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ISDA PRESS REPORT - OCTOBER 25, 2001
ACCOUNTING * FASB Adds Performance Reporting Project, Defers Intangible Assets Disclosure Decision - BNA CREDIT DERIVATIVES * Railtrack, Swissair First Test of Europe's Default Swap Market - Bloomberg REGULATORY * Canada Publishes Final Regulations To Implement Financial Services Framework - BNA RISK MANAGEMENT * The Case for Catastrophe Bonds TRADING PRACTICE * End Of Cantor Treasurys Quotes On Telerate Causes Bother - Dow Jones FASB Adds Performance Reporting Project, Defers Intangible Assets Disclosure Decision BNA - October 25, 2001 NORWALK, Conn.--The Financial Accounting Standards Board Oct. 24 formally added a project on performance reporting to its rulemaking agenda, but it deferred a decision on whether to start a separate standard-setting effort on disclosures about intangible assets. The topic of intangibles was the subject of extended debate among FASB's seven members as they weighed its importance in allocating staff resources to such a project or to two other issues vying for the attention of rulemakers. FASB heard arguments from one board member, John Wulff, suggesting that an effort to simplify and codify standards and other guidance that form statements of generally accepted principles, together with writing standards on revenue recognition and defining liability, may be more suitable candidates for rulemaking. Major U.S. corporations, through at least one trade group, the Institute of Management Accountants, counseled the course described by Wulff, a former leader of Financial Executive International's Committee on Corporate Reporting. That committee opposes FASB's taking on the performance reporting and intangibles projects as outlined in a prospectus issued about two months ago. FASB settled on a compromise plan offered by board Chairman Edmund Jenkins. In the compromise, the panel's staff will carry out further preparatory work on intangible assets. At the same time, FASB's staff will study the three potential projects--revenue recognition and liability definition, simplification and codification of accounting rules, and disclosures about intangibles--with an eye toward deciding an appropriate use of staff accountants' time. The additional work on intangibles is to focus on summarizing existing research on such non-concrete assets as in-process research and development, patents, and customer lists, with particular focus on questions about what information on intangibles is useful to investors, security analysts, and other users of financial statements. FASB would not carry out polling or surveys, the board emphasized. The board tentatively set a deadline of Dec. 24 for completion of the two-pronged work by its staff. That timetable would suggest FASB plans to make a more definitive decision on adding a second, or even a third, standard-setting project in early 2002. 'Minimum Approach' in Performance Reporting Effort FASB's new rulemaking on performance reporting represents an effort to improve and make more useful information displayed on all the basic financial statements, both interim and annual. In such a "display and presentation" project, the board would not address recognition and measurement questions, according to a staff summary. FASB's staff recommended that the board "stick close" to what is known as the minimum approach in the performance reporting project, said Ronald Bossio, a senior staff project manager. Pursuing that approach was the avenue favored by most of the board's constituents who expressed support for starting the standard-setting effort. The minimum approach is described by FASB's staff as one that would have the board "explore whether certain line items, subtotals, and totals should be defined in standards and required to be displayed in financial statements, including interim statements. "Line items and amounts that would be considered include those related to metrics commonly used by investors and creditors in assessing financial performance," the staff continued in a summary distributed at the board's Oct. 24 meeting. Favored less by constituents and not advocated so far by any board member in preliminary discussions is a broader approach. Under that, FASB would describe how key financial metrics--usually ratios or some other indicator--should be calculated if they are presented in financial statements. However, the methods of figuring such metrics would not be required to be shown in the financial statements, according to the staff's summary of the broader path. Gary Schieneman, a veteran security analyst who joined FASB in July, said he supports taking on the project on performance reporting. He added, however, "I think it will be difficult to stick closely to the minimum approach." Michael Crooch, a colleague on the board, said he, too, supports the rulemaking effort, but voiced a concern that the effort "may be a project that has no bounds. This is one we have to watch with regard to scope." The International Accounting Standards Board has begun its own standard-setting on performance reporting. That task is being carried out jointly with the United Kingdom's Accounting Standards Board in an effort, in part, toward helping ensure convergence of financial reporting rules around the world. FASB plans to monitor the IASB-ASB joint project. Defining Simplification Wulff, a former high-ranking financial executive at Union Carbide who joined FASB with Schieneman, first raised the issue of perhaps taking on other projects--revenue recognition and simplification--when he was asked to voice a view on embarking on the performance reporting project. what "simplification" is came to a head in FASB's debate when Wulff, weighing the intangible assets project, questioned moving ahead on that effort before understanding how many staff resources would be used in writing standards on disclosures about intangibles. Some in the community of financial statement preparers--generally U.S. corporations and their trade groups--oppose FASB's taking on the performance reporting and intangibles projects. Instead, they suggest the accounting board should begin rulemaking on liability and revenue recognition and what the Institute of Management Accountants (IMA) labels "FASB Codification/Simplification." FASB board members and IASB's liaison to the U.S. board, James Leisenring, said they know what codification means. The name signifies a collection of FASB's authoritative literature and GAAP in general that should be collected in "one comprehensive format," as IMA's Financial Reporting Committee wrote in a Sept. 19 letter to the accounting board. However, several board members and Leisenring, FASB's former vice chairman, regarded arguments for simplification warily, as shown by their comments Oct. 24. "I know what codification is," said Leisenring. "I don't know what simplification is." He and FASB members Neel Foster and Katherine Schipper suggested they know what simplification could mean, but did not elaborate, instead making veiled references to moves such as requiring full fair value-based recognition of financial instruments in the income statement, widely opposed by banks and corporations. Simplification a Complicated Effort "I also know that isn't what they want," Leisenring said of advocates of a simplification project. He suggested that, if such a project is anything like IASB's current effort to improve existing international accounting standards, simplification would prove not so simple--and would consume hundreds of hours of staff time "if it's a serious endeavor." Foster labeled arguments that FASB should begin a simplification effort "an attempt to tie this organization up for the next 20 years." Schipper, who alone objected to Jenkins's compromise on the intangibles project, said the board should begin the rulemaking on disclosures about intangibles "immediately" and proceed "full speed ahead." Schipper cited the lack of comparability in current reporting on purchased intangible assets, which are accounted for under FASB's new rules on business combinations, and on intangibles that are internally generated. The latter and their values often are not reflected at all in financial statements, although they are said to be key drivers in the so-called "new economy." In-process research and development, which figured prominently in mergers and acquisitions in the high technology sector, "needs a very strong look," she added. Schipper, a former accounting professor at the University of Chicago and Duke University, said of accounting for intangibles: "This issue has been studied up and down, left and right, ... from floor to ceiling. "You may think [the academic] research is stupid and misguided. I don't," she said in urging a quick start on standard-setting. Other Action by FASB In other action at its Oct. 24 meeting, the board tentatively decided to: * reactivate its dormant project on costs associated with activities stemming from disposal of a factory or other hard asset used in a discontinued business operation and reconsider all of the guidance in Issue No. 94-3 of FASB's Emerging Issues Task Force, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity," including one-time employee termination benefits and other restructuring costs; * issue draft rules in mid-November to rescind FASB Statement No. 4, Reporting Gains and Losses from Extinguishment of Debt, and to make miscellaneous technical corrections, including non-substantive changes to FASB Statement No. 13, Accounting for Leases, and amendments related to FASB Statements No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets; and * consider at an upcoming meeting plans to revive--and most likely head in a different rulemaking direction than previously pursued--the board's 20-year-old project on consolidations policy, or defining when an affiliate of a company should be deemed a subsidiary and have its activities included in the financial statements of the parent. In previous incarnations of FASB, an accounting model based on control of an entity did not garner enough support to advance to a final accounting standard and was criticized strongly by FEI and others. The control-based model departed from the traditional majority equity ownership model, which several FASB members suggest is not followed in current practice despite its standing as accounting gospel. Railtrack, Swissair First Test of Europe's Default Swap Market Bloomberg - October 2001 By Tom Kohn Europe's $250 billion market for credit default swaps, a form of insurance against companies missing their debt payments, is getting its first test as Railtrack Plc and Swissair Group wrestle with insolvency. Credit default swaps let banks and other investors juggle the risk that a bond or loan won't be paid back. The buyer of such protection pays an annual premium, and the seller pays if there's a so-called credit event, such as a company going bankrupt. ``Railtrack is the bigger of the two tests to the overall market,'' said Dale Lattanzio, head of structured credit trading at Merrill Lynch & Co. ``While the government said the bonds will be OK, under the terms of the contract it triggered a credit event, and the credit derivatives market is treating it'' as such. Britain's government seized control of Railtrack on Sunday to stop the owner of the U.K.'s rail network going bankrupt. It would have debts of 700 million pounds ($1 billion) by December and 1.7 billion pounds by March, government lawyer David Richards told the High Court. Railtrack owes bondholders more than $2.2 billion. Swissair is seeking bankruptcy protection after running out of money Oct. 1. Europe's seventh-biggest airline owes bondholders $2.6 billion. The company's market value is currently $48 million, after its shares fell 97 percent this year. Settling Claims Default swaps traded for both companies, and were triggered by the announcements. ``We're going through the process of settling claims,'' said Lattanzio. ``There's a broad agreement in the London-based credit derivatives market, and it's been fairly orderly with no market disruptions.'' Sellers of credit protection aren't likely to refuse to pay out on their contracts, traders said. Still, because the companies' near-bankruptcies sparked swap payments it will test the legal contracts on which the banks rely. Credit derivative agreements depend on legal documents developed by the International Swaps and Derivatives Association, which represents about 540 securities firms. Banks use ISDA contracts for credit default swaps to ensure their agreements won't collapse if unexpected events occur. ISDA defines a credit event as ``bankruptcy, failure to pay, obligation default, obligation acceleration, repudiation or moratorium, and restructuring.'' ``The likelihood is that the documentation should stand up,'' said Ruth Ainslie, senior policy director at ISDA in New York. She said that depends if banks used ISDA agreements and ``whether or not they have been radically changed.'' ISDA has received legal opinions on Swiss and U.K. jurisdiction, because ISDA contracts cover a ``very broad range'' of agreements, she said. `Consternation' The U.K. government plans to transfer Railtrack's bonds into a new company, rated at least ``BBB'' by Standard & Poor's and ``Baa2'' by Moody's. Bondholders would get interest and be repaid when the debt matures at ``broadly'' the same terms, Transport Secretary Stephen Byers said this week. ``Initially there was consternation when Railtrack was put into receivership,'' said Ned Swan, a partner and derivatives specialist at law firm Simmons & Simmons. Still, ``it's a major company with major assets. It was a surprise, but these things will be worked out.'' The Bank of England estimates the credit derivatives market has a face value of about $1 trillion, with credit default swaps accounting for about half the market. London trading accounts for ``just under'' half the market. Up to 2,000 swaps on companies are traded, with 500 to 1,000 trading ``actively.'' the bank said in a June report. The central bank cited British Bankers' Association and U.S. government figures as well as its own estimates. The U.S. Office for the Comptroller of the Currency reported U.S. commercial banks had credit derivatives with a face value of $351 billion at the end of the second quarter. U.K. securities watchdog the Financial Services Authority monitors the banks trading credit default swaps, though doesn't regulate credit derivatives. ``We don't regulate it as a product,'' said Karin Loudon, an FSA spokeswoman. ``It's up to the banks to manage their own legal risk.'' UBS AG sued Deutsche Bank AG for $10 million at Britain's high court in March for failing to pay on a default swap when Armstrong World Industries Inc., the U.S.'s biggest vinyl-flooring maker, defaulted on its debt. The dispute centered on Armstrong's name, because the contract referred to its parent company, Armstrong Holdings Inc., according to the court filing. The two banks settled the suit March 15. An FSA spokesman said at the time that regulators don't typically intervene in such cases because banks usually resolve disputes among themselves. Canada Publishes Final Regulations To Implement Financial Services Framework BNA - October 25, 2001 OTTAWA--The Canadian government has implemented new framework legislation for the financial services sector, including domestic and foreign banks, trust companies, insurance companies, credit unions and other financial institutions, Secretary of State (International Financial Institutions) James Peterson said Oct. 24. Implementation of Bill C-8, An Act to establish the Financial Consumer Agency of Canada and to amend certain Acts in relation to financial institutions, coincides with the publication of a finalized package of regulations necessary to give effect to the legislation's provisions, Peterson said in a statement. "The measures contained in Bill C-8 will help to ensure that the Canadian financial services sector continues to be among the safest and most accessible in the world," he said. "The legislation will promote efficiency and growth in the sector, foster international competitiveness and domestic competition, empower and protect consumers of financial services, and improve the regulatory environment." The legislation also creates the Financial Consumer Agency of Canada, which begins operations Oct. 24 and will enforce compliance with the legislation's consumer provisions and educate consumers on how the legislation benefits them, he said. The new agency has been in the public spotlight recently as a necessary element of the federal government's efforts to track down and freeze assets in Canada of international terrorist organizations. The Department of Finance published the finalized package of 75 regulations in the Oct. 24, 2001 issue of the Canada Gazette, Part II. The regulations are particularly important because a key element of the new financial framework is the use of regulations to provide a more flexible regulatory environment for the financial sector, said a regulatory impact analysis statement published with the finalized regulations. "This allows the government to make modest policy adjustments to the framework in response to significant changes taking place in the global environment in which financial institutions operate. Many regulations are being proposed or modified in order to achieve this policy objective of creating a more flexible regulatory regime," the impact analysis statement said. The current proposals are the first of several packages of regulations that will be brought forward to implement the policy intent of the new Act, and will include regulations essential to operation of the legislation, it said. Of the 75 regulations, 37 relate to the new framework's restructuring of the permitted investment regime, while 18 are related to the new holding company regime for financial institutions, six relate to creation of the new Financial Consumer Agency of Canada, six relate to changes to the foreign bank regime and the remaining eight are aimed at various other policy objectives, it said. Key areas of the regulations relate to the activities of banks include: * definition of "aggregate financial exposure" for banks engaging in certain transactions with related parties that are not federally regulated financial institutions; * limits on the commercial lending activities of financial institutions other than banks; * requirements for financial institutions to inform customers with a complaint about a product or service on how to contact the Financial Consumer Agency of Canada; * exemption of certain classes of entities from the status of being an entity associated with a foreign bank and exemption of certain classes of entities from the definition of foreign bank; * definition of the term "equity" when used in dealing with ownership rules for banks and demutualized insurance companies; * rules on the investment powers of entities in which a financial institution holds more than 10 percent of the voting shares or 25 percent of the equity, but not control; * definition of "financial leasing"; * prescription of a range of information-processing activities permitted for banks and authorized foreign banks, including payroll processing, clearing and management of deposit accounts; * prescribed limits for the amounts of real property and equity investments permitted for financial institutions; * rules governing the ability of an entity to identify itself as a member of a group in describing its corporate relationship with a foreign bank; * prohibitions that apply to a foreign bank's real property activities outside of its authorized foreign bank branch; * rules governing the content of a prospectus; * expansion of the scope of commercial companies in which financial institutions are permitted to invest, subject to a number of constraints and caps; and * provisions permitting regulated securities entities to hold shares of a parent bank holding company to a limit of one percent of the bank holding company's regulatory capital. End Of Cantor Treasurys Quotes On Telerate Causes Bother Dow Jones - October 25, 2001 TOKYO -- Some Japanese institutional investors were a little peeved Thursday when information provider Telerate stopped offering Treasurys' pricing from major inter-dealer broker Cantor Fitzgerald Securities, but the change hasn't hampered trading of U.S. government debt, said Tokyo traders. Telerate, owned by Moneyline, stopped posting Cantor Fitzgerald real-time U.S. Treasury bond pricing on its screens globally from 5:00 p.m. EDT Wednesday. The information and data provider said it would replace the service with price quotes from rival inter-dealer broker BrokerTec Global LLC. But as of 0700 GMT (3:00 a.m. EDT Thursday) the display remained blank. The reason for the change wasn't immediately clear. "Investors have called in to say it's inconvenient that they can't check the Cantor page (on Telerate) and have asked about prices," said a foreign securities house trader in Tokyo. "They are now logging onto the Cantor's website or having to set up a Cantor page on a Bloomberg terminal." Apart from a bit of hassle suffered by some investors, however, impact on trading was limited. Even with comprehensive on-screen price data investors will typically phone up several brokerages to get bond price quotes before deciding to trade, said a trader at a large Japanese insurance company. Losing access to price indications wouldn't change that practice, he added. Brokerage and bank Treasurys dealers, and their colleagues in the swaps market, were unaffected as apparently none of them rely solely on the Telerate service for U.S. debt security pricing information, traders said. Telerate continues to provide limited non real-time U.S. government bond pricing data from Cantor Fitzgerald and other brokers on a separate display. The Case for Catastrophe Bonds The New York Times - October 25, 2001 By Hal R. Varian The insurance industry faces claims of at least $40 billion tied to the World Trade Center attacks, and it remains exposed to significant risk from future incidents. Retail insurance companies are considering exclusions for terrorist damage, leaving property owners unable to buy the coverage they need. The problem lies in the reinsurance industry, the wholesale market where insurers lay off large risks to pools of investors willing to absorb them. Warren E. Buffett's reinsurance company, General Re, has done well in the last few years offering property reinsurance because there have not been major hurricanes or earthquakes. But its luck ran out last month: General Re has said it is liable for over $2 billion of the total industry losses in the Sept. 11 attacks. Earthquakes and hurricanes, unpleasant as they are, present manageable risks: insurers know roughly how often they occur in various places, what their likely magnitudes are and how much property damage might be expected. Terrorist risk is much harder to quantify, leading to the current paralysis in the reinsurance market. The insurance industry has been lobbying in Washington to make the federal government the insurer of last resort against terrorism, which means that taxpayers will end up bearing the financial risk of future attacks. Britain adopted a government-backed reinsurance market several years ago and, so far, it has worked reasonably well. But there is another way to supplement traditional reinsurance markets that has been attracting increasing attention: catastrophe bonds. These bonds, generally sold to large institutions, have typically been tied to natural disasters, like earthquakes or hurricanes, but they could, in principle, be used to provide financial backing for terrorism insurance. Here is how they work. A financial intermediary, like a reinsurance company or an investment bank, issues a bond tied to a particular insurable event, like a Los Angeles earthquake. If there is no earthquake, investors are paid a generous interest rate. But if the earthquake occurs and the claims exceed an amount specified in the bond, investors sacrifice their principal and interest. How generous does the interest rate have to be? That is left up to the market. If the bond sales offer cheaper reinsurance coverage than do traditional private placements used in the reinsurance market, these bonds, known as cat bonds, are a preferred method of finance. Cat bonds are a form of "contingent security," a concept first formulated by Kenneth J. Arrow of Stanford University, winner of the 1972 Nobel in economic science. Back in 1952, Professor Arrow came up with the idea of a security that would pay a fixed amount of money depending on whether or not some event occurred. He showed that portfolios of such contingent securities could be used to allocate virtually any kind of risk in an efficient manner. The analysis by Professor Arrow was long thought to be of only theoretical interest. But it turned out that all sorts of options and other derivatives could be best understood using contingent securities. Now Wall Street rocket scientists draw on this 50-year-old work when creating exotic new derivatives. There are a number of special cases of contingent securities. Consider a security tied to my house burning down. This would certainly affect my net worth, but would have negligible impact on the owners of the other 70 million housing units in the United States. This kind of personal risk can easily be shared among many people, each paying only a small amount if the event occurs, and homeowners insurance is to ease this kind of risk sharing. This works fine for small independent risks, but there are other sorts of events that impose large costs on many people at the same time, like earthquakes or hurricanes. Insurance companies are able to deal with such events using reinsurance markets, where the risk is transferred to large investors. There are other financial institutions that also allow for risk transfer for this sort of widespread risk. The orange juice futures market in Chicago is essentially a market in a contingent security tied to whether it freezes in Orlando, Fla. A futures market allows market participants who bear a significant risk (like farmers worried that their crop might be destroyed) to transfer some of that risk to others, who are, of course, paid to absorb it. The futures market allows shifting of risk rather than a simple sharing of risk. Risk sharing and risk shifting are familiar terms, but there is another phenomenon worth noting, something I like to call "risk shafting." This is when some risk - often a particularly large risk - is transferred to a third party who is forced to bear it involuntarily. In many cases, these third parties are taxpayers, who are not even aware of their potential liability. Hence the debate that is going on in Washington now: should the insurance industry be able to transfer the risk from future terrorist attacks to taxpayers? Or would it be better to use existing reinsurance markets or new financial instruments like catastrophe bonds to shift the risk to those willing and able to bear it if appropriately compensated? Cat bonds have some attractive features. They can spread risks widely and can be subdivided indefinitely, allowing each investor to bear only a small part of the risk. The money backing up the insurance is paid in advance, so there is no default risk to the insured. As the market for cat bonds matures, secondary markets may develop, particularly if the bonds become standardized and bundled into portfolios. If so, the market price of cat bonds will reflect the market perceptions of the likelihood of the event associated with the bond, just as price changes on the orange juice futures market reflect the likelihood of a freeze in Florida. The market for cat bonds is still immature, and is only a fraction of the size of traditional reinsurance. But cat bonds and other sorts of contingent securities may well end up being part of the long-run solution to the problems of the reinsurance industry. **End of ISDA Press Report for October 25, 2001** THE ISDA PRESS REPORT IS PREPARED FOR THE LIMITED USE OF ISDA STAFF, ISDA'S BOARD OF DIRECTORS AND SPECIFIED CONSULTANTS TO ISDA ONLY. THIS PRESS REPORT IS NOT FOR DISTRIBUTION (EITHER WITHIN OR WITHOUT AN ORGANIZATION), AND ISDA IS NOT RESPONSIBLE FOR ANY USE TO WHICH THESE MATERIALS MAY BE PUT. Scott Marra Administrator for Policy and Media Relations International Swaps and Derivatives Association 600 Fifth Avenue Rockefeller Center - 27th floor New York, NY 10020 Phone: (212) 332-2578 Fax: (212) 332-1212 Email: smarra@isda.org
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