As a new wave of concerns about instability in global credit markets crests, financial standard setters and regulators have moved to tighten regulations and increase disclosures for credit derivatives. The Financial Accounting Standards Board May 30 issued a proposed staff position on accounting guidance that it hopes will improve disclosures about the $62 trillion dollar credit derivatives market, an area that has recently come under heavy regulatory and market scrutiny. FASB said that over the past few years, credit default swaps have become the most dominant product of the credit derivatives market.

According to the International Swaps and Derivatives Association (ISDA), the estimated notional amount of outstanding credit default swaps rose to $62.2 trillion in December 2007 from $34.4 trillion in December 2006 and $17.1 trillion in December 2005. On June 9, a group of major financial institutions met at the Federal Reserve Bank of New York and agreed to several steps designed to improve trading and reduce risk in the over-the-counter credit derivatives markets. According to a statement released by the New York Fed, those steps include: reducing the volume of such trades; improving infrastructure and automation; incorporating an auction-based settlement mechanism into standard credit derivatives documentation; and "developing a central counterparty for credit default swaps that, with a robust risk management regime, can help reduce systemic risk."

"We are working closely with the Securities and Exchange Commission (SEC), with banking supervisors in the United States and the other major economies, and with the U.S. Treasury to strengthen the financial foundation of the major investment and commercial banks," Timothy Geithner, president of the New York Federal Reserve Bank, said in a June 9 speech. "We have encouraged a significant increase in the quality of public disclosure."

"Greater product standardization and improved disclosure can also help, as will changes to the accounting rules that govern what risks reside on and off balance sheets," Geithner said

"Finally, central banks, governments and supervisors have to look much more carefully at the interaction between accounting, tax, disclosure and capital requirements, and their effects on overall leverage and risk across the financial system," Geithner said. "Capital requirements alone are rarely the most important constraint." For U.S. commercial banks the notional value of credit derivative contracts, 98 percent of which are credit default swaps, increased 3 percent during the fourth quarter of 2007 to $14.4 trillion, according to an April 2 report from the Comptroller of the Currency. "Currently the OCC is working with other financial supervisors and major market participants to address infrastructure issues in credit derivatives," the OCC report said.

Payment/Performance Risk of Guarantees. FASB issued its proposed guidance as FASB Staff Position (FSP) FAS 133-b and FIN 45-c, Disclosures About Credit Derivatives and Certain Guarantees: an Amendment of FASB Statement No. 133 and FASB Interpretation No. 45, to be effective for fiscal years and interim periods ending after Nov. 15, 2008.

The proposal would amend FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, to require additional disclosures about creditindexed derivative instruments-such as credit default swaps, credit spread options and credit index products. Moreover, it would also amend paragraph 13(a) of FASB Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, to require an additional disclosure about the current status of the payment/performance risk of a guarantee. The proposed guidance is aimed at enhancing transparency of the effect of credit derivatives and guarantees on an entity's financial position, financial performance, and cash flows, FASB said.

FASB said the current status of the payment/ performance risk of the guarantee could be indicated by either current external credit ratings, when available, or current internal categories/groupings based on the manner in which the guarantor manages its risk. The deadline for comments is June 30.

Credit Default Swaps Ballooning. FASB decided in April to add a narrowly scoped issue as a short-term agenda project to improve disclosures about credit derivatives, particularly in light of the dominance of credit default swaps and the turmoil in the credit markets (4 APPR 399, 5/2/08).

FASB said, however, it may consider a future longterm project to improve disclosures about all financial instruments and achieve greater convergence with the International Accounting Standards Board. The scope of International Financial Reporting Standard 7, Financial Instruments: Disclosures, includes all financial instruments, not just derivative instruments.

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FASB said some sellers of credit derivatives have been faced with severe adverse conditions because a large number of referenced obligations that their credit default swaps are guaranteeing are facing actual or potential defaults. As a result, the sellers of credit default swaps may have large liabilities associated with those actual and potential defaults.

Moreover, due to the potential effects those defaults may have on their financial position, some sellers of these instruments are facing the potential of a credit downgrade or already have been downgraded by one or more credit-rating agencies.

David Zion, a research analyst for Credit Suisse, said in a June 6 analysis that credit default swaps are an area "where disclosures are lacking and claims on cash can be large."

"If the new disclosures allow investors to do a better job of estimating the potential cash claims associated with contingent liabilities and credit derivatives, it could impact how a company is valued," Zion said. "For example, if investors were to increase their estimates of the claims on cash flow from what was previously expected, that's bad for valuations, and vice versa."

FASB said financial statement users expressed concerns that the disclosure requirements in FAS 133 do not adequately address the potential adverse effects of changes in credit risk on the financial position and performance of the sellers of credit derivatives.

"Kudos to the FASB for realizing something was needed quickly," Charles Mulford, director of the Georgia Tech Financial Analysis Lab, told BNA June 10. While Mulford said this proposed FSP alone "is not the do-all, end-all," he said the proposed disclosures are the "sunlight" that is necessary for any market to function. "I think that the disclosures are needed and will be very useful to analysts and investors in evaluating the risk of a credit derivatives seller," Mulford said.

Similar Risks and Rewards; Similar Disclosures. According to an FASB written summary, a financial guarantee contract refers to circumstances in which the guaranteed party owns the underlying guaranteed obligation. However, in the case of many credit derivatives, the guaranteed party does not necessarily own the underlying assets referenced in the derivative contract.

Under current guidance, regardless of this differentiating feature, the risks and rewards of a financial guarantee or a credit derivative are substantially similar- however, the disclosure requirements of FIN 45 apply to only some, but not all, credit derivatives. FASB said that therefore it believes that instruments with similar risks and rewards should have similar disclosures and, therefore, the disclosures in FIN 45 should apply to all credit derivatives.

FASB said it is particularly seeking comments on the FSP from preparers of financial statements, including whether the proposed disclosures are operational and whether the proposed effective date will provide them with adequate time to implement the final FSP. A spokeswoman for the ISDA told BNA June 9 that the association is preparing a comment but declined to comment further on the proposed FSP.

In addition, the board is seeking input on any operational problems due to the fact that entities must also implement FASB Statement No. 161, Disclosures about Derivative Instruments and Hedging Activities, which is effective for the same period as that being proposed under the FSP.

FASB said it is seeking early implementation for the FSP because the proposed disclosures for all credit derivatives within the scope of FAS 133 are similar to those already being provided for certain credit derivatives that are within the scope of FIN 45.