Accounting for Interest Rate Derivatives FAS ASC 815

1. Accounting for Interest Rate DerivativesFAS ASC 815 Presented by Frank Wilary and Douglas Winn October 20, 2014

2. Frank Wilary, Principal and Co-founder • Mr. Wilary has over twenty years of diversified experience in the financial services industry. Areas of expertise include asset-liability management, capital markets, asset-backed securitization, derivatives and information systems. • Mr. Wilary's primary responsibility is to lead the firm’s asset liability management and non-Agency MBS business lines. • Prior to co-founding Wilary Winn, Mr. Wilary held senior positions in treasury, capital markets, accounting, finance and systems within two organizations.

3. Douglas Winn, President and Co-Founder • Mr. Winn co-founded Wilary Winn in the summer of 2003 and his primary responsibility is to set the firm's strategic direction. Since inception, Wilary Winn has grown rapidly and currently has more than 375 clients located in 47 states and the District of Columbia. Wilary Winn’s clients include community banks, 43 of which are publicly traded, and credit unions, including 26 of the top 100. • Mr. Winn is a nationally recognized expert regarding the accounting and regulatory rules for financial institutions and has recently led seminars on the subject for many of the country's largest public accounting firms, the AICPA, the FDIC, and the NCUA.

4. Overall Agenda • NCUA rule • Requirements • Limits • Application process • How derivatives can reduce IRR • “Hedge accounting” • Can be very complex • Elective • Permitted derivatives are “vanilla”

5. Agenda – The New Rule • Eligibility • Permitted derivatives • Limits • Hedging example • Alternatives for managing IRR • Counterparties and margining • Policies and internal controls • Required reporting • Application process

6. Agenda – Hedge Accounting • Describe hedge accounting and provide examples • Address hedge effectiveness testing • Define hedge ineffectiveness – testing vs. bookkeeping • Provide alternative to hedge accounting

7. Why Now? • Changes in interest rates over one-year time periods from 1955 to 2008 • 30% of the time periods experienced changes of interest rates of over 200 bps • 16% of the time periods experienced changes of interest rates of over 300 bps. • 9% of the time periods experienced changes of interest rates of over 400 bps Source: FDIC Supervisory Insights, Winter 2009

8. Who is Eligible • Federal Credit Unions with more than $250 million in total assets • Must have CAMEL 3 or better • Must have management CAMEL of 2 or better • Credit unions with less than $250 million can apply to NCUA field director for authority

9. Hedging Instruments NCUA authorizes credit unions to use only the following derivatives: • Interest Rate Swaps • An agreement to exchange future payments of interest on a notional amount at specific times and for a specific time period • Interest Rate Caps • A contract, based on a reference interest rate, for payment to the purchaser when the reference interest rate rises above the level specified in the contract • Interest Rate Floors • A contract, based on a reference interest rate, for payment to the purchaser when the reference interest rate falls below the level specified in the contract

10. Hedging Instruments NCUA authorizes credit unions to use only the following derivatives: • Basis Swaps • An agreement between two parties in which the parties make periodic payments to each other based on floating rate indices multiplied by a notional amount • Treasury Note Futures • A U.S. Treasury note financial contract that obligates the buyer to take delivery of Treasury notes (or the seller to deliver Treasury notes) at a predetermined future date and price. Futures contracts are standardized to facilitate trading on an exchange Note: Wilary Winn Risk Management believes all of the derivatives permitted by the NCUA meet the definition of a derivative under GAAP.

11. Other Restrictions • Swaps, caps, and floors can be amortizing and include a forward start date (90 day maximum) • Amortization cannot be linked to another financial instrument – e.g. a reference pool of mortgage loans • Treasury futures are limited to notes (maturity of 10 years or less) • Derivatives cannot be leveraged

12. Other Restrictions • Must be based on domestic interest rates (LIBOR) • Must be denominated in U.S. Dollars • Maximum maturity is 15 years (except for Treasury Futures) • Must meet the definition of derivative under GAAP

13. Economic Considerations • OTC swaps pricing varies considerably • Consider engaging independent third party advisor that can obtain multiple bids • We also recommend having an advisor help with the purchase of interest rate caps and floors • Treasury futures are exchange traded • Pricing is the same for everyone • Must post collateral

14. Derivatives Limits • Notional Amount • Takes into account type of derivative, time to maturity and net worth • Fair Value Loss Limit • Loss limit does not include hedge benefit – measures the derivatives only • Limit is based on net aggregate loss of derivatives and net worth

15. Weighted Average Remaining Maturity Notional Cannot net offsetting transaction – calculation is cumulative WARMN = Adjusted notional * (WARM/10)

16. Hedging Example 2-Year Interest Rate Swap – Pay Fixed, Receive Floating Entry Limit Calculations

17. Hedging Example 5-YearInterest Rate Swap – Pay Fixed, Receive Floating Entry Limit Calculations

18. Hedging Example Balance Sheet & 2 Year Net Interest Income Projection

19. Hedging Example 2-Year Interest Rate Swap – Pay Fixed, Receive Floating Base Case Swap Cash Flows on $50 MM Notional

20. Hedging Example 2 Year Net Interest Income Projection with Swap

21. Hedging Alternatives • Originate floating-rate loan products • Purchase floating-rate securities • Sell long-term fixed rate assets • Purchase of short-term assets • Increased use of share certificates – longer term with higher early withdrawal penalties

22. Counterparty Agreements, Collateral, and Margining Can have exchange traded, centrally cleared, or non-cleared derivatives • Exchange traded and cleared: • Comply with Commodity Futures Trading Commission Rules • Dealers must be CFTC registrants • Comply with margining rules set by futures commission merchant • Non-cleared derivatives: • Must have ISDA master service agreement • Must have minimum daily margining of $250,000 • Marginal collateral can include only cash, US Treasuries, GSE debt, GSE residential MBS

23. Counterparty Agreements, Collateral, and Margining • Must have systems in place to manage collateral and margining requirements • System must include posting, tracking, valuing and reporting of collateral • Must assess liquidity needs in light of margining requirements

24. Operational Support Required Experience and Competencies • Board – must receive derivatives training – updated annually • Senior Executive Officers must understand, approve, and provide oversight • Qualified Derivatives Personnel • Must understand ALM, including use of derivatives • Must know how to evaluate counterparty, collateral and margining risks • Must understand accounting and financial reporting in accordance with GAAP

25. External Service Providers • Can use ESPs, provided ESP: • Is not a counterparty • Is not a principal or agent in the derivatives transactions • Does not have discretionary authority to execute trades • CU must be capable of overseeing ESP • ESP’s role must be documented • ESP cannot conduct ALM or liquidity risk management in lieu of credit union

26. Internal Controls • Transaction support - must identify transaction and show how it will be effective • Internal controls review – must perform review for 2 years (internal audit or external auditor) • Financial statement audit – must have financial statement audit performed • Must have written processes in place including schematic (flow chart or organization chart) • Must have appropriate segregation of duties • Must have legal review of derivatives contracts • Must have written policies and procedures

27. Elements of a Derivatives Policy • Key participants • Participants’ responsibilities and internal controls - including who is permitted to enter into derivatives transaction • Objective of hedge and nature of risk being hedged • Hedge period • Authority for implementation of the derivatives program • Purpose and implementation guidelines • Permissible derivative instruments • Hedge limits • Hedge designations • Hedge effectiveness • Reporting requirements

28. Derivatives Reporting Requirements • Quarterly board reports • Monthly reporting to senior executives and ALCO, if applicable. At a minimum, the reports must show: • Any areas of noncompliance • Comparison to internal limits • Itemization of individual positions and current fair values with comparison to NCUA limits • NEV calculations with and without derivatives • Evaluation of effectiveness in mitigating IRR • Evaluation of “hedge accounting”

29. Credit Unions Must Apply for Authority to Use Derivatives • Demonstrate how derivatives will mitigate IRR • Detail derivatives the CU intends to use and why • Have policies in place • Detail how credit union will acquire appropriate resources, controls and systems to implement sound program • Specify how ESPs will be used • Address margining and collateral • Describe how it will meet GAAP

30. Credit Unions Must Apply for Authority to Use Derivatives • Cannot enter into derivative transactions until approved • Entry limits when approved • Standard limits apply after CU has been using derivatives for one year and NCUA has not voiced any safety and soundness concerns • Pilot program participants must be fully compliant within 12 months

31. Accounting for Derivatives Derivatives must be accounted for and reported at fair value Three options to decrease resulting income statement volatility: • Fair Value Hedge Accounting • Fair Value Accounting • Cash Flow Hedge Accounting

32. Accounting for Derivatives Two types of hedge accounting 1. Fair value hedge Change in fair value of the hedging instrument runs through the income statement, along with the change in the fair value of the item being hedged – used for existing financial assets and liabilities • Cash flow hedge “Effective” portion of the hedge is reported in Other Comprehensive Income, while the ineffective portion is reported in current earnings – used for forecasted transactions or variable payments on existing financial assets and liabilities

33. Accounting for Derivatives Type of accounting depends on the item being hedged – Credit Union enters into a Pay Fixed, Receive Floating Interest Rate Swap Fair Value Hedge Example: CU wants to hedge against the decrease in fair value of a fixed rate loan portfolio defines hedge as change in benchmark interest rate If benchmark interest rate increases, fair value of the loans will decrease, and the fair value of the swap will increase. Change in each runs through the income statement Cash Flow Hedge Example: CU wants to hedge against increase in dividend payments on CD accounts as they renew Defines hedge as risk of an increase in the forecasted payments to its members. Effective portion will run through OCI

34. Hedge Documentation Formal designation and documentation required at inception The CU’s objective and strategy for the hedge must include (815-20-25-3b 2): • The hedging instrument – the derivative (interest rate swap, interest rate floor, interest rate cap, etc.) • The hedged item or transaction – the asset or liability being hedged • The nature of the risk being hedged – interest rate risk • The method that will be used to retrospectively and prospectively measure the hedge’s effectiveness

35. Hedge Documentation • The method that will be used to measure hedge ineffectiveness • Benchmark interest rate being hedged Eligible benchmark rates are (815-20-25-6A): Treasury rates Federal funds effective swap rate LIBOR

36. Hedge Documentation • Fair Value Hedge • Can hedge the change in fair value of an entire or a portion of an asset or liability (815-20-25-11) • Cash Flow Hedge – Variability in Expected Future Cash Flows Related to: • An existing recognized asset or liability (such as all or certain future interest payments on variable rate debt) • A forecasted transaction (such as a forecasted purchase or sale) (815-20-25-13)

37. Hedge Effectiveness To qualify for hedge accounting, the hedging relationship (both at inception of the hedge and on an ongoing basis), shall be expected to be highly effective in achieving either of the following (815-20-25-75): • Offsetting changes in fair value attributable to the hedged risk during the period that the hedge is designated - a fair value hedge • Offsetting cash flows attributable to the hedged risk during the term of the hedge - a cash flow hedge

38. Hedge Effectiveness Hedge Effectiveness can be measured in two ways: 1. Dollar-offset approach (815-20-35-5a) • Compares changes in fair value or cash flow of the hedged item and the derivative • Can be applied period by period (cannot be less than 3 months) or cumulatively • Most believe a dollar offset range of 80%-125% would be considered highly effective • Statistical methodologies • May permit a CU to continue to use hedge accounting for the current period even though the dollar-offset approach appears ineffective (815-20-55-68) • Complex to implement and requires multiple observation periods

39. Hedge Effectiveness: Dollar-Offset Approach Example $50 MM pay fixed / receive floating 5-year interest rate swap Hedged item – a group of fixed rate investments held AFS

40. Hedge Effectiveness: Statistical Approaches Regression Analysis • Minimum of 30 observations • Must consider changes in the value of the derivative and the hedged item • Time horizon must coincide or be less than the time horizon of the hedge relationship • Must consider whether to regress value changes or value levels • Must review distribution of error terms EY Derivatives and Hedging, October 2013 4.9.2.4

41. Hedge Effectiveness: Statistical Approaches Regression Analysis continued • R-squared result must exceed a pre-specified level (e.g. 0.80) • Hedge relationship must correspond to beta (the slope of the regression line) • Standard error must be used to calculate the reliability using the t statistic • T-test must be passed at a 95% confidence level • Must consider y-intercept • Must compare results to dollar offset results EY Derivatives and Hedging, October 2013 4.9.2.4

42. Hedge Effectiveness: Statistical Approaches R-squared Analysis Hedged item – floating dividend rate on money market shares

43. Hedge Effectives A credit union shall consider hedge effectiveness in two different ways: 1. Prospective Considerations 2. Retrospective Evaluations

44. Hedge Effectiveness Prospective Considerations (815-20-25-79a) • Can be based on regression or other statistical analysis of past changes in fair values or cash flows as well as on other relevant information • Shall consider all reasonably possible changes in fair value (if a fair value hedge) or in fair value or cash flows (if a cash flow hedge) of the derivative instrument and the hedged items for the period used to assess whether the requirement for expectation of highly effective offset is satisfied • Not be limited only to the likely or expected changes in fair value (if a fair value hedge) or in fair value or cash flow (if a cash flow hedge) • Generally involves a probability-weighted analysis – consistent with FASB Concepts Statement No. 7

45. Hedge Effectiveness Retrospective Considerations (815-20-25-79a) • An assessment of effectiveness shall be performed whenever financial statements or earnings are reported, and at least every three months • Can be based on dollar offset or statistical approaches • Dollar-offset measurement can be for period or cumulative • Statistical methods must be similar period to period (e.g. same number of data points)

46. Hedge Effectiveness Other Considerations for Cash Flow Hedges Effectiveness testing for a cash flow hedge involving an interest rate swap can be done using one of three methods: • Change in variable cash flows method(815-30-35-16 through 24) • Hypothetical derivative method (815-30-35-25 through 30) • Change in fair value method (815-30-35-31 through 32) We will show examples of each later on in the presentation

47. What if the Hedge is No Longer Effective? The hedge accounting is discontinued prospectively, resulting in potential income statement volatility as the derivative is marked to market with no offset to the hedged item (fair value hedge 815-25-40-1 and cash flow hedge 815-30-40-1) Fair value adjustments for fixed rate financial instruments related to fair value hedges are recognized prospectively using the effective interest rate method when hedge accounting is discontinued (815-25-35-9) Cash flow hedge - the net gain or loss remains in AOCI unless it is probable that the forecasted transaction will not occur by the end of the originally specified time period plus a 2 month extension (815-30-40-4)

48. Hedge Ineffectiveness Hedge ineffectiveness is measured by the Dollar-offset method Fair Value Hedge: Hedge ineffectiveness flows through the income statement based on any difference between the change in the value of the derivative and the change in value of the hedged item (815-20-35-1b) Cash Flow Hedge: Ineffectiveness must be separately measured and recorded on the income statement. If the fair value of the derivative changes by more than the present value of hedged cash flows, the difference is the ineffective amount. If the fair value of the hedged cash flows changes by more than the change in the fair value of the derivative then no ineffectiveness (815-20-35-1c)

49. Short-Cut Method Entities can assume no ineffectiveness in an interest rate swap in two instances: • A private company that enters into a pay fixed, receive floating interest rate swap (this exemption does not apply to financial institutions) (815-20-25-131B) • A swap can be examined to determine if it can be accounted for under the Short-Cut Method (this applies to all companies, including financial institutions)

50. Short-Cut Method To conclude no hedge ineffectiveness in a hedge with an interest rate swap, all of the following conditions must be met for both fair value and cash flow hedges (815-20-25-104): • Notional amount of swap matches principal amount of item being hedged • Fair value of the swap is zero at inception Note: For the purposed of determining zero: can ignore bid/ask spread at inception, commissions, and other transaction costs