Interest rate swap providers for collateralized debt obligations may have to consolidate the whole portfolio even though they do not own any of the assets or liabilities. The Emerging Issues Task Force of the Financial Accounting Standards Board is meeting next month to discuss the matter. Jim Mountain, partner in the securitization practice at Deloitte in New York, said the idea that an interest rate swap counterparty could have to consolidate a structured credit vehicle is going to grate on auditors, investors and dealers.
Ron Lott, senior technical advisor at FASB, said the rule says whoever is exposed to most of the variability has to consolidate the special-purpose vehicle, but it doesn't say how to calculate the variability. Lisa Filomia-Aktas, partner at Ernst & Young in New York, said the issue has started to attract attention because CDOs referenced to high-grade assets, such as AAA asset-backed securities, may have so little credit variability that the interest rate risk would be more volatile.
There are four or five different views at the moment as to what should be done, so this is unlikely to get resolved at the first meeting next month, noted Lott. Filomia-Aktas said a clarification is important because CDO professionals could be at a disadvantage if they took one view and their competitors took another.
"This is not just balance sheet cosmetics. At a minimum it's earning statement geography and potentially because the balance sheet might be measured on a different basis you might have different total earnings," explained Mountain, adding, "This could potentially be very disruptive."
Mountain explained that there is nothing in FIN46R that says interest rate risk should be treated any differently to equity or credit risk and therefore the EITF is likely to examine this on the same risk/reward valuation. One of the complications, however, is how to measure the interest rate risk. For example, the swap counterparty receiving floating rates doesn't know what its future cash flows will be so would appear to hold the risk. On the other hand, a fair value calculation shows that the entity receiving the fixed rate also has variability because whether the fixed rate is above or below the market rate will influence the value of the swap. These are fundamental questions that are still open, noted Mountain.
