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The “last-of-layer” method permits reporting entities to designate the portion of a closed portfolio of prepayable financial assets, beneficial interests secured by prepayable financial assets, or a combination that is not expected to be prepaid as the hedged item in a fair value hedge. Although the last-of-layer model was designed with an eye towards mortgage loans or mortgage-backed securities, it may be applicable to other prepayable assets as well. However, the guidance does not extend to prepayable 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 can be assumed to be the same for hedge accounting purposes.
  • If the remaining term is the same, the benchmark rate component of the contractual cash flows on each asset in the portfolio will be the same because the benchmark rate component is determined as of hedge designation.
  • The guidance indicates that prepayments do not need to be considered in measuring the hedged item in a last-of-layer 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).
The result is a portfolio of bonds that should pass the similar assets test qualitatively.

ASC 815-20-55-14A

If both of the following conditions exist, the quantitative test described in paragraph 815-20-55-14 may be performed qualitatively and only at hedge inception:
  1. The hedged item is a closed portfolio of prepayable financial assets or one or more beneficial interests designated in accordance with paragraph 815-20-25-12A.
  2. 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 last-of-layer hedges

Last-of-layer hedges are designated as the “last x dollar amount” of prepayable financial assets in a closed portfolio for a defined partial-term period. The reporting entity needs to support its expectation that the hedged amount (the last of layer) 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 last of layer is the balance that is “anticipated to be outstanding” considering “prepayments, defaults, and other events,” such as sales, throughout the defined partial-term period. 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 last of 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 partial-term period and update that expectation each period. On a quarterly basis, the analysis performed under ASC 815-20-25-12A(a) must be reperformed using then-current expectations of prepayments, defaults, and other events 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, it can 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 dedesignation of the hedging relationship when necessary, if it identifies the need to do so before the remaining assets in the pool fall below the layer designated.
Discontinuance of last-of-layer hedges is addressed in DH 10.3.8.

6.5.2 Measurement of the hedged item in a last-of-layer hedge

Under the last-of-layer method, a reporting entity is not required to incorporate prepayment risk into the measurement of the hedged item.

ASC 815-20-25-12A

For a closed portfolio of prepayable financial assets or one or more beneficial interests secured by a portfolio of prepayable financial instruments, an entity may designate as the hedged item a stated amount of the asset or assets that are not expected to be affected by prepayments, defaults, and other factors affecting the timing and amount of cash flows if the designation is made in conjunction with the partial-term hedging election in paragraph 815-20-25-12(b)(2)(ii) (this designation is referred to throughout Topic 815 as the “last-of-layer method”).
  1. As part of the initial hedge documentation, an analysis shall be completed and documented to support the entity’s expectation that the hedged item (that is, the designated last of layer) is anticipated to be outstanding as of the hedged item’s assumed maturity date in accordance with the entity’s partial-term hedge election. That analysis shall incorporate the entity’s current expectations of prepayments, defaults, and other events affecting the timing and amount of cash flows associated with the closed portfolio of prepayable financial assets or beneficial interest(s) secured by a portfolio of prepayable financial instruments.
  2. For purposes of its analysis, the entity may assume that as prepayments, defaults, and other events affecting the timing and amount of cash flows occur, they first will be applied to the portion of the closed portfolio of prepayable financial assets or one or more beneficial interests that is not part of the hedged item (that is, the designated last of layer).

6.5.3 Basis adjustments in last-of-layer hedges

Basis adjustments on the closed portfolio in a last-of-layer hedge may need to be allocated to the individual assets in the portfolio for various reasons, including calculating impairments or interest income, determining the carrying amount for assets removed from the portfolio, or for disclosure.
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