Last-of-Layer Hedging for Financial Institutions
Lenders such as banks, mortgage lenders, and credit unions manage large portfolios of fixed-rate loans. Typically, these assets are funded with floating-rate liabilities. This mismatch between fixed-rate assets and floating-rate liabilities can cause unwelcome earnings volatility.
Fortunately, FASB allows hedge accounting protection of pre-payable financial assets or a closed-end fund of pre-payable financial assets. Institutions can hedge the portion of their portfolios that are not expected to be affected by prepayments, defaults, or other characteristics that reduce maturities below the amount hedged.
Fair Value Hedge Objective
When funding fixed-rate assets with floating rate liabilities, the institution is at risk of rising rates.
A Fair Value hedge under ASC 815 allows both the hedge (mortgage portfolio) and the derivative (fixed for floating swap) to be fair valued through income. When the mortgage portfolio increases in value, the swap decreases in value — and vice versa. The result is little or no net earnings impact due to changes in the value of the hedged portfolio and, more importantly, the economics line up (fixed assets funded with fixed liabilities).
In ASU 2017-12, the FASB made several changes to fair value hedging, including allowing the hedged item to assume the same maturity as the hedged instrument. This has made partial-term hedging much more effective than in the past. No longer is there a maturity mismatch between the hedge and hedged item, which often leads to an ineffective hedge relationship or unwanted volatility.
In the Last-of-Layer hedge strategy, the hedged item becomes the portion of the total portfolio that is last to be subject to prepayment risk (See Exhibit A). This is the opposite of how most cash flow hedge programs are defined. In all other hedge designations, you are forbidden to retrospectively assign the layer of the exposure applied to the derivative, so programs hedge “the first amounts” of a hedge-able item and build up to the full hedged amount. In this hedge strategy, the hedged item starts with the most stable portion of the hedge-able portfolio, the last items to actually be subject to prepayment or default risk.
The partial term hedging is permitted under ASC 815-20-25-12(b)(2)(ii). As long as the termination date of the derivative is prior to the termination date of the assets, you can use partial term hedging to protect the period up through derivative termination.
Last-of-Layer Qualifying Item Criteria for Special Hedge Accounting
To qualify for this fair value portfolio hedging, all of the assets hedged must be similar in nature. In the past, this requirement was a show-stopper. Now, institutions can use the elections available in ASC 815 to define the hedged item and hedged risks to meet the similar assets test (see exhibit B).
ASU 2017-12 accounting guidance is making the last-of-layer hedge accounting method popular among financial institutions. Institutions can now isolate specific risks in a closed portfolio of pre-payable fixed-rate assets and hedge them efficiently, applying partial term hedge accounting in a last-of-layer approach. What used to fail as an effective hedge strategy of interest rate risk is now likely to qualify for and maintain an effective hedge relationship under ASC 815. The FASB is currently working on additional guidance that will expand this new strategy to include the ability to use a layered approach.