The Bond Market Association is urging the Governmental Accounting Standards Board toallow state and local governments to disclose the aggregate amount of their exposure tointerest rate swaps in their financial statements.
This is one of several modifications that TBMA yesterday asked GASB to make in its drafttechnical bulletin on derivatives disclosures. The bulletin, which was issued in earlyApril and is to be finalized next month, calls for municipal issuers to disclose in thenotes of their financial statements detailed information about the terms, risks, andfair value of their derivatives contracts such as swaps and swaptions.
But in a two-and-a-half-page letter sent to GASB yesterday, TBMA said the drafttechnical bulletin "should be clarified to permit aggregation of derivatives bycategory, e.g. interest rates, foreign currency, commodities, etc." Associationofficials said they are not trying to minimize derivatives disclosures.
"You'd just be aggregating exposures, which is perfectly appropriate," said GaryKillian, the head of TBMA's new-products division, who is also managing director andhead of the municipal products division at Lehman Brothers. "If the issuer's convertedall of its fixed-rate debt to floating, you want to know what's going to happen to theissuer's cost of debt if rates go up 50 basis points."
"Aggregation of positions for governments that have large derivative positions willsimplify the reporting requirements while providing users with an understanding of theoverall derivative positions and any related risks," the letter said.
It also said that GASB "should consider limiting the definition of a derivative tofreestanding derivatives," rather than embedded derivatives, because "the identificationof embedded derivatives is complex."
"The board should consider embedded derivatives and related disclosures, if any, as partof its ongoing project on derivatives," the letter said. TBMA was referring to GASB'sproject to determine whether state and local governments should include derivatives asassets or liabilities on their balance sheets, and, if so, how to account for hedging.
Killian said that TBMA's use of the term "embedded derivatives" is meant to coveroptions for the investor that are embedded in bonds, such as call dates, and does notmean swaps issued together with bonds.
"What the market has come to know as a swap between the issuer and a counterparty needsto be disclosed," he said. "What doesn't need to be disclosed is the value of the calloption on the issuer's debt, for example."
TBMA also said that disclosures about termination risk "should be required only when thecounterparty can unilaterally terminate the derivative or when it is probable that thecounterparty will request to terminate the derivative and the government will acceptsuch request."
The letter said GASB's calls for disclosures about credit risk "should be revised toinclude only a qualitative discussion about how credit risk is monitored and mitigated,including collateral, master-netting arrangements, counterparty diversity, andcounterparty credit ratings."
"A qualitative discussion will allow government entities to better explain theirstrategy on credit risk, and will be more meaningful to users than a strictly quantitiespresentation," the association said.
The letter urged GASB not to require the disclosure of maximum credit loss "withoutconsideration of collateral," warning that without taking into account collateral thiswould not be a meaningful disclosure.
In the draft guidance, GASB requires disclosure of the maximum amount of loss due tocredit risk - based on the fair value of the derivative - that the government mightincur due to counterparty default.
But TBMA said: "We would recommend that the language be clarified to show that the fairvalue of the derivative should be based on the current market value (mark-to-market),and not on assumed market values if rates move up or down. As written, the maximumamount of loss due to credit risk is technically unlimited."
The association said that several of its members were concerned that some of GASB'smethodology for calculating fair value seems to be based on how taxable swaps arevalued.
"To value a tax-exempt swap, the cash flows are discounted at LIBOR rather than at therate itself," the letter said. "As written, tax-exempt swaps would be valued bydiscounting at tax-exempt rates, when in fact they are valued by discounting at taxable(LIBOR) rates."
TBMA said in its letter that its comments are intended to help issuers and investors."We write solely to offer comments and observations on making these disclosures lessburdensome for the governmental entity and more useful to end users," the letter said.
As currently drafted, GASB's derivatives disclosure guidance would be effective forissuers' fiscal years ending after June 15. The Government Finance Officers Associationis trying to get GASB to push back the effective date.
