The drop in rates in Q1 has increased the net cash payments on pay-fixed, receive-variable interest rate swaps and at the same time increased the derivative losses. What does this mean for your hedge accounting?
The good news is that the drop in rates has not impacted the three major hedge accounting strategies that Financial Institutions use in any meaningful way. Yes, most pay-fixed, receive-variable swaps are in loss positions, but the hedge accounting has ensured that there is very little impact on earnings from these losses.
Let’s take a quick look at these strategies and the earnings impacts:
Last of Layer Hedging of Fixed Rate Mortgages
The losses on the derivatives have been offset by gains on the closed portfolio of fixed rate assets and earnings volatility while higher than it was before rates dropped, has remained relatively low.
A word of caution:
Institutions need to be sure that they have updated the modeling of expected prepayments, defaults, etc., impacting the timing and amount of interest payments on the hedged portfolio. With the dip in rates, refinancing is on the rise, which may lead to a reduction in fixed rate assets substantial enough to result in an overhedged position.
What happens if your forecast was overly optimistic?
If your exposure notional is headed towards your hedge notional, you will need to de-designate a portion of the swap. As long as you de-designate BEFORE the exposure principal amount drops below the hedged amount, there are no “foot-faults” in the hedge accounting. You may have some unwanted economic impacts (unwinding a portion of a swap and needing to pay cash if it’s in a loss position), but your future ability to forecast is not called into question so you may choose to re-designate a portion of the derivative.
If you wait until you are overhedged, then what?
If your exposure notional outstanding dips below the hedged amount, you must discontinue hedge accounting. In other words, you lose the ability to partially dedesignate the derivative and instead lose hedge accounting prospectively on the entire derivative.
Hedging of FHLB Advances and Certificates of Deposit
The losses on these cash flow designated derivatives continue to be deferred in other comprehensive income (OCI). The increase in net payments on the derivatives is offset by a decrease in interest paid on the advances.
This is cash flow hedging at its best – no immediate earnings impact! Your borrowing costs will be higher as a result of the derivative(s), but that impact will be recognized at the cash event, not based on market movement.
Things to think about:
As with any cash flow hedge designation, it’s important to revisit probability at least quarterly to ensure that the balance in your hedged portfolio is expected to continue to be greater than the amount hedged. As rates have dropped, how has that impacted operations? Does your institution still plan to use FHLB advances to fund customer deposits? Have you seen a run-off in your hedged CD balances? These are the questions that you should be asking.
What happens if your need for FHLB Advances or CD’s has declined?
With cash flow hedging, if you end up overhedged and your effectiveness assessment fails, then you will need to dedesignate the derivative. The portion of the gains (or losses) deferred in OCI relating to any amounts that are considered remote are flushed through earnings immediately and the portion that relates to amounts considered possible are amortized over the remaining hedge period. Subsequent changes in value of the derivative will impact earnings except for any portions redesignated in another qualifying hedge relationship.
Each of these strategies have proven successful in protecting earnings during the volatile market swings of 2020. If you need help exploring the nuances of these hedging strategies, we have a team of experts ready to assist. We also host webinars that cover the basics of fair value and cash flow hedge accounting, LIBOR cessation and other interest rate, foreign exchange and commodity hedging subjects. Check out our training calendar, here.