The U.S. Financial Accounting Standard 133, which requires derivatives hedges to be marked-to-market, is "not working as planned," according to Patrick Parkinson, associate director at the Federal Reserve Board in Washington. Parkinson, speaking at the International Swaps and Derivatives Association's North American Regional Member Conference, said the rule distorts economic hedges. As would be expected, there was widespread support for his comments at the derivatives gathering.
Derivatives professionals object to FAS 133 because it does not recognize macro hedging, in which securities or loans are bundled together and the overall risk is hedged. FAS 133 accounting came into effect for fiscal years beginning after July 15, 1999. A conference delegate said one of the reasons why the rule does not work is it distorts earnings statements by including unrealized profits and losses.
An example of how FAS 133 is failing can be seen in the recent example of Freddie Mac, which hit the headlines this year over mismatches made in its accounting, said Parkinson. The mortgage giant's FAS 133 hedges did not conform to Generally Accepted Accounting Principles (GAAP). The agency could have tweaked the hedges, however, to conform to GAAP without altering the nature of the traders. This leads to questions over the efficacy of the legislation, he said.
Derivatives dealers believe FAS 133 is impeding innovation as well as negatively affecting trading volumes. Indeed, Keith Bailey, ISDA chairman and managing director at Merrill Lynch in New York, said the inability to tie macro hedges to underlying securities under the accounting rules dissuades clients from entering trades. The accounting rules also imply more volatility in earnings than there may actually be in the business, he said.
Ernest Patrikis, ISDA board member and senior v.p. and general counsel at American International Group, noted that end-users are afraid to take risks and enter innovative hedges as a result of excessive legislation, including FAS 133, saying "So many of us have to pay for the sins of a few." Michael Wiseman, partner at Sullivan & Cromwell, agreed, "Today, if a bright, 25-year old walks into the office of a chief financial officer with an innovative idea, they would be thrown out."