State and local governments could be required to disclose in financial statements theirexposure to derivatives under new accounting rules being considered by the GovernmentalAccounting Standards Board.
Under the proposed policy, states and municipalities would have to disclose theiroverall exposure to swaps, swaptions, and other derivatives in footnotes of financialstatements by estimating the fair value of the deals or the costs of terminating them.
"For those active in the market it will be significant," said GASB project manager RandyFinden. "We'll have a better understanding of what they are doing. I think we are goingto be pretty well consistent with what Wall Street is asking for."
If the proposal - which was first reviewed by the GASB board last week - is adopted, therules would go into effect after June 15. Finden said the board would review theproposal for a second time next month and then a draft would be released for publiccomments. GASB cannot mandate the disclosure requirements, but issuers would have tofollow them to get a clean opinion from an auditor.
The disclosure proposal comes as the use of derivatives has expanded widely in themunicipal market; by one estimate the volume of swaps on bonds has reached $400 billion.At the same time, investors, rating agencies, and others in the industry have called fornew standards for disclosing information on derivative deals.
Eventually GASB could require that governments also take into account in their financialstatements the value of their swaps and the effectiveness of using derivatives to hedgerisk. The value of swaps, which are used to alter interest rate exposure and can reducethe interest cost of debt, goes up and down as interest rates rise and fall.
Finden said GASB would begin looking at accounting for swaps, which he characterized asa long-term project, in the spring.
Last year, the Financial Accounting Standards Board began requiring corporations to markto market their swaps and account for the effectiveness of their hedges under acontroversial rule called FAS 133.
The policy also applied to issuers in the municipal market such as hospitals andutilities that use corporate accounting standards.
The FASB policy was also controversial in the municipal market because it treated TheBond Market Association municipal swap index as a more risky benchmark than the LondonInterbank Offered Rate.
Other than some limited guidance issued in 1994 by GASB, governmental issuers have hadlittle guidelines for disclosing derivative deals and accounting for the costsassociated with those deals in their financial statements. In the municipal market, mostderivatives are floating-to-fixed-rate swaps, in which the issuer sells floating ratedebt and in a long-term contract with a financial company swaps to a fixed rate.
If GASB's new policy is adopted, state and local governments would at the very least berequired to show in their annual financial statements overall exposure to swaps. Findensaid under the existing proposal, GASB would require issuers to come with a fair valueof their swaps or a projected cost of terminating deals they have done.
The proposed policy was developed with input from Wall Street, which appears to supportthe change. "All of this information is good," said Nathaniel R. Singer, senior managingdirector in municipal capital markets at Bear, Stearns & Co. "To the extent issuersdisclose more information, it only means investors are going to be more comfortable."
Singer pointed out that there is more than sufficient technology and expertise to valuethe termination cost for a swap, though he insisted such events were rare. Terminationrisk is considered one of the main risks in interest rate swaps, along with basis riskand counterparty risk.
Recently, other groups have been pushing for greater disclosure. Rating agencies havebegun incorporating swap exposure into their credit rating analyses, though no issuerhas been downgraded as a result of risky deals. In addition, the Municipal SecuritiesRulemaking Board has launched a review of derivatives and the National Federation ofMunicipal Analysts is considering developing recommended disclosure practices for suchtransactions.
The Securities and Exchange Commission's muni chief has urged both underwriters andissuers to disclose any risks associated with derivatives if they would be material toan investor's investment decision.
Also, National Association of Bond Lawyers members said at a meeting last week thatissuers should begin considering disclosing any information on derivatives that ismaterial on a transaction-by-transaction basis in official statements as well ascumulatively in annual financial secondary market disclosure. This would be accomplishedunder GASB's proposed policy.
