1 auditing derivatives c delano gray june 6, 2009

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Auditing DerivativesAuditing Derivatives

C Delano GrayJune 6, 2009

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Gambling on Derivatives

Hedging Risk or Courting Disaster?

"It could rip your guts out overnight ... the biggest, most potentially lucrative, and destructive market in the world ."

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"We view them as time bombs both for the parties that deal in them and the economic system ... In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

Warren Buffett

"In no circumstances enter the derivatives trading market without first agreeing it in writing with me ... at some time in the future it could bring the world's financial

system to its knees." Sir Julian Hodge

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Unlike Warren Buffet, Sir Julian Hodge, the Welsh banker, issued his apocalyptic warning three years before the first rash of derivatives disasters involving Metallgesellschaft, Orange County, Sears Roebuck, Proctor & Gamble, happened in 1994. More was to come in 1995 in the form of the Daiwa and Barings scandals. None of those on their own, however, threatened to bring the world financial system to its knees. Until recently the crisis that came closest to doing so involved LTCM in September 1998. Nearly 10 years later, in March 2008, the FED took emergency action to avoid what was called derivatives Chernobyl. That action seemed to have worked ... for a while, but the Credit Crunch has raised worries, could a mega-catastrophe lie around the corner ...?

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Toxic Derivatives and the Credit CrunchThe market in 2008 was worth over $516 trillion or about 10 times the value of the entire world's output. This enormous ticking time bomb threatens to wreck international efforts to solve the world's biggest

financial crisis since the 1930s

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Long-Term Capital Management (LTCM) was a U.S. hedge fund which used trading strategies such as fixed income arbitrage, statistical arbitrage, and pairs trading, combined with high leverage. It failed spectacularly in the late 1990s, leading to a

massive bailout by other major banks and investment houses,[1] which was supervised by the Federal Reserve.

LTCM was founded in 1994 by John Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Board of directors members included Myron Scholes

and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences.[2] Initially enormously successful with annualized returns of over 40% (after fees) in its first years, in 1998 it lost $4.6 billion in less than four months following the Russian financial crisis and became a prominent example of the risk potential in the

hedge fund industry. The fund folded in early 2000.The collapse of LTCM was the subject of Roger Lowenstein's book When Genius Failed:

The Rise and Fall of Long-Term Capital Management, published in 2000.

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Derivatives Derivatives

What Does Derivative Mean?A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.

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DerivativesDerivatives Futures contracts, forward contracts, options and swaps are the most

common types of derivatives. Derivatives are contracts and can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.

Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes. For example, a European investor purchasing shares of an American company off of an American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros

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Forwards and FuturesForwards and Futures

Definitionforward contract A trade that is agreed to

at one point in time but will take place at some later time.

future An exchange-traded derivative that is similar to a forward.

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OptionsOptions

DEFINITIONThe right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific amount of a given stock, commodity, currency, index, or debt, at a specified price (the strike price) during a specified period of time.

For stock options, the amount is usually 100 shares. Each option has a buyer, called the holder, and a seller, known as the writer. If the option contract is exercised, the writer is responsible for fulfilling the terms of the contract by delivering the shares to the appropriate party

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SwapsSwaps

DEFINITION

An exchange of streams of payments over time according to specified terms. The most common type is an interest rate swap, in which one party agrees to pay a fixed interest rate in return for receiving a adjustable rate from another party.

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Interest only stripsInterest only strips

DefinitionA security with cash flows based entirely

on the monthly interest payments received from a mortgage pool

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Principal-only stripPrincipal-only strip

Definition A version of a stripped mortgage-backed security

which has cash flows that are based entirely on the monthly principal payments received from a mortgage pool. Investors tend to buy principal-only strips when they suspect that interest rates are about to decline, because the principal will be paid at a faster rate.

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Stripped mortgage-backed Stripped mortgage-backed securitiessecurities

Definition A mortgage-backed instrument which is comprised of

two parts: interest and principal. In some cases, the security is made up of a certain percentage of both interest and principal. The ideal situation for investors is for the security to either be an interest-only strip or a principal-only strip. In these scenarios, the securities are very sensitive to the change in interest rate, so an investor will choose to purchase one or the other based on the direction he/she believes the interest rates are headed.

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Ginnie MaeGinnie Mae

DefinitionA security issued by the Government

National Mortgage Association.

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Freddie MacFreddie Mac

Definition A security issued by the Federal Home

Loan Mortgage Corporation and secured by a pool of conventional home mortgages.

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Collateralized mortgage Collateralized mortgage obligation (CMO)obligation (CMO)

A security backed by a pool of pass-through rates , structured so that there are several classes of bondholders with varying maturities, called tranches. The principal payments from the underlying pool of pass-through securities are used to retire the bonds on a priority basis as specified in the prospectus. Related: mortgage pass-through security

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SecuritizationSecuritization

DefinitionThe process of aggregating similar

instruments, such as loans or mortgages, into a negotiable security.

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Creating a more or less standard investment instrument such as the mortgage pass-through security, by pooling assets to back the instrument. Also refers to the replacement of nonmarketable loans and/or cash flows provided by financial intermediaries with negotiable securities issued in the public capital markets

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The process by which a company packages its illiquid assets as a security.

For example, when a company makes an initial public offering, it effectively packages the company's ownership into a certain number of stock certificates. Securities are backed by an asset, such as equity, or debt, such as a portion of a mortgage. Securitization allows a company access to greater funding to expand its operations or investments, or some other reason

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Credit default swapCredit default swap

Definition A specific kind of counterparty agreement which allows the

transfer of third party credit risk from one party to the other. One party in the swap is a lender and faces credit risk from

a third party, and the counterparty in the credit default swap agrees to insure this risk in exchange of regular periodic payments (essentially an insurance premium). If the third party defaults, the party providing insurance will have to purchase from the insured party the defaulted asset. In turn, the insurer pays the insured the remaining interest on the debt, as well as the principal.

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Sallie MaeSallie Mae

What Does Sallie Mae - Student Loan Marketing Association Mean?A publicly traded company that is the largest provider of educational loans in the U.S. Along with providing student loans, Sallie Mae purchases student loans from the original lenders and provides financing to state student-loan agencies.

Sallie Mae®, the nation's leading provider of student loans and administrator of college savings plans, has helped millions of Americans achieve their dream of a higher education. The company primarily provides federal and private student loans for undergraduate and graduate students and their parents

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December 28, 2007Sallie Mae Sells Securities to Try to Pay Off Derivatives

By REUTERSSallie Mae, the largest student lending company in the United States, said it sold $2 billion of common stock and

$1 billion of convertible securities Thursday in a deal that would help pay off bad derivatives bets.The common stock offering was increased from an originally planned $1.5 billion, and shares were priced at

$19.65, equal to Sallie Mae’s closing share price on Thursday.The preferred shares will offer a dividend of 7.25 percent until the investors convert them into common stock, or

until their mandatory conversion into common stock on Dec. 15, 2010.Sallie Mae, formally known as the SLM Corporation, said on Wednesday that it was issuing convertible preferred securities and common shares. About $2 billion of the proceeds would be used to pay off derivatives known as

equity forward contracts, the company said.Sallie Mae used equity forwards as part of its share buyback plan for years. The contracts allowed the company

to reduce the cost of buying back its shares as long as its stock price kept rising.But if Sallie Mae’s share price fell far enough, the company had to buy back a large number of shares at above-

market prices.In this case, Sallie Mae will use about $2 billion from its offering to buy back about 44 million shares, now worth

closer to $865 million.

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AU Section 332AU Section 332

Auditing DerivativeAuditing Derivative Instruments SAS 92Instruments SAS 92

Applicability .01 This section provides guidance to

auditors in planning and performing auditing procedures for assertions about derivative instruments, hedging activities, and investments in securities that are made in an entity's financial statements.

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AssertionsAssertions

a. Assertions about classes of transactions and events for the period under audit:

i. Occurrence. Transactions and events that have been recorded have occurred and pertain to the entity. ii. Completeness. All transactions and events that should have been recorded have been recorded. iii. Accuracy. Amounts and other data relating to recorded

transactions and events have been recorded appropriately. iv. Cutoff. Transactions and events have been recorded in the correct accounting period. v. Classification. Transactions and events have been recorded in the proper accounts.

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b. Assertions about account balances at the period end: i. Existence. Assets, liabilities, and equity interests exist. ii. Rights and obligations. The entity holds or controls the rights toassets, and liabilities are the obligations of the entity. iii. Completeness. All assets, liabilities, and equity interests thatshould have been recorded have been recorded. iv. Valuation and allocation. Assets, liabilities, and equity interestsare included in the financial statements at appropriate amountsand any resulting valuation or allocation adjustments are appropriatelyrecorded.

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c. Assertions about presentation and disclosure: i. Occurrence and rights and obligations. Disclosed events andtransactions have occurred and pertain to the entity. ii. Completeness. All disclosures that should have been included inthe financial statements have been included. iii. Classification and understandability. Financial information is

appropriatelypresented and described and disclosures are clearlyexpressed. iv. Accuracy and valuation. Financial and other information are

disclosedfairly and at appropriate amounts

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Derivative Instruments Included in theDerivative Instruments Included in theScope of this SectionScope of this Section

A derivative is a financial instrument or other contract with all three of the characteristics listed in FASB Statement No. 133, which are the following.

a. It has (1) one or more underlyings and (2) one or more notional amounts or payment provisions or both. Those terms determine the amount of the settlement or settlements, and, in some cases, whether or not settlement is required.

b. It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.

c. Its terms require or permit net settlement, it can readily be settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

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The Need for Special Skill or Knowledge The Need for Special Skill or Knowledge to Plan and Perform Auditing to Plan and Perform Auditing

ProceduresProcedures

The auditor may need special skill or knowledge to plan and perform

auditing procedures for certain assertions about derivatives and securities. Examples

of such auditing procedures and the special skill or knowledge required

include—

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Understanding the application of generally accepted accounting principlesfor assertions about derivatives, which might require that theauditor have special knowledge because of the complexity of those principles.In addition, a derivative may have complex features that requirethe auditor to have special knowledge to evaluate the measurementand disclosure of the derivative in conformity with generally acceptedaccounting principles. For example, features embedded in contracts oragreements may require separate accounting as a derivative, and complex pricing structures may increase the complexity of the assumptions used in estimating the fair value of a derivative.

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Understanding the determination of the fair values of derivatives andsecurities, including the appropriateness of various types of valuationmodels and the reasonableness of key factors and assumptions, whichmay require knowledge of valuation concepts.

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Assessing inherent risk and control risk for assertions about derivativesused in hedging activities, which may require an understandingof general risk management concepts and typical asset/liability management strategies

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Audit Risk and MaterialityAudit Risk and MaterialityAU AU 312312Requires the auditor to design procedures to obtain

reasonable assurance of detecting misstatements of assertions about derivatives and securities that, when aggregated with misstatements of other assertions, could cause the financial statements taken as a whole to be materially misstated. When designing such procedures, the auditor should consider the inherent risk and control risk for these assertions.

The auditor may also consider the work performed by the entity's internal auditors in designing procedures.

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Inherent Risk AssessmentInherent Risk Assessment

The Auditor must consider the inherent risk for an assertion about a derivative or security and its susceptibility to a material misstatement, assuming there are no related controls.

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Considerations that might affect the auditor's assessment ofinherent risk for assertions about a derivative or security include the following.

• Management's objectives

•The complexity of the features of the derivative or security.

•The complexity of the features of the derivative or security.

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Other ToolsOther Tools

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COSO and DerivativesCOSO and Derivatives

Internal Control Issues in Derivatives UsageProblems surrounding the use of derivatives in recent years often revolved around difficulty in understanding their risks and their use for risk management purposes. These problems highlight the need for management to develop internal control systems for derivative activities.

SEE the COSO supplements Executive Summaries.

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Formulating Policies Governing Derivatives Formulating Policies Governing Derivatives

Used for Risk ManagementUsed for Risk Management S1 Is the process of developing a policy governing

derivatives use in the context of the overall risk management policy of an entity. It recognizes that risk management policies encompass all aspects of control. It also recognizes the importance of establishing clear and carefully written policies to avoid confusion and miscommunication, and provides examples of various aspects of a risk management policy for derivatives.

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Illustrative Control Procedures Illustrative Control Procedures Reference Tool Reference Tool S2 Are examples of controls over derivative

activities associated with each of the five components of control specified in the COSO Framework. It can be used as a reference for establishing, assessing, and improving controls relating to derivative activities, and can be useful for selecting controls considered to be appropriate in particular circumstances.

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THE FIVE COMPONENTS

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Utilizing the COSO Framework Control Utilizing the COSO Framework Control Principles in Derivatives ManagementPrinciples in Derivatives Management

The Control Environment consists of the integrity, ethical values, and competence of the entity's personnel, as well as management's philosophy and operating style. An active and effective board of directors should provide oversight. It should recognize that the "tone at the top" and the attitude toward controlling risk affect the nature and extent of derivative activities

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Risk Assessment is the identification and analysis of risks relevant to achieving objectives that form a basis for determining how risks should be managed. From a risk management perspective, entity-wide objectives relating to the use of derivatives should be consistent with risk management objectives. Mechanisms should exist for the identification and assessment of business risks relevant to the entity's unique circumstances. Use of derivatives should be based on a careful assessment of such business risks.

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Control Activities are the policies and procedures to help ensure that management directives are carried out. Policies governing derivative use should be clearly defined and communicated throughout the organization. The risk management policy should include procedures for identifying, measuring, assessing, and limiting business risks as the foundation for using derivatives for risk management purposes.

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Information and Communication focus on the nature and quality of information needed for effective control, the systems used to develop such information, and reports necessary to communicate it effectively. Communications should ensure that duties and control responsibilities relating to derivative activities are understood across the organization.

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Monitoring is the component that assesses the quality and effectiveness of the system's performance over time. Control systems relating to derivative activities should be monitored to ensure the integrity of system-generated reports. The organizational structure should include an independent monitoring function over derivatives, providing senior management with an understanding of the risks of derivative activities, validating results, and assessing compliance with established policies.

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Applying the COSO Framework Control Applying the COSO Framework Control Principles to DerivativesPrinciples to Derivatives

The use of derivatives for risk management purposes, should generally involve the following:

Understanding operations and entity-wide objectives. Identifying, measuring, assessing, and modifying business risk. Evaluating the use of derivatives to control market risk and linking

use to entity-wide and activity-level objectives. Defining risk management activities and terms relating to

derivatives to provide a clear understanding of their intended use. Assessing the appropriateness of specified activities and strategies

relating to the use of derivatives. Establishing procedures for obtaining and communicating

information and analyzing and monitoring risk management activities and their results.

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FALLOUT

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Overview of Fiscal Responses Overview of Fiscal Responses to the Crisisto the Crisis Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted in response to

the global financial crisis and authorizes the U.S. Secretary of the Treasury to spend U.S.$700 billion to purchase on guarantee distressed assets.

Trouble Asset Relief Program (“TARP”) is nominally a crucial part of EESA TARP can operate as a revolving purchase facility, allowing financial institutions to

sell assets to decrease their debt to capital markets ratio Financial institutions that are “established and regulated” under the laws of the U.S.

with “significant operations” in the U.S. (may include U.S. subsidiaries/branches of non-U.S.institutions)

Places limits on executive compensation for participating institutions Equity Participation by U.S. Department of the Treasury in participating institutions Participation Disclosure: Likely public disclosure by institutions that participate in the

program, including the amount of assets that were sold and the price Additional funds used to rescue the U.S. auto industry and other individual “too big to

fail” financial institutions (e.g. AIG, Merrill Lynch, etc.) The implementation of EESA and TARP has evolved in phases that appear reflexive

to day-to-day conditions

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Approaches to Regulation of Approaches to Regulation of Systemic RiskSystemic Risk Approaches offered from a variety of government and industry

reports (U.S. Government Accountability Office, Group of Thirty, etc.) include:

Identify and regulate financial institutions that pose systemic risk Regulation through economic stimulus package (e.g. EESA) Limit excessive leverage in U.S. financial institutions Increase supervision of the shadow financial system (e.g. hedge

funds, fund managers) Create a new system for federal and state regulation of mortgages

and other consumer credit products Reform of credit rating system Make establishment of global financial regulatory floor a top U.S.

diplomatic priority Paradigm shift in financial regulation from U.S. rules-based

approach to “European-style” prudential/principles-based approach

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Regulation and Fair Value AccountingRegulation and Fair Value AccountingStandardsStandards Regulation and Fair Value Accounting Standards • Mark to Market Accounting Mark to market is an accounting methodology under Federal Accounting Standards Board Statement No. 157 (FAS 157) that assigns a value to a position held in a financial instrument

based on the current market price for the instrument or similar instruments. FAS 157 changed the definition of “fair value” of assets to include the mark to market accounting practice Intention is to inform investors of the value of assets in current prices During depressed market conditions, mark to market accounting can cause companies to report

asset values that are far less than the book value of the assets Both Mary Schapiro and Timothy Geithner believe that mark to market accounting rules should

be kept in place EESA directed the SEC to commence a study of fair value accounting standards. The study report: Observed that mark-to-market accounting did not appear to play a meaningful role in the bank

failures of 2008 Noted that investors generally believe that fair value accounting increased financial reporting

transparency and facilitates better investment decision-making Provided recommendations for improved application of fair value accounting rules

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Other ActionOther Action

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Hedge FundsHedge Funds

Currently, hedge funds are not required to disclose the identity of their investors, the contents of their portfolios, or their leverage with regulatory authorities.

Many hedge funds self-regulate either by disclosing information to their investors and creditors or by voluntarily registering with the SEC

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Credit Default SwapsCredit Default Swaps

Currently, the Commodities Futures Modernization Act of 2000 prohibits the SEC and CFTC from regulating all types of swaps including interest rate, currency, equity, commodity and credit swaps.

SEC, Federal Reserve and CFTC are assisting in the establishment of a central counterparty for the CDS market

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QUESTIONS

1 auditing derivatives c delano gray june 6, 2009

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