Basics of Credit Derivatives

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Accounting for credit derivatives

Update 10th July 2002 The IASB has proposd a recast of the derivatives accounting standard. For brief update and text of the proposed changes, see here.

 

Accounting for credit derivatives is based on the accounting standards for derivatives. Accounting standards for derivatives are themselves in a flux and are currently a part of an ongoing project for international harmonisation. See for more Vinod Kothari's site on accounting for financial instruments.

From accounting viewpoint, the key consideration is whether a credit derivative is a derivative, or a simple financial guarantee.

The IAS 39 Implementation Guide (Questions and Answers) puts it as follows:

"Question 1- 2 Credit derivatives Financial guarantee contracts that provide for payments to be made if the debtor fails to make payment when due are excluded from IAS 39. Some credit default derivatives, such as certain credit default swaps and other credit default products, contain similar provisions. Are they also excluded from IAS 39?

Yes, if the credit default derivative cannot be distinguished from a financial guarantee contract that would be excluded from IAS 39.

To illustrate: Bank A has total outstanding loans of 100 million to its largest customer, Company C. Bank A is concerned about concentration risk and enters into a credit default swap contract with Bank B to diversify its exposure without actually selling the loans. Under the terms of the credit default swap, Bank A pays a fee to Bank B at an annual rate of 50 basis points on amounts outstanding. In the event Company C defaults on any principal or interest payments, Bank B pays Bank A for any loss. There is no characteristic of the credit default swap that distinguishes it from a financial guarantee contract. Because the credit default swap provides for payments to a creditor (Bank A) in the event of failure of a debtor (Company C) to pay when due, it is outside the scope of IAS 39. IAS 37, Provisions, Contingent Liabilities and Contingent Assets, provides guidance for recognising and measuring financial guarantees, warranty obligations, and other similar instruments.

On the other hand, a credit swap is within the scope of IAS 39 if payment by Bank B to Bank A is contingent on an event other than payment default by Company C, such as a ratings downgrade or a change in credit spread above an agreed level or Company C's default on debt payable to a third party. "

Most credit derivatives will define a "credit event" and such event will usually be more comprehensive than a default of the obligor. Hence, it is unlikely that credit derivative contracts will fall under the exclusion related to financial guarantee contractw.

If they are not financial guarantee contracts, they are covered by IAS 39/ FAS 133. Accordingly, the fair value of the derivative contract, both in the books of the protection buyer and the protection seller will be computed and put on books in each reporting period. As for all derivative contracts, the changes in fair value are routed through the revenue statements.

In case of an investor in a credit linked note or a synthetic CDO, there is an embedded credit derivative in the investment. Accounting rules require the separation of an embedded derivative if the economic substance of the derivative is not closely related to the host contract. The host contract is one of investment, and the derivative is one of a credit protection: the two are obviously unrelated. Therefore, it will be necessary for all investors in credit linked notes and synthetic CDOs to separate the credit derivative and account for it on fair value basis on each reporting date.

For more guide on derivatives accounting, see our site on derivatives accounting.