Amid growing calls for more derivatives disclosure, the GovernmentalAccounting Standards Board has proposed that states and localities disclose in the notesof their annual financial statements detailed information about the terms and risks ofderivatives contracts such as swaps and swaptions.
The GASB released the proposed guidance Wednesday, asking for public comments on it andsetting a May 16 deadline for receiving those comments. The board hopes to be able toissue final guidance in June that would take effect for governments' fiscal years endingafter June 15, 2003, said Randal J. Finden, GASB project manager.
The board cannot mandate the disclosures, but if the guidance is adopted, issuers willhave to follow it in order to get clean opinions from auditors.
The proposed guidance comes as federal regulators and some market participants havebecome increasingly concerned that issuers and dealers are not disclosing enoughinformation about derivatives.
Martha Mahan Haines, the director of the Securities and Exchange Commission's Office ofMunicipal Securities, has been urging issuers to make sure they understand the risks ofderivatives and to disclose those risks if they are material. She has urged dealers, aspart of their due-diligence responsibilities, to check to see if issuers havederivatives exposures and to ensure those risks are disclosed, if material.
Several members of the National Association of Bond Lawyers said at a meeting in Floridafive weeks ago that they were not seeing much disclosure in this area. The GovernmentFinance Officers Association's debt committee is revising its guidance on derivatives,and the National Federation of Municipal Analysts is developing disclosurerecommendations for derivatives.
Finden said yesterday that the GASB also has been concerned about the lack of, orinconsistency of, disclosure for derivatives, particularly since the market for theseinstruments has exploded as governments try to deal with major fiscal troubles. Whilethe board has issued accounting guidance for derivatives investments, this proposal isits first proposed guidance for derivative contracts or commitments such as swaps andswaptions that are not investments.
"The concern that we have is with interest-rate swaps and swaptions that are notinvestments and are not reported on the statement of net assets on balance sheets," saidFinden. "The disclosures we're seeing are inconsistent, and people have a lot ofquestions about them."
"What we wanted to do is make sure that when investors are reading through the typicalnote disclosures, they should be able to know the who, what, why, when, and how theissuers are doing these things," he said. Investors "will know what is the issuer'sobjective, what are the details and terms of the contract, how long is it going to last,how much is it worth, and is it under water or above water," he said.
Monique Moyer, the chairman of the GFOA's debt committee, said yesterday that shesupports the GASB's efforts, but worries the fair-value disclosures might presentissuers with problems.
"I think it's appropriate for GASB to be looking at this, and they have made an effortto reach out to market participants in working on this," said Moyer, the director of themayor's office of public finance for San Francisco. "I'm very supportive of having afootnote on derivatives disclosures. It won't be perfect, because I think one of theproblems will be figuring out how to value the derivative product each and every annumon the financials."
"Those of us who are doing derivatives need to think about that valuation and thatcalculation when we enter into our derivative contracts, because otherwise we may findourselves with auditors who insist that we follow the same methodology that is requiredto calculate termination value, which would be an inelegant solution," she said.
In its proposed guidance, the GASB is urging states and localities to disclose theirobjectives for entering into derivative contracts. Governments also should disclosetheir strategies for achieving those objectives, the GASB said.
The board said governments should disclose the major terms of the transaction,including: the notional or face amount of the contract; interest rates including caps,floors, or collars; any embedded options; the date that the derivative became effective;and the date the derivative is scheduled to terminate or mature.
Note disclosures also should include the fair value of the derivative at the reportingdate and whether the fair value was based on anything other than quoted market prices,as well as the method and assumptions used to determine the fair value, the GASB said.An appendix to the guidance details acceptable methods for such valuations.
The board proposed that issuers disclose the risks associated with the derivativestransactions, including credit risk, interest rate risk, basis risk, termination risk,rollover risk and market-access risk.
If issuers have exposure to credit risk, the GASB said, they should disclose: the creditratings of counterparties; the extent of diversification among counterparties; themaximum amount of loss that they could occur due to credit risk; any collateral or othersecurities that support the derivatives subject to credit risk; and information aboutany master netting arrangements that are designed to mitigate credit risk.
Interest-rate risk is the risk that interest-rate changes will adversely affect the fairvalues of a government's financial instruments or cash flows, the GASB said in itsguidance. Governments should disclose the terms of derivatives that increase such risks.
Basis risk is the risk that arises when variable interest rates on a derivative and anassociated bond or other interest-paying financial instrument are based on differentindexes, the board said. If an issuer has exposure to such risk, it should disclose thepayment terms of the derivative, as well as of the associated debt, it said.
Termination risk is the risk that a derivative's unscheduled end either forces thegovernment to make potentially significant unscheduled termination payments to thecounterparty or affects the government's asset/liability strategy, the GASB said in theproposed guidance. Issuers should disclose any termination payments that have occurred,any dates on which a derivative may be terminated, and any out-of-the-ordinarytermination events contained in contractual documents, the board said.
Governments also should disclose rollover risk, or the risk that the derivativesassociated with a variable-rate bond that rolls over for 20 or 30 years does not extendto the maturity of that bond, the GASB said. They also should disclose market-accessrisk, or the risk that, if they enter into a swaption, they will not be able to accessthe credit market at the time the swap is to take place.
Further, if a derivative, such as a variable-to-fixed interest-rate swap, is issued withthe intention of effectively making the variable rate of an associated debt obligationpay a synthetic interest rate, then the derivative's net cash flow should be disclosedin addition to the debt service requirements, GASB said.
