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6.5 Portfolio layer method
Publication date: 31 Jul 2022
us Derivatives & hedging guide
This section assumes adoption of ASU 2022-01. The “portfolio layer” method permits reporting entities to designate the portion of a closed portfolio of financial assets, beneficial interests secured by financial assets, or a combination of the two, that is not expected to be prepaid during the hedge period as the hedged item in a fair value hedge. Although the portfolio layer model (originally referred to as the last-of-layer model) was designed to consider prepayable mortgage loans or mortgage-backed securities, it may be applicable to other assets as well. ASU 2022-01 specifically allows for a closed portfolio of financial assets to include both prepayable and non-prepayable assets. The guidance allows an entity to essentially ignore prepayment risk in the hedge relationship even when prepayable assets are present in the closed portfolio. It does so by permitting designation of the portion of the pool not expected to be prepaid, defaulted, or sold as the hedged item. The guidance, however, does not extend to financial liabilities.
This hedging strategy leverages the guidance related to partial-term fair value hedges and the ability to measure the hedged item based on the benchmark component of the total contractual coupon. The combination of these decisions impacts the application of the similar assets test (required for all hedges of groups of assets to prove that the individual assets share the same risk exposure for the risk designated as being hedged).
- If the hedged item is designated using the partial-term guidance (i.e., the hedge period is not through the maturity date of the assets in the portfolio), the remaining term of all assets in the portfolio may be the same for hedge accounting purposes. In order to apply the portfolio layer method, the partial-term guidance will frequently be used.
- If the remaining term is the same, the benchmark rate component of the contractual cash flows on each asset in the portfolio will be similar because the benchmark rate component is determined as of hedge designation. A reporting entity is not required to use the benchmark rate component of the contractual cash flows to implement portfolio layer method hedging but would be required to quantitatively assess the similar assets test if not used. In addition, if the benchmark rate component guidance is not used, there may be additional complexities in calculating the change in fair value of the hedged item. As a result, we believe for practical reasons, most entities will elect to use the benchmark component of contractual cash flows since assessing similar assets and effectiveness and measuring the change in fair value of the hedged item would be more difficult when using the full contractual cash flows because each asset may have different contractual cash flows.
- The guidance indicates that prepayments do not need to be considered in measuring the hedged item in a portfolio layer method hedge because what is being hedged is a portion of the portfolio that will remain throughout the assumed maturity (i.e., through the end of the designated partial term period).
In certain circumstances, the use of a qualitative assessment may be acceptable for the portfolio of hedged items in a portfolio layer method hedge to satisfy the similar assets test.
If both of the following conditions exist, the quantitative test described in paragraph 815-20-55-14 may be performed qualitatively on a hedge-by-hedge basis and only at hedge inception:
- The hedged item is a hedged layer in a portfolio layer hedge designated in accordance with paragraph 815-20-25-12A.
- An entity measures the change in fair value of the hedged item based on the benchmark rate component of the contractual coupon cash flows in accordance with paragraph 815-25-35-13.
Using the benchmark rate component of the contractual coupon cash flows when all assets have the same assumed maturity date and prepayment risk does not affect the measurement of the hedged item results in all hedged items having the same benchmark rate component coupon cash flows.
6.5.1 Designation of portfolio layer method hedges
Portfolio layer method hedges are designated as the “last x dollar amount” of financial assets in a closed portfolio for a defined hedge period. The reporting entity needs to support its expectation that the designated hedged amount will remain outstanding through the defined partial-term hedge period. This is not a forecasted transaction, as in a cash flow hedge, but rather an estimate of the hedged item in a fair value hedge. As such, the reporting entity does not need to assert that the hedged amount is probable of being outstanding throughout the hedge period. The hedged layer is the balance that is “anticipated to be outstanding” considering “current expectations of prepayments, defaults, and other factors,” such as sales, throughout the defined hedge period. We believe entities should use their best estimate in order to determine if their current expectations indicate that there will be sufficient assets in the closed pool to support a hedged layer. Entities may consider utilizing the same assumptions as used in other areas of GAAP, such as when using a discounted cash flow for impairment purposes or computing fair value. When assets are removed from the closed portfolio through those events, they are deemed to be the ones that are not hedged, provided the removal of those assets does not cause the remaining balance of the portfolio to fall below the designated hedged layer amount.
The reporting entity needs to support and document its expectation that the hedged balance will remain outstanding through the end of the designated hedge period and update that expectation each period. On a quarterly basis (at a minimum), the analysis performed under ASC 815-20-25-12A(a) must be reperformed using then-current expectations of prepayments, defaults, and other factors affecting the timing and amount of cash flows associated with the closed portfolio to ensure the hedged balance is still expected to be outstanding at the end of the defined partial-term period. If expectations change, an entity should revisit the hedged balance. There is no concept of tainting, as there is with hedges of forecasted transactions in the cash flow hedging model. As a result, the reporting entity can re-evaluate its assumptions and adjust the hedged balance through partial voluntary dedesignation of the hedging relationship when necessary, if it identifies the need to do so when the remaining assets in the pool are projected to fall below or actually fall below the hedged amount designated. If at any point the reporting entity projects that it will not have sufficient assets in the future to support a hedged layer, it has an anticipated breach and must partially or fully dedesignate that hedged layer. An actual breach would occur if at any point the actual assets in the closed portfolio fall below the hedged amount.
Discontinuance of portfolio layer method hedges is addressed in DH 10.3.8.
ASU 2022-01 allows entities to designate multiple portfolio layer method hedges of the same closed portfolio of assets. For each designated hedged layer, however, the closed portfolio must have an amount of assets that is expected to remain outstanding to support each hedged layer individually and in totality. For instance, if a reporting entity has a portfolio of prepayable fixed rate loans that total $100 million of principal and expects that $70 million of the pool of assets would still remain outstanding after five years and $50 million of the pool of assets would still exist after seven years, an entity could enter into both a five-year hedge with a designated hedge amount of $20 million fair value hedge, and a seven-year hedge with a designated hedge amount of $50 million. In this situation, the reporting entity would be hedging $70 million of assets in the first five years since both hedges will be active during that time and would only be hedging $50 million of assets in years six and seven after the first hedge layer matures. Each hedged layer would require separate hedge documentation even though the hedges reference the same closed portfolio of assets.
ASU 2022-01 also allows for the use of amortizing notional swaps or forward starting swaps when entering into a portfolio layer method hedge. The use of an amortizing notional swap would be considered a hedge of a single layer. As a result, the hedge objectives discussed in the previous paragraph could be accomplished using two spot starting swaps as illustrated or using a spot starting swap and a forward starting swap or an amortizing notional swap.
When creating a closed pool of assets, entities may wish to use assets with different maturity dates. For example, assume an entity creates a closed pool of assets comprised of the following:
- $100m of assets with a three-year maturity
- $200m of assets with a five-year maturity
- $225m of assets with a seven-year maturity
Also assume that an entity has two interest rate swaps designated as hedging instruments in two portfolio layer method hedges with this closed pool of assets identified as the hedged item:
- $25m swap with a five-year maturity
- $50m swap with a seven-year maturity
In assessing whether the entity expects to have sufficient assets over the hedged period, different groups of assets would be available to support different hedges:
Hedging instrument |
Assets supporting the hedging relationship |
|---|---|
$25m five-year swap
|
|
$50m seven-year swap
|
|
In this example, the only assets available to support the seven-year hedging relationship are the seven-year assets. As a result, the entity should assess how much of the seven-year assets are expected to remain outstanding through their contractual maturity to support the seven-year hedging relationship. The portion of the seven-year asset group that is not being relied upon to support the seven-year hedging relationship would be available to support the five-year hedging relationship.
Note that in this situation, the $100m of three-year assets within the closed pool are not supporting either hedging relationship. However, since assets cannot be added to a closed pool once it is established, entities may want to include assets (such as three-year assets in this example) to support future shorter-term hedge relationships.
In this situation, the seven-year assets support the five-year hedge relationship (or the five-year layer) and the seven-year hedge relationship (the seven-year layer). In a portfolio layer method hedging relationship, the individual assets that support each hedge relationship are not specifically identified. For the purposes of supporting the five-year hedge relationship, the seven-year assets are assumed to be five-year assets through the use of the partial-term hedging guidance and, assuming an entity elects to hedge the benchmark interest rate component of the contractual cash flows, will have an assumed coupon based on the five-year benchmark interest rate. As a result, an entity may be able to conclude that the hedged components of the seven-year assets are similar to the five-year assets when performing the similar asset analysis. These assumed terms for the seven-year assets will also be used for the purposes of measuring change in fair value of the hedged item. For the purposes of supporting the seven-year hedge relationship, the seven-year assets have a seven-year maturity and, assuming an entity elects to hedge the benchmark interest rate component of the contractual cash flows, will have an assumed coupon based on the seven-year benchmark interest rate.
Refer to DH 10.3.8 for discussion on how reporting entities would select which layers to dedesignate in a multiple hedged layer strategy when there is a voluntary designation, anticipated, or actual breach.
6.5.2 Measurement of the hedged item in a portfolio layer hedge
Under the portfolio layer method, a reporting entity is not required to incorporate prepayment risk into the measurement of the hedged item.
For a closed portfolio of financial assets or one or more beneficial interests secured by a portfolio of financial instruments, an entity may designate as the hedged item or items a hedged layer or layers if the following criteria are met (this designation is referred to throughout Topic 815 as the “portfolio layer method”).
- As part of the initial hedge documentation, an analysis is completed and documented to support the entity’s expectation that the hedged item or items (that is, the hedged layer or layers in aggregate) is anticipated to be outstanding for the designated hedge period hedged. That analysis shall incorporate the entity’s current expectations of prepayments, defaults, and other factors affecting the timing and amount of cash flows associated with the closed portfolio.
- For purposes of its analysis in (a), the entity assumes that as prepayments, defaults, and other factors affecting the timing and amount of cash flows occur, they first will be applied to the portion of the closed portfolio that is not hedged.
- The entity elects to apply the partial-term hedging guidance in paragraph 815-20-25-12(b)(2)(ii) to the assets or beneficial interests used to support the entity’s expectation in (a). An asset that matures on a hedged layer’s assumed maturity date meets this requirement.
The measurement of the hedged item will be based on the assumed maturity date (and perhaps the proposed investment date) of the hedged item utilizing the partial term hedging guidance (see DH 6.5.1). The measurement of the hedged item may also be based on the benchmark component of the contractual cash flows if an entity elects to apply that guidance.
ASU 2022-01 clarified that multiple portfolio layers are allowable within a single closed portfolio of assets (codified in ASC 815-20-25-12B).
After a closed portfolio is established in accordance with paragraph 815-20-25-12A, an entity may dedesignate new hedging relationships associated with the closed portfolio without dedesignating any existing hedging relationships associated with the closed portfolio if the criteria in paragraph 815-20-25-12A are met for those newly designated hedging relationships.
6.5.3 Basis adjustments in portfolio layer method hedges
Basis adjustments on the closed portfolio in a portfolio layer method hedge should not be allocated to the individual assets in the portfolio until the hedge is dedesignated.
For an active portfolio layer method hedge, basis adjustments should be maintained on the closed portfolio of assets, however, the basis adjustment would not be allocated to individual assets and an entity is prohibited from considering the basis adjustment when determining if an available-for-sale security is impaired or when measuring expected credit losses. Consistent with the guidance in ASC 815-25-35-6, the basis adjustment associated with available-for-sale securities would result in an adjustment to the amount recorded in AOCI for those securities. For available-for-sale securities subject to fair value hedges, changes in the fair value of the security for the hedged risk are recognized in earnings as opposed to AOCI.
If the closed pool of assets are presented in different financial statement line items within the statement of financial position, the portfolio layer method basis adjustments should be allocated to those line items using a systematic and rational method. One such method would be proportional based on the unpaid principal/par amount of assets within the closed portfolio presented on each line.
Once a portfolio layer method hedge is discontinued, the remaining basis adjustment should be allocated to the individual assets within the closed pool. If the hedge is voluntarily dedesignated or is dedesignated as part of an anticipation of a breach, the basis adjustment associated with the dedesignated amount of the hedged layer should be allocated to the remaining individual assets within the closed portfolio that are available to support the hedged layer or layers (that is, those assets with a contractual maturity date on or after the end of the hedge period for the dedesignated layer or layers). In either a single or multiple hedged layer strategy, the basis adjustments should be allocated to individual assets using a systematic and rational method. Partial dedesignations are allowed, so only the basis adjustment associated with the amount dedesignated would be allocated to individual assets.
If an actual breach occurs, an entity must determine the amount of the basis adjustment associated with the amount of the hedged layer that exceeds the remaining closed portfolio. That basis adjustment should be recognized immediately in interest income. Partial dedesignations are also allowed in the event of an actual breach, and any amount dedesignated in excess of the actual breach amount would be treated the same as in a voluntary or anticipated breach and allocated to the remaining assets in the closed pool.
The basis adjustments allocated to individual assets should be amortized into income in a manner consistent with amortization of premiums or discounts for that asset. Refer to DH 10.3.8 for further discussion on the dedesignation of portfolio layer method hedges.
6.5.4 Transition guidance for ASU 2022-01
The provisions of ASU 2022-01 are required to be adopted by public business entities for fiscal years beginning after December 15, 2022 and by all other entities for fiscal years beginning after December 15, 2023. Early adoption of the standard is permitted on any date subsequent to the issuance of ASU 2022-01.
All provisions of the standard are to be adopted on a prospective basis with the exception of the accounting for basis adjustments, which must be adopted on a modified retrospective basis. As discussed in DH 6.5.3, under ASU 2022-01, basis adjustments should not be allocated to individual assets within the closed portfolio of assets, but maintained against the closed portfolio of assets as a whole. Reporting entities that had previously entered into portfolio layer method hedges (at which time they were known as “last-of-layer” hedges) and had allocated basis adjustments to the individual assets associated with these hedges, should reverse this allocation on all active portfolio layer method hedges. For active hedges, this may result in a cumulative effect adjustment to the opening balance of retained earnings as the removal of the basis adjustments from the individual assets will have an impact to the accounting at the individual asset level, including in recording credit loss and accounting for premiums and discounts.
ASU 2022-01 allows reporting entities to make a one-time reclassification of debt securities that are currently classified as held to maturity to available for sale. In order to reclassify a debt security, the security must be included in a closed portfolio that is designated in a portfolio layer method hedge within 30 days of the date of adoption of the standard. As a result of this special transition provision, this reclassification would not call into question the reporting entity’s previous assertions that it had the intent and ability to hold these debt securities until maturity.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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