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Ready. Set. Hedge.

Changes to hedge accounting rules could be a boon for corporates, which will have more flexibility to manage interest-rate and commodity risk.

New rules affecting how companies and institutions report their hedging activities aren't usually headline news. Yet, changes that the Financial Accounting Standard Board (FASB) is expected to finalize this month could have far-reaching effects for a wide range of companies, especially banks and other financial institutions.

For some corporates, hedging strategies—which allow entities to use instruments such as futures, options and other derivatives to offset risk—don’t currently qualify for hedge accounting. The new rules from the FASB would eliminate some of those barriers and better synchronize a company’s risk management activities and accounting. The result could mean lower earnings volatility, increased multiples and improved capital efficiency for those companies.

This added flexibility could boost bank demand for conventional mortgage securities—and just in time.

Banks stand to benefit directly—with more leeway to hedge interest rate risk on prepayable assets, such as mortgage-backed securities—and indirectly, via higher trading activity from their clients, according to a recent Morgan Stanley Research report “Ready. Set. Hedge."

“We estimate that every 5% increase in fixed income trading revenue could drive 1% earnings-per-share upside for the U.S. money center banks," says Betsy Graseck, who covers U.S. Large Cap Banks for Morgan Stanley. “The rules also give banks more flexibility in managing their balance sheets."

Graseck estimates that easing regulations should free up capital for higher ROA activities and buybacks—most beneficial for moneycenters where earnings per share could rise 14%-20% over the next 12-18 months. These new hedge rules support that bull case scenario.

More Options to Hedge

The crux of the change is that it gives entities more flexibility to separate components of risk to determine if a hedge qualifies for special accounting treatment. This makes it possible to apply hedge accounting to areas that were previously difficult to hedge.

“Today, many banks hold significant amounts of prepayable assets, such as mortgage-backed securities, as held-to-maturity investments," says Todd Castagno, a Morgan Stanley equity strategist and accounting expert.  

Going forward, he expects banks to maintain a broader inventory of prepayable assets as available for sale, hedging away the volatility to regulatory capital ratios.  “The biggest change is that banks can now add mortgages when they find either the spreads or the yields attractive without having to commit to putting them into the held-to-maturity portfolio, increasing balance sheet flexibility."

Banks Eye Mortgage Supply

This added flexibility could boost bank demand for conventional mortgage securities—and just in time. The Federal Reserve Bank is expected to announce the beginning of balance sheet normalization at its upcoming Federal Open Market Committee (FOMC) meeting and by 2018 it could shed up to $168 billion in mortgages from its balance sheet. “If this proposal passes, we expect that banks will be available to absorb more of the 2018 net issuance after accounting for Fed wind-down," says Jay Bacow, a strategist covering agency mortgages.

The allowance to reclassify prepayable assets should also give banks an opportunity to “rethink" some of their municipal bond holdings by reclassifying them.

“This effectively loosens the standards for banks to transact in the muni market by making it easier to sell those assets," says municipal bond strategist Michael Zezas. “Dealers could be more comfortable holding inventory over time, thus improving market liquidity."

For more Morgan Stanley Research on the impact of hedging rule changes, ask your Morgan Stanley representative or Financial Advisor for the full report, “Ready. Set. Hedge" (Jul 21, 2017). Plus, more Ideas.