Hedge accounting considerations for loan deferrals

Among the many impacts COVID-19 is having on our businesses, the economy, and life in general, hedge accounting is not an obvious one. Financial institutions that are working with their borrowers to help manage the impact of this pandemic should also assess the impact these changes will have on their hedging programs. This bulletin will focus on the impact COVID-19 loan modifications will have on balance sheet hedging programs.

Impact to fair value hedges — whether banks are hedging fixed-rate loans individually or in a portfolio style last-of-layer program, they should consider reviewing if payment deferrals constitute a change in the key features of the contract and therefore may require a dedesignation of the hedging relationship or exclusion from the last-of-layer closed portfolio.

Impact to cash flow hedges — designating pools of floating-rate loans that are based on the same risk exposure (i.e. 1-month LIBOR) is one of the most commonly used strategies financial institutions employ to manage exposure to falling rates. Payment deferrals applied to these designated floating-rate loans could call into question the probability of these forecasted transactions and may jeopardize hedge accounting continuance.

Background

As early as mid-March, banks across the country started considering ways to provide some relief to their customers through the use of payment deferrals on commercial loan obligations. These payment deferrals may be structured in different ways to accommodate the varying needs of the impacted borrowers. They may simply involve the deferral of a few interest-only or principal and interest payments or could require full contract amendment to either extend the existing maturity date of the loan or change the principal amortization of the loan altogether.

On March 22, 2020, federal and state banking regulators, in consultation with the Financial Accounting Standards Board (FASB), issued a joint statement encouraging financial institutions to work proactively with borrowers who are encountering financial hardship as a result of COVID-19. The resulting contract modifications will not be subject to the typical regulatory and accounting outcomes. Specifically, contract modifications entered into for purposes of accommodating borrower hardship as a result of COVID-19 will not be considered to be troubled debt restructurings (TDRs) nor will they be expected to be placed in nonaccrual status or past due. Furthermore, it is expected that examiners will not automatically expect these contract modifications to negatively impact the risk rating on capital rules. While these changes will help alleviate some of the regulatory and accounting burden of these payment accommodations, their impacts on hedging activities has not been mitigated. Barring specific relief provided by various regulatory and standard setting bodies in the foreseeable future, financial institutions may need to adjust their balance sheet hedging programs accordingly.

Balance sheet hedging

For banks with balance sheet hedging programs where they are utilizing derivatives to manage their interest rate risk sensitivity and electing hedge accounting application, COVID-19 contract modifications may result in possible early dedesignation events. U.S. GAAP requires that hedging relationships be dedesignated should there be any changes to the key terms of either the hedging instrument or the forecasted hedged transactions in a given hedging relationship. At the point of dedesignation, cumulative gains or losses are quantified and their subsequent treatment is based on the respective hedged transactions.

Chatham can help banks think through loan modification scenarios that have the least impact on your hedging programs.

Fair value hedges

In a fair value hedge of interest rate risk, banks are exchanging fixed-rate cash flows from their loan portfolios into floating-rate cash flows via the use of interest rate swaps. The fair value hedge accounting model requires changes in fair value of the hedged item(s) and changes in fair value of the hedging instrument (i.e. swaps) to be recorded in earnings in the current period. As a result, we have historically advised banks to match the economic details of the hedged loans with the interest rate swaps used to hedge them in order to avoid income statement volatility as a result of the fair value hedge accounting requirements. When a mismatch is introduced in the hedging relationship due to a change in the loan terms, its impact could either increase the amount of income statement volatility — the fair value adjustment of the loan and the swap would not be optimal anymore — or jeopardize the hedging relationship overall and banks could lose hedge accounting.

If contract modifications are not deemed to be related to key terms of the hedged transactions, banks should ensure these changes are reflected in the periodic effectiveness assessment for each hedging relationship. As an example, banks may offer their borrowers a delay in the payment of six monthly payments of principal and interest. So long as the loan is still considered to be performing and the interest is being accrued, hedge accounting may not be compromised. However, the ongoing effectiveness assessment must be updated for the fact that the payment of six months of interest will not occur until a later date.

If the key terms of a hedged fixed-rate loan or portfolio of loans are amended, we urge financial institutions to proactively reach out to their Chatham representative. We will help you analyze the impact these changes may have on your hedging relationships.

Typical term amendments that would require dedesignation of hedging relationships include but are not limited to modifications of maturity date, total coupon, and prepayment optionality that are embedded in the contracts. Furthermore, if institutions are utilizing the portfolio hedging strategy under the fair value hedging model, commonly referred to as last-of-layer, where an interest rate swap is used to hedge a last layer amount of a closed portfolio of loans that is not expected to be affected by prepayments and other early termination events, they will need to consider if loan modifications to accommodate borrower hardship as a result of COVID-19 will cause these loans to not be considered eligible to be hedged as part of the closed portfolio. This may result in a reduction of eligible loans within the closed portfolios of loans creating potential shortages and, therefore, possible loss of hedge accounting treatments.

In working with various financial institutions since late 2017 on the newly released last-of-layer strategy, we have consistently recommended taking a conservative approach by constructing large eligible closed portfolios of eligible loans and hedging the last layer that is most certainly not expected to be affected by prepayments, defaults, and other events.

Cash flow hedges

Cash flow hedges of pools of floating-rate loans are subject to different hedge accounting rules than the fixed-rate portfolios noted earlier. Under the cash flow hedging model, institutions need to assert that hedged forecasted transactions are probable to occur for the duration of the hedge. This assertion is necessary and typically easy to maintain on hedging strategies involving pools of floating-rate loans that share the same risk (i.e. 1-month LIBOR interest receipts from loan assets) as banks are constantly lending money and structure notes similarly. The payment deferral accommodations present a unique challenge for these types of hedges and the related probability assertion.

It is important to note that Chatham has historically advised institutions that use this hedging strategy to be conservative and not hedge 100% of their floating-rate loan capacity. As a result, the impact of payment deferrals on these hedging programs will be minimized if the amount of outstanding loan principal without payment deferrals is sufficient to cover the derivative notional amounts in aggregate. Institutions should consider developing a tracking system to stratify loan pools based on whether they would impact their hedging capacity.

In the event that the loan modifications are offered to a majority of the commercial borrower base and most of the hedged floating-rate loans are impacted by the changes, banks should consider the impact on their hedging relationships. As noted above, if payments are deferred but still accruing and, therefore, affecting earnings in the current period through the recognition of interest income, an auditor outreach is warranted to conclude if this would suffice for hedge accounting continuation. Under existing GAAP, the cash flow hedging model is looking to interest payments/receipts, but we believe that so long as any deferred/delayed hedged transactions were delayed due to COVID-19 and continue to be probable to be paid/collected at a later date, and are affecting earnings, they should still qualify for hedge accounting; however, a discussion with auditors is recommended prior to applying this assumption.

If payments are deferred and not accruing for a period of time, hedge accounting may be lost. The cumulative gain or loss that has been recorded in Other Comprehensive Income (OCI) would be reclassified into earnings when the hedged transactions affect earnings or immediately recognized in earnings for a missed forecast. Generally if the hedged interest receipts are not expected to occur in the originally designated time period or two months after, a missed forecast is considered to have occurred. We believe that the COVID-19 pandemic would qualify as an extenuating circumstance, which would allow for deferrals of interest payments/receipts beyond the given two-month window to satisfy the probability assertion and gains/losses reported in OCI to not be accelerated into earnings immediately. Furthermore, we encourage institutions to discuss with their auditors that even in the event of a missed forecast as a result of the pandemic relief programs, hedgers should not be subject to the three-strike rule that would not allow these types of hedges to be entered into in future period. This is specifically important because loan modifications will likely occur over time and hedging relationships may be subject to multiple amendments as we progress through this pandemic timeline.

Once institutions have assessed the impact of payment deferrals on current hedging relationships, they may consider redesignating their derivatives into new hedging relationships, if hedge accounting was lost or even as a proactive measure.

Conclusion

We have had several conversations with the FASB, Securities and Exchange Commission (SEC), and many national practices of large audit firms on these topics and continue to advocate for our clients as we help navigate these changes.