Accounting and Auditing Derivatives

Accounting and Auditing Derivatives C Delano Gray September 22, 2009

A two-year government study warns that derivatives, the complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system. GAO 1994

Testimony • Before the Congressional Oversight Panel • United States Government Accountability Office • GAO • For Release on Delivery Expected at 9:00 a.m. EST • Wednesday, January 14, 2009 • FINANCIAL REGULATION • A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System • Statement of Gene L. Dodaro Acting Comptroller General of the United States

F I N A N C I A L C R I S I S Financial Crises Comprises of … • Banking Crises • Economic Crises • Capital Market Bubbles • Currency Crises

F I N A N C I A L C R I S I S • Banking Crises • Bankruptcy • Inability to pay debts. OR • Run on the Bank , Credit Crunch

F I N A N C I A L C R I S I S • Economic Crises • An economic crisis can take the form of a recession or a depression. • Economic Crisis will most likely experience a falling GDP, a drying up of liquidity and rising/falling prices due to inflation / deflation

F I N A N C I A L C R I S I S • Capital Market Bubbles/Crashes • Market Price of stocks are higher than present value of future Cash flows. • A dramatic decline of stock prices in a market. Crashes are driven by panic as much as by underlying economic factors

F I N A N C I A L C R I S I S A Short History

Global Financial Crisis • The global financial crisis of 2008 is the • worst of its kind since the Great • Depression • Began with failures of large financial • institutions in the United States • Rapidly evolved into a global crisis • resulting in a number of European bank failures

Crisis • Usually, some financial institutions or • assets suddenly lose a large part of • their value • – Banking Panics (and recessions) • – Stock market crashes • – Bursting of financial bubles • – Currency crisis • – Sovereign defaults

Result • Commercial banks suffer a sudden rush of withdrawals • by depositors, this is called a bank run • – September 7, 2008: • • Two United States Government sponsored enterprises • (GSEs), Fannie Mae (Federal National Mortgage • Association) and Freddie Mac (Federal Home Loan • Mortgage Corporation), into conservatorship run by • FHFA • – September 14, 2008 • • Lehman Brothers files for bankruptcy. • • Sale of Merrill Lynch to Bank of America • – September 16, 2008 • • AIG faces severe liquidity crunch • • Financial institutions lost a large part of their value in • coming days and weeks

Causes • • Leveraged Investment • • Asset-Liability Mismatch • • Regulatory Failures • • Fraud – Medford • • Contangion • • Self-fulfilling Prophecy • Sub-prime Mortgage

Before • 1 year ago RBS paid $100 billion for ABN Amro. • For this amount it could now buy: • Citibank $22.5 billion • Morgan Stanley $10.5 billion • Goldman Sachs $21 billion • Merrill Lynch $12.3 billion • Deutsche Bank $13 billion • Barclays $12.7 billion • And still have $8 billion change......with which it would • be able to pick up GM, Ford, Chrysler and the Honda F1 Team.

CAUSES OF FINANCIAL CRISIS • Strategic Complementarities in Financial Markets • Successful investment requires each investor in financial market to guess what other investors will do • John Keynes compared Financial markets to a “Beauty Contest Game” • Mr. George Soros an Analyst , has called this need to guess the intentions of other “Reflexivity”

Banking • The banking industry can be divided in several ways, commonly beginning with wholesale vs. retail banking • Retail, or commercial banks, provide various services to individuals and families: • Depository services such as checking and savings accounts and CDs • Financing in the form of credit cards, auto loans, student loans, and home mortgages • Less common services like currency exchange and merchant banking • Most individuals deal with commercial banks their whole lives • These banks are well-known brands like Bank One, Wells Fargo, Bank of America, and Citibank

Investment Banking Overview • The private side is further divided into product and industry elements: • Product groups specialize in a certain service or instrument, such as M&A, bonds, common and preferred stock, etc. – these groups run transactions • Industry groups cover all client firms which operate in a certain field, like mining, health care, or telecommunications – they are relationship managers and assist management with multiple needs • The industry is broadly segmented into “buy side” and “sell side:” • The sell side of banking includes any firm which structures transactions or issues instruments • The buy side describes the firms which buy (i.e. invest in) such issues, like insurance companies, pension funds, and other asset managers all the way down to retail brokers

Non Banks • Non-bank financial institutions: • Include: Large non-bank financial institutions like AIG, G.E. Financial, Transamerica, MBIA, and others • Key industries like insurance & reinsurance, asset management, and leasing, which also offer a deal atmosphere and high finance experience while being more approachable than the bulge bracket banks • The financial information industry: • Banks rely on several outside providers for much of their analysis and information, like Moody’s, S&P, Fitch, Reuters, Factset, Disclosure, KMV, and others

THE ACT In 1933, in the wake of the 1929 stock market crash and during a nationwide commercial bank failure and the Great Depression, two members of Congress put their names on what is known today as the Glass-Steagall Act (GSA). This act separated investment and commercial banking activities.

THE OTHER ACT In November of 1999 Congress repealed the GSA with the establishment of the Gramm-Leach-Bliley Act, which eliminated the GSA restrictions against affiliations between commercial and investment banks. Furthermore, the Gramm-Leach-Bliley Act allows banking institutions to provide a broader range of services, including underwriting and other dealing activities.

Hedging • What does it mean to "hedge"? • To "hedge" means to manage risk. Any given money manager may make an allocation/investment that could be described as speculative; if this same manager simultaneously makes an allocation to an allocation/investment specifically designed to balance or counter-act any negative performance from his speculative position then this would be his hedging position.There are many types of perceivable risk - Market, Interest rate, Inflation, Sectoral, Regional, Currency, etc. Hedge fund managers utilise the complete arsenal of financial weapons (holding cash, short selling, buying selling or swapping options, futures, commodity and/or currency futures, etc.) and are expert in concocting hedging positions for most conceivable risks.

Fair Value • Measurement • Definition of Fair Value • Fair value is the price that would be received to • sell an asset or paid to transfer a liability in an orderly • transaction between market participants at the measurement • date. • The asset or liability • A fair value measurement is for a particular asset • or liability. Therefore, the measurement should consider • attributes specific to the asset or liability, for example, • the condition and/or location of the asset or liability • and restrictions, if any, on the sale or use of the asset at the measurement date

Rules (Some of ) • FAS 133, 149, 155, 157, 159 • Au 312 Risk, 314 Entity, 318 Performance-Risk, 326 Evidence, 332 Derivatives

Gambling on Derivatives Hedging Risk or Courting Disaster?

"We view them as time bombs both for the parties that deal in them and the economic system ... In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." Warren Buffett "In no circumstances enter the derivatives trading market without first agreeing it in writing with me ... at some time in the future it could bring the world's financial system to its knees." Sir Julian Hodge

Unlike Warren Buffet, Sir Julian Hodge, the Welsh banker, issued his apocalyptic warning three years before the first rash of derivatives disasters involving Metallgesellschaft, Orange County, Sears Roebuck, Proctor & Gamble, happened in 1994. More was to come in 1995 in the form of the Daiwa and Barings scandals. None of those on their own, however, threatened to bring the world financial system to its knees. Until recently the crisis that came closest to doing so involved LTCM in September 1998. Nearly 10 years later, in March 2008, the FED took emergency action to avoid what was called derivatives Chernobyl. That action seemed to have worked ... for a while, but the Credit Crunch has raised worries, could a mega-catastrophe lie around the corner ...?

Toxic Derivatives and the Credit Crunch The market in 2008 was worth over $516 trillion or about 10 times the value of the entire world's output. This enormous ticking time bomb threatens to wreck international efforts to solve the world's biggest financial crisis since the 1930s

Long-Term Capital Management (LTCM) was a U.S. hedge fund which used trading strategies such as fixed income arbitrage, statistical arbitrage, and pairs trading, combined with high leverage. It failed spectacularly in the late 1990s, leading to a massive bailout by other major banks and investment houses,[1] which was supervised by the Federal Reserve. LTCM was founded in 1994 by John Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Board of directors members included Myron Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences.[2] Initially enormously successful with annualized returns of over 40% (after fees) in its first years, in 1998 it lost $4.6 billion in less than four months following the Russian financial crisis and became a prominent example of the risk potential in the hedge fund industry. The fund folded in early 2000. The collapse of LTCM was the subject of Roger Lowenstein's book When Genius Failed: The Rise and Fall of Long-Term Capital Management, published in 2000.

Derivatives • What Does Derivative Mean?A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.

Derivatives • Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Derivatives are contracts and can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region. Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes. For example, a European investor purchasing shares of an American company off of an American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros

Forwards and Futures Definition • forward contract A trade that is agreed to at one point in time but will take place at some later time. • future An exchange-traded derivative that is similar to a forward.

Options DEFINITIONThe right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific amount of a given stock, commodity, currency, index, or debt, at a specified price (the strike price) during a specified period of time. • For stock options, the amount is usually 100 shares. Each option has a buyer, called the holder, and a seller, known as the writer. If the option contract is exercised, the writer is responsible for fulfilling the terms of the contract by delivering the shares to the appropriate party

Swaps DEFINITIONAn exchange of streams of payments over time according to specified terms. The most common type is an interest rate swap, in which one party agrees to pay a fixed interest rate in return for receiving a adjustable rate from another party.

Interest only strips Definition • A security with cash flows based entirely on the monthly interest payments received from a mortgage pool

Principal-only strip Definition • A version of a stripped mortgage-backed security which has cash flows that are based entirely on the monthly principal payments received from a mortgage pool. Investors tend to buy principal-only strips when they suspect that interest rates are about to decline, because the principal will be paid at a faster rate.

Stripped mortgage-backed securities Definition • A mortgage-backed instrument which is comprised of two parts: interest and principal. In some cases, the security is made up of a certain percentage of both interest and principal. The ideal situation for investors is for the security to either be an interest-only strip or a principal-only strip. In these scenarios, the securities are very sensitive to the change in interest rate, so an investor will choose to purchase one or the other based on the direction he/she believes the interest rates are headed.

Ginnie Mae Definition • A security issued by the Government National Mortgage Association.

Freddie Mac Definition • A security issued by the Federal Home Loan Mortgage Corporation and secured by a pool of conventional home mortgages.

Collateralized mortgage obligation (CMO) • A security backed by a pool of pass-through rates , structured so that there are several classes of bondholders with varying maturities, called tranches. The principal payments from the underlying pool of pass-through securities are used to retire the bonds on a priority basis as specified in the prospectus. Related: mortgage pass-through security

Securitization Definition • The process of aggregating similar instruments, such as loans or mortgages, into a negotiable security.

Securitization • Creating a more or less standard investment instrument such as the mortgage pass-through security, by pooling assets to back the instrument. Also refers to the replacement of nonmarketable loans and/or cash flows provided by financial intermediaries with negotiable securities issued in the public capital markets

Securitization The process by which a company packages its illiquid assets as a security. For example, when a company makes an initial public offering, it effectively packages the company's ownership into a certain number of stock certificates. Securities are backed by an asset, such as equity, or debt, such as a portion of a mortgage. Securitization allows a company access to greater funding to expand its operations or investments, or some other reason

Credit default swap Definition • A specific kind of counterparty agreement which allows the transfer of third party credit risk from one party to the other. • One party in the swap is a lender and faces credit risk from a third party, and the counterparty in the credit default swap agrees to insure this risk in exchange of regular periodic payments (essentially an insurance premium). If the third party defaults, the party providing insurance will have to purchase from the insured party the defaulted asset. In turn, the insurer pays the insured the remaining interest on the debt, as well as the principal.

Sallie Mae What Does Sallie Mae - Student Loan Marketing Association Mean?A publicly traded company that is the largest provider of educational loans in the U.S. Along with providing student loans, Sallie Mae purchases student loans from the original lenders and provides financing to state student-loan agencies. Sallie Mae®, the nation's leading provider of student loans and administrator of college savings plans, has helped millions of Americans achieve their dream of a higher education. The company primarily provides federal and private student loans for undergraduate and graduate students and their parents

CDO Definition Collateralized debt obligations (CDOs) are a type of structuredasset-backed security (ABS) whose value and payments are derived from a portfolio of fixed-income underlying assets. CDOs are assigned different risk classes, or tranches, whereby "senior" tranches are considered the safest securities. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupon payments (and interest rates) or lower prices to compensate for additional default risk.

December 28, 2007 Sallie Mae Sells Securities to Try to Pay Off Derivatives By REUTERS Sallie Mae, the largest student lending company in the United States, said it sold $2 billion of common stock and $1 billion of convertible securities Thursday in a deal that would help pay off bad derivatives bets. The common stock offering was increased from an originally planned $1.5 billion, and shares were priced at $19.65, equal to Sallie Mae’s closing share price on Thursday. The preferred shares will offer a dividend of 7.25 percent until the investors convert them into common stock, or until their mandatory conversion into common stock on Dec. 15, 2010. Sallie Mae, formally known as the SLM Corporation, said on Wednesday that it was issuing convertible preferred securities and common shares. About $2 billion of the proceeds would be used to pay off derivatives known as equity forward contracts, the company said. Sallie Mae used equity forwards as part of its share buyback plan for years. The contracts allowed the company to reduce the cost of buying back its shares as long as its stock price kept rising. But if Sallie Mae’s share price fell far enough, the company had to buy back a large number of shares at above-market prices. In this case, Sallie Mae will use about $2 billion from its offering to buy back about 44 million shares, now worth closer to $865 million.

AU Section 332Auditing DerivativeInstruments SAS 92 • Applicability • .01 This section provides guidance to auditors in planning and performing auditing procedures for assertions about derivative instruments, hedging activities, and investments in securities that are made in an entity's financial statements.

Assertions a. Assertions about classes of transactions and events for the period under audit: • i. Occurrence. Transactions and events that have been recorded • have occurred and pertain to the entity. • ii. Completeness. All transactions and events that should have been • recorded have been recorded. • iii. Accuracy. Amounts and other data relating to recorded transactions • and events have been recorded appropriately. • iv. Cutoff. Transactions and events have been recorded in the correct • accounting period. • v. Classification. Transactions and events have been recorded in the • proper accounts.

Assertions b. Assertions about account balances at the period end: • i. Existence. Assets, liabilities, and equity interests exist. • ii. Rights and obligations. The entity holds or controls the rights to assets, and liabilities are the obligations of the entity. • iii. Completeness. All assets, liabilities, and equity interests that should have been recorded have been recorded. • iv. Valuation and allocation. Assets, liabilities, and equity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded.

Assertions c. Assertions about presentation and disclosure: • i. Occurrence and rights and obligations. Disclosed events and transactions have occurred and pertain to the entity. • ii. Completeness. All disclosures that should have been included in the financial statements have been included. • iii. Classification and understandability. Financial information is appropriately presented and described and disclosures are clearly expressed. • iv. Accuracy and valuation. Financial and other information are disclosed fairly and at appropriate amounts

Derivative Instruments Included in theScope of this Section A derivative is a financial instrument or other contract with all three of the characteristics listed in FASB Statement No. 133, which are the following. • a. It has (1) one or more underlyings and (2) one or more notional amounts or payment provisions or both. Those terms determine the amount of the settlement or settlements, and, in some cases, whether or not settlement is required. • b. It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors. • c. Its terms require or permit net settlement, it can readily be settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

Accounting and Auditing Derivatives