The Bond Market Association is urging the Governmental Accounting Standards Board to allow state and local governments to disclose the aggregate amount of their exposure to interest rate swaps in their financial statements.
This is one of several modifications that TBMA yesterday asked GASB to make in its draft technical bulletin on derivatives disclosures. The bulletin, which was issued in early April and is to be finalized next month, calls for municipal issuers to disclose in the notes of their financial statements detailed information about the terms, risks, and fair 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 draft technical bulletin "should be clarified to permit aggregation of derivatives by category, e.g. interest rates, foreign currency, commodities, etc." Association officials said they are not trying to minimize derivatives disclosures.
"You'd just be aggregating exposures, which is perfectly appropriate," said Gary Killian, the head of TBMA's new-products division, who is also managing director and head of the municipal products division at Lehman Brothers. "If the issuer's converted all of its fixed-rate debt to floating, you want to know what's going to happen to the issuer's cost of debt if rates go up 50 basis points."
"Aggregation of positions for governments that have large derivative positions will simplify the reporting requirements while providing users with an understanding of the overall derivative positions and any related risks," the letter said.
It also said that GASB "should consider limiting the definition of a derivative to freestanding derivatives," rather than embedded derivatives, because "the identification of embedded derivatives is complex."
"The board should consider embedded derivatives and related disclosures, if any, as part of its ongoing project on derivatives," the letter said. TBMA was referring to GASB's project to determine whether state and local governments should include derivatives as assets 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 cover options for the investor that are embedded in bonds, such as call dates, and does not mean swaps issued together with bonds.
"What the market has come to know as a swap between the issuer and a counterparty needs to be disclosed," he said. "What doesn't need to be disclosed is the value of the call option on the issuer's debt, for example."
TBMA also said that disclosures about termination risk "should be required only when the counterparty can unilaterally terminate the derivative or when it is probable that the counterparty will request to terminate the derivative and the government will accept such request."
The letter said GASB's calls for disclosures about credit risk "should be revised to include only a qualitative discussion about how credit risk is monitored and mitigated, including collateral, master-netting arrangements, counterparty diversity, and counterparty credit ratings."
"A qualitative discussion will allow government entities to better explain their strategy on credit risk, and will be more meaningful to users than a strictly quantities presentation," the association said.
The letter urged GASB not to require the disclosure of maximum credit loss "without consideration of collateral," warning that without taking into account collateral this would not be a meaningful disclosure.
In the draft guidance, GASB requires disclosure of the maximum amount of loss due to credit risk -- based on the fair value of the derivative -- that the government might incur due to counterparty default.
But TBMA said: "We would recommend that the language be clarified to show that the fair value 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 maximum amount of loss due to credit risk is technically unlimited."
The association said that several of its members were concerned that some of GASB's methodology for calculating fair value seems to be based on how taxable swaps are valued.
"To value a tax-exempt swap, the cash flows are discounted at LIBOR rather than at the rate itself," the letter said. "As written, tax-exempt swaps would be valued by discounting 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 less burdensome for the governmental entity and more useful to end users," the letter said.
As currently drafted, GASB's derivatives disclosure guidance would be effective for issuers' fiscal years ending after June 15. The Government Finance Officers Association is trying to get GASB to push back the effective date.
