1997 Twenty-Fifth Annual National Conference on Current SEC Developments December 10, 1997 Remarks by Walter R. Teets Academic Accounting Fellow Current Accounting Projects Office of the Chief Accountant United States Securities and Exchange Commission (c) Copyright 1997. All rights reserved ______________________________ As a matter of policy, the Commission disclaims responsibility for any private publications or statements by any of its employees. The views expressed are those of the author, and do not necessarily reflect the views of the Commission or the author's colleagues on the staff. INTRODUCTION Good morning. I would like to thank the AICPA for inviting me to participate in this conference. This morning, I will be talking about disclosures made under the SEC's rule requiring quantitative and qualitative information about market risk sensitive instruments. Earlier today, Jane Adams mentioned several OCA projects related to the market risk release. I will provide some of the staff's observations on market risk disclosures presented in 10-Ks files by companies with June, July, and August year ends. Included in materials distributed this morning are examples modeled on filings the staff has examined. I will use those to illustrate my remarks in seven areas. PLACEMENT OF THE DISCLOSURES The first issue is WHERE the disclosures are located. Item 6 under the "General Instructions to Paragraphs 305(a) and 305(b)" specifies that "registrants should present the [quantitative and qualitative] information outside of, and not incorporate the information into, the financial statements (including the footnotes to the financial statements)." Nonetheless, some registrants are including the market risk disclosures in the footnotes. Registrants should be aware that the safe harbor for forward looking statements provided in Section 27A of the Securities Act and Section 21E of the Exchange Act does not apply if the disclosures are placed in the footnotes to the financial statements. This is one of many points stressed in the SEC staff publication "Questions and Answers About the New 'Market Risk' Disclosure Rules," available at the SEC website, http://www.sec.gov/rules/othern/derivfaq.htm. Illustration 1 shows sensitivity analysis disclosures in the registrant's financial instruments footnote. The column "Hypothetical decrease in fair value (Unaudited)" was simply appended to the fair value disclosure table the registrant used in its 1996 filing. The fair value table in 1996 appeared in the footnotes to the financial statements. The modified table with the added "hypothetical decrease" column was still placed in the footnotes in the 1997 filing. ____________________________________________________________________________ Illustration 1 Note X: Financial Instruments Fair value of financial instruments (in thousands) - - --------------------------------------------------------------------------- Hypothetical decrease Face Carrying Fair in fair value(1) amount(1) amount(1) value(1) (Unaudited) - - --------------------------------------------------------------------------- JUNE 30, 1997 Long-term debt $ (852) $ (839) $ (819) $ 154 Hedging instruments: Forward contracts 1,074 (19) (12) (132) Options 719 6 1 -- Interest rate swaps 261 18 (10) (8) - - --------------------------------------------------------------------------- JUNE 30, 1996 Long-term debt $(1,006) $(1,000) $ (987) $ 71 Hedging instruments: Forward contracts 868 (1) (2) (69) Options 702 1 -- -- Interest rate swaps 275 17 (16) (10) - - --------------------------------------------------------------------------- (1) Asset/(liability) ____________________________________________________________________________ SEPARATE DISCLOSURES BY RISK CATEGORY A second observation can be made based on Illustration 1. The rule requires that "separate quantitative information shall be presented, to the extent material, for each market risk exposure category" if the registrant chooses to use sensitivity analysis. In the table provided, the registrant reports sensitivity measures for the types of instruments, not the risk categories. That is, the long-term debt and interest rate swaps are subject to interest rate risk. From other information in the 10-K, the forwards and options hedge foreign exchange exposures. The rule allows disclosure of separate measures for each of the four items shown, but requires a single measure for each market risk category. Therefore, this disclosure could be improved by providing separate totals for interest rate sensitivity and foreign exchange rate sensitivity. INSTRUMENTS SUBJECT TO MORE THAN ONE MARKET RISK The table in Illustration 2 provides another example of a registrant failing to provide separate disclosures by risk category, and illustrates another problem as well. This registrant chose to provide information in a tabular format. The rule requires that "market risk sensitive instruments that are exposed to rate or price changes in more than one market risk exposure category should be presented within the tabular information for each of the risk exposure categories to which those instruments are exposed." Interest rate sensitive instruments and foreign exchange sensitive instruments are included in the same table. In addition, there is no indication that the yen and deutschemark denominated debt instruments are subject to both interest rate and foreign exchange risk. ____________________________________________________________________________ Illustration 2. Fair Value, Expected maturity Subse- June 30, dates (in millions) 1998 1999 2000 2001 2002 quent Total 1997 - -------------------------------------------------------------------------- DEBT Current commercial paper $246 $246 $246 Avg. interest rates 5.3% Current - yen 218 218 225 Avg. interest rates 5.1% Interest rate swaps 15 90 8 Non current - yen $124 124 291 Avg. interest rates 4.9% Non current - Deutschemark 41 41 41 Average interest rates 6.6% Non current - U.S. $ 118 225 $ 6 349 364 Average interest rates - fixed 7.5% 9.1% 9.6% Average interest rates - variable 4.1% FIRM COMMITMENTS, FORWARD CONTRACTS Contract notional amount - yen purchased 218 214 (28) Average contractual exchange rate 1.55 1.68 ============================================================================ (a) Represents unrealized exchange gains related to hedge of yen denominated debt. ____________________________________________________________________________ CROSS-REFERENCES A consistent problem seen in numerous filings is a lack of cross-referencing. The rule states that "registrants are encouraged to provide the required information in one location. However, alternative presentation, such as inclusion of all or part of the information in Management's Discussion and Analysis, may be used at the discretion of the registrant. If information is disclosed in more than one location, registrants should provide cross-references to the locations of the related disclosures." Again, consider Illustration 2. If a tabular format is chosen, the registrant should provide "contract terms sufficient to determine future cash flows from those instruments, categorized by expected maturity dates." The rule goes on to suggest that for swaps, the contract terms should include "notional amounts, weighted average pay rates or prices, and weighted average receive rates or prices." Consider the interest rate swap line. Assuming that the numbers in the table are notional amounts, they do not provide enough information to allow the reader to determine related cash flows. However, 20 pages earlier, the reader could have found Illustration 3, which has exactly the type of information suggested by the rule. Many registrants are providing no cross-referencing to help the readers tie disclosures together. ____________________________________________________________________________ Illustration 3 Notional amounts outstanding (in millions) and weighted average rates at June 30 are: 1997 1996 - ----------------------------------------------- Received Fixed/pay floating - notional amounts $90 $90 Weighted average receive rate 6.2% 6.2% Weighted average pay rate 5.9% 6.0% Pay Fixed/received floating notional amounts $15 $55 Weighted average pay rate 6.5% 7.1% Weighted average receive rate 5.0% 6.4% =============================================== ______________________________________________________________________________ INTEREST RATE RISK DISCLOSURES BY BANKS AND THRIFTS Registrants have asked whether the interest rate "gap" or "sensitivity" table routinely prepared by some banks meet the requirement in the rule for tabular information. This is addressed in "Questions and Answers About the New 'Market Risk' Disclosure Rules." The "gap" table format is acceptable, but requires some modification. Necessary revisions commonly would include: (1) conforming the maturity categories to those specified in the release; (2) grouping cash flows by maturity dates rather than repricing dates; (3) providing the level of detail required by the release; (4) providing average interest rates on the instruments; (5) providing fair values. The staff has seen several examples of "gap" tables modified to address the market risk disclosure requirements. Almost all could have been improved by insuring that all of these modifications were incorporated. Another format may be convenient for thrifts. Illustration 4 provides an example of the interest rate sensitivity analysis done by thrifts in accordance with Thrift Bulletin #13 issued by the Office of Thrift Supervision. This table and related explanatory material complies with the market risk disclosure rule in regards to interest rate risk. Both dollar and percentage changes in fair values are shown for 100, 200, 300, and 400 basis point increases and decreases. Note also the explanatory materials (only a part of the actual filing's explanatory materials), presented in Illustration 5. Indicating the sensitivity of the sensitivity analysis to assumptions about features such as interest rate repricing caps on variable-rate loans and prepayment options is important information to help the reader understand the numbers presented. Although this disclosure is good in general, also note, however, that the headings of the third and fourth columns, "Actual Change" and "Actual Percentage Change" are a bit misleading. These are really hypothetical changes. I would also caution registrants to remember two items if they are considering using the interest rate sensitivity analysis prepared in accordance with Thrift Bulletin #13. First, if the registrant is a holding company, with a thrift subsidiary, the interest rate risk analysis needs to include any financial instruments of the holding company, in addition to the thrift's instruments. Second, don't overlook the other risk categories, which are not addressed by Thrift Bulletin #13 compliance. ____________________________________________________________________________ Illustration 4 - ------------------------------------------------------------ Percent Change Market Value ------------------ Change in Of Portfolio Actual Board Interest Rates Equity Change Actual Limit - -------------- ------------ ---------- -------- ------- (Dollars in Millions) 400 bp rise $ 372 $(201) (35)% (40)% 300 bp rise 424 (149) (26) (30) 200 bp rise 475 (98) (17) (20) 100 bp rise 538 (35) (6) (10) Base Scenario 573 -- -- -- 100 bp decline 590 17 3 10 200 bp decline 613 40 7 20 300 bp decline 642 69 12 30 400 bp decline 687 114 20 40 - ------------------------------------------------------------ ______________________________________________________________________________ Illustration 5 Computation of prospective effects of hypothetical interest rate changes are based on many assumptions, including relative levels of market interest rates, loan prepayments and deposits decay. They should not be relied upon as indicative of actual results. Further, the computations do not contemplate certain actions the management could undertake in response to changes in interest rates. Certain shortcomings are inherent in the method of analysis used in the computation of NPV. If market conditions vary from assumptions used in the calculation of the NPV, actual values may differ from those projections presented. Certain assets, such as adjustable-rate loans, have features which restrict changes in interest rates on a short-term basis and over the life of the assets. Additionally, the proportion of fixed-rate loans in the Corporation's portfolio could increase in future periods if market interest rates remain at or decrease below current levels due to refinance activity. Further, in the event of a change in interest rates, early withdrawal and prepayment levels would likely deviate significantly from those assumed in the analysis. Finally, the ability of some borrowers to repay their adjustable-rate mortgage loans may decrease in the event of interest rate increases. ______________________________________________________________________________ EXPLANATORY MATERIAL The quality of explanatory material accompanying the quantitative disclosures is quite variable across the filings the staff has seen. Consider the following two disclosures about equity price risk. (1) "Marketable equity securities at July 31, 1997, which are recorded at a fair value of $713 million have exposure to price risk. This risk is estimated as the potential loss in fair value resulting from a 10% adverse change in prices quoted by stock exchanges and amounts to $71 million. Actual results may differ." (2) "The modeling technique used measures the hypothetical change in fair values arising from selected hypothetical changes in each stock's price. Stock price fluctuations of plus or minus 10%, plus or minus 25%, and plus or minus 40% were selected based on the probability of their occurrence." [Table with 10%, 25%, and 40% price moves omitted.] "Within the Company's public equity investment portfolio, a 10% movement in the stock price has occurred in 60% of the quarters since the shares were initially offered or in the last three years; a 25% movement in the stock price has occurred in 39% of the quarters since the shares were initially offered or in the last three years; and a 40% movement in the stock price has occurred in 12% of the quarters since the shares were initially offered or in the last three years." The first seems, to me, to simply tell us the obvious: 10% of $713 million is $71 million, and hypothetical events may not occur. The second gives the reader a richer context within which to interpret the quantitative disclosure. In general, the discussions the staff has seen of assumptions, parameters, and limitations of the quantitative disclosures have been very brief and not very informative. These are new disclosures for many readers; providing context will be a great help to investors. INCLUSION OF INFORMATION ABOUT UNDERLYING POSITIONS Registrants are "encouraged to include other market risk sensitive instruments, positions, and transactions" within the quantitative disclosures. Illustration 6 shows the sensitivity analysis provided by a registrant for foreign exchange risk. In the second column, foreign exchange contracts are listed by currency. The third column provides the exposures underlying the foreign exchange contracts, leading to a net position in the fourth column. Finally, the potential loss from a hypothetical 10% depreciation in the value of the U.S. dollar is provided in the last column. By including both the market risk sensitive financial instruments and the underlying positions, the registrant provides a more complete picture of overall exposure to foreign exchange rate changes than would be provided if only the financial instruments were included. ______________________________________________________________________________ Illustration 6. JULY 31, 1997 U.S.DOLLAR NET UNDERLYING FOREIGN (dollars VALUE OF NET FOREIGN NET EXPOSED EXCHANGE LOSS in millions) FOREIGN CURRENCY LONG/(SHORT) FROM 10% EXCHANGE TRANSACTION CURRENCY DEPRECIATION OF CURRENCY CONTRACTS EXPOSURES POSITION U.S. DOLLAR - -------- ------------ -------------- ------------ --------------- Swiss Franc $ 3.1 $ 9.7 $ (6.6) $ (0.7) German Mark 8.0 8.4 0.4 -- Canadian Dollar 2.5 2.1 (0.4) -- British Pound 12.5 10.3 (2.2) (0.3) Argentine Peso 28.7 27.8 (0.9) -- Japanese Yen 8.0 8.8 0.8 -- Others 44.7 41.9 (2.8) (0.3) ------------ ------------ ------------ ------------ Total $ 107.5 $ 109.0 $ (11.7) $ (1.3) ============ ============ ============ ============ ______________________________________________________________________________ SUMMARY The market risk disclosure rule provides a number of different disclosure alternatives. Each of the alternatives requires different kinds of information. I would like to reiterate the principle deficiencies the staff has encountered in the 10-Ks reviewed thus far. First, please remember the market risk disclosures are to be provided outside of the footnotes, and that the safe harbor provisions will not apply to disclosures made in the footnotes to the financial statements. Second, registrants should provide separate quantitative disclosures for each material market risk category, that is, for interest rate, foreign exchange, commodity, and equity risk exposures. If an instrument is at risk in more than one category, the instrument should be included in the disclosures for each applicable category. Third, if registrants place material needed for compliance with the market risk release in different parts of the 10-K, complete cross-referencing should be provided. Finally, registrants should provide sufficient discussion of the assumptions, parameters, and limitations underlying the quantitative disclosures, so readers will have adequate context for interpretation of the disclosures.