date).

Typically, the early closing date was on

or about the 20th day of the month; e.g., FNBC determined the

value of its portfolio as of December 31, 1993, on the basis of

the midmarket values on December 20, 1993.36

FNBC adjusted its

books for periodic payments made during the period between the

early closing date and yearend, but did not adjust its books for

changes in valuation from the early closing date to yearend.

FNBC did not consider those changes in valuation material from

the viewpoint of the entire operations of FNBC (and not just from

the viewpoint of FNBC’s swaps operation).

FNBC had an internally imposed accounting schedule that

dictated its use of the early closing date.

FNBC had a rigid

deadline under which it would close its books on the second

business day after the end of a month.

In the early 1990’s, FNBC

attempted to value its swaps as of the last day of the month but

Significant valuation changes occurred from the close of

business on Dec. 20, 1993, through the close of business on

Dec. 31, 1993. In the case of one swap, for example, FNBC

reported that the midmarket value for that swap was $104,233 as

of Dec. 20, 1993. The swap had a midmarket value of $97,721 as

of Dec. 31, 1993, or, in other words, a decrease of 6.2 percent

in the 11 days.

-112encountered problems under which it had difficulty meeting its 2business-day deadline.

The Devon system, for example, did not

automatically post to the general ledger, and thousands of

entries had to be entered manually each month.

Because FNBC was

unable to enter all of these entries correctly within 2 business

days after the close of the year, it established the early

closing date.

FNBC’s use of its early closing date was approved by FNBC’s

chief accounting officer, and the stub period adjustments (those

adjustments for the period extending from the early closing date

until the yearend date) were discussed with FNBC’s outside

auditors.

FNBC’s auditors concluded that FNBC’s financial

statements presented fairly, in all material respects, FNBC’s

financial position at yearend.

FNBC’s Administrative Costs Adjustment

Overview

FNBC made an internal forecast of future administrative

costs which it expected to incur in administering its existing

swap portfolio to maturity.

For Federal income tax purposes,

FNBC considered the present value of these costs an adjustment to

the midmarket value of its swaps.

FNBC ascertained its forecast

by (1) projecting future costs to manage the current portfolio of

swaps and interest rate guarantees; (2) reducing the projected

costs in each future year by the proportion of the current

-113portfolio that would mature before the start of the future year,

as ascertained from a “rolloff” schedule; (3) discounting the

future costs to present value; and (4) assigning 30 percent of

future costs to interest rate guarantees and the remaining 70

percent to swaps.

FNBC’s finance department was responsible for computing the

administrative costs adjustment.

Its objective was to ascertain

the costs attributable to administering the existing swaps over

their existing life, assuming that there were no new deals.

of the end of the quarter, FNBC (through its finance department)

calculated the administrative costs adjustment on a portfolio

(rather than swap-by-swap) basis; i.e., FNBC determined the

administrative costs for the entire portfolio and did not compute

or allocate those costs to individual swaps.

FNBC did not

calculate a per-swap administrative expense amount.

For the relevant years, the amounts of the administrative

costs that FNBC estimated were needed to manage its swaps to

maturity were as follows:

Year

Estimated

Administrative Costs

1989

1990

1991

1992

1993

$4,271,337

5,253,337

3,318,920

3,843,770

4,832,469

For Federal income tax purposes, FNBC reported the annual

increases or decreases to these estimated administrative costs as

-114administrative costs adjustments to its midmarket values.

FNBC

reported the following amounts for administrative costs

adjustments (with the negative amounts decreasing the midmarket

values and the positive amounts increasing the midmarket values):

Year

Administrative

Costs Adjustment

1990

1991

1992

1993

($982,000)

1,934,417

(524,850)

(988,699)

The administrative costs adjustment’s net effect on income was to

decrease (or increase) income per books by the net increase (or

decrease) in the aggregate balance of the administrative costs

adjustment.

Calculation of the Adjustment

FNBC’s administrative costs adjustment reflected FNBC’s

estimate of the aggregate of:

(1) Its future budgeted costs

(both direct and indirect) for its swaps business, (2) its future

budgeted costs (both direct and indirect) for the alloca

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