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
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.
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:
Assets supporting the hedging relationship
- $200m of five-year assets
- $225m of seven-year assets that, for the purposes of this hedge relationship, are assumed to be five-year assets using the partial term hedging guidance
- $225m of seven-year assets
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.