Most hospitals receive swap mark-to-market reports from counterparties each month, but some chief financial officers --and their auditors-- are unaware that under FASB, mark-to-market values must be adjusted before being used in audited financial statements.
FASB ASC 820 Fair Value Measurements and Disclosures defines fair value as the price that would be paid to transfer an asset or liability such as a swap as of the measurement date.
In the case of swaps, a key consideration of ASC 820 is that fair value include an adjustment for counterparty credit risk or non-performance risk.
Credit risk is the risk that any amount owed by one party to the other under the swap contract is not paid at the time of the transfer. Given that many hospitals carry swaps at a significant liability, credit risk is not a trivial matter.
To better understand how credit risk affects fair value, we review valuation approaches, future cash flows, discount rates, and collateral.
In general, valuation theory relies on three approaches: income approach, market approach, and cost approach.
With interest rate swaps, the income approach is the preferred approach.
The income approach values swaps using discounted cash flow analysis ("DCF") as the present value of all net cash flows projected to be exchanged between the two parties, based on an assumed discount rate.
The key inputs to DCF are future cash flows and discount rate (including any credit valuation adjustments) used to present value these cash flows.
Future Cash Flows
Interest rate swaps future cash flows consist of two payment streams or "legs":
- Fixed Leg:
Payments based on a fixed interest rate defined in the initial swap contract. With pay-fixed swaps, this is the leg that the hospital pays. The rate is known and usually set so that the net present value of the Floating Leg and Fixed Leg payments is zero at inception (aka "on-market").
- Floating Leg:
Payments based on a variable interest rate, typically LIBOR (taxable swaps) or a percentage of LIBOR (tax-exempt swaps), often plus a spread. With pay-fixed swaps, this is the leg the swap counterparty pays the hospital. Since by definition the floating rate varies, Floating Payments must be estimated based on the LIBOR forward curve. The forward curve is derived by "bootstrapping" the LIBOR spot curve, a forward substitution method using quoted periodic spot rates to estimate future spot rates based on a "no arbitrage" principle.
The discount rate is the rate used to discount projected cash flows for both legs of the swap. It is based on the current LIBOR spot rate yield curve, but under ASC 820 it can be adjusted for the credit (non-payment) risk associated with the party who is a net debtor on the measurement date.
The higher the non-performance risk, the higher the discount rate, and the lower the resulting present value of future net cash flows. This adjustment is known as the Credit Valuation Adjustment ("CVA").
In the corporate world, the CVA can often be quantified using Credit Default Swaps ("CDS") spreads. A CDS is a contract where the seller receives a series of payments from a buyer, and the buyer receives a single payment if a credit instrument defaults. The CDS cost represents the incremental yield investors require as compensation for non-performance risk.
While credit default swaps can be very handy to measure counterparty credit/non-performance risk, there is no CDS market for not-for-profit entities, so instead, the CVA is estimated using bond yields.
In todays' low rate environment, most hospitals who entered into pay-fixed swaps are net debtors. If on measurement date the hospital is the net debtor, the CVA will be based on the hospital's credit risk. If on the other hand the swap counterparty is the net debtor, the adjustment will be based on the swap counterparty's credit risk.
If the hospital owed under the swap and has bonds outstanding (as most do), the CVA is estimated based on how the hospital's bonds trade compared to a risk-free index such as the Municipal Market Data or MMD index, as well as general credit spreads for other hospital bonds in the same rating category.
Because the discount rate used to present value future net cash flows is based off LIBOR --a taxable rate-- credit spreads to the MMD are grossed up to a taxable-equivalent spread based on the ratio between taxable and tax-exempt rates for a term corresponding to the swap's remaining average life. If the credit spread is based on taxable rates, gross up is not applicable.
If the hospital is fortunate enough to be owed a termination payment by the swap counterparty, the credit spread is based on the counterparty's bond ratings and other counterparties in the same rating category.
Once the CVA spread is determined, it is simply added to the discount rate used in mark-to-market reports and the present value of the net cash flows is recalculated.
The difference between the new and old net present value is the CVA.
One benefit of the adjustment is that when the discount rate is higher, any amount owed by one party to the other is reduced. If the hospital carries a liability, the CVA will lower it. Of course, this can work against the hospital if the swap becomes an asset, but at that point the swap counterparty's credit quality is used so if the counterparty is better rated, the CVA could be smaller.
If the swap has collateral posting requirements, the amount at risk is smaller as the difference between the mark-to-market value and the value of the collateral posted as of the measurement date.
If the collateral is equal to or greater than the mark-to-market, there is no credit risk to the other party and the CVA is therefore zero. If on the other hand the collateral amount is less than the mark-to-market, the CVA is calculated based on the uncollateralized balance.
Hospitals with swaps on their books are advised to review their interest rate swap valuation methodology to ensure that non-performance risk is factored in the fair value reported in financial statements and the calculation is properly documented.
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This material is intended for general information purposes only and does not constitute legal advice. For legal issues, readers should consult legal counsel. To discuss this article or municipal advisory services, email or call 888-699-4830. HFA Partners, LLC is an Independent Registered Municipal Advisor registered with the Securities and Exchange Commission (SEC) and the Municipal Securities Rulemaking Board (MSRB) under the Dodd-Frank Act of 2010.
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