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Accounting and Auditing Derivatives. C Delano Gray September 22, 2009. A two-year government study warns that derivatives, the complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system. GAO 1994.

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Accounting and auditing derivatives l.jpg

Accounting and Auditing Derivatives

C Delano Gray

September 22, 2009


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A two-year government study warns that derivatives, the complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system.

GAO 1994


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  • Testimony complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system.

  • Before the Congressional Oversight Panel

  • United States Government Accountability Office

    • GAO

    • For Release on Delivery Expected at 9:00 a.m. EST

    • Wednesday, January 14, 2009

  • FINANCIAL REGULATION

  • A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System

  • Statement of Gene L. Dodaro Acting Comptroller General of the United States


  • F i n a n c i a l c r i s i s l.jpg
    F I N A N C I A L C R I S I S complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system.

    Financial Crises Comprises of …

    • Banking Crises

    • Economic Crises

    • Capital Market Bubbles

    • Currency Crises


    F i n a n c i a l c r i s i s5 l.jpg
    F I N A N C I A L C R I S I S complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system.

    • Banking Crises

      • Bankruptcy

        • Inability to pay debts.

          OR

        • Run on the Bank , Credit Crunch


    F i n a n c i a l c r i s i s6 l.jpg
    F I N A N C I A L C R I S I S complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system.

    • Economic Crises

      • An economic crisis can take the form of a recession or a depression.

      • Economic Crisis will most likely experience a falling GDP, a drying up of liquidity and rising/falling prices due to inflation / deflation


    F i n a n c i a l c r i s i s7 l.jpg
    F I N A N C I A L C R I S I S complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system.

    • Capital Market Bubbles/Crashes

      • Market Price of stocks are higher than present value of future Cash flows.

      • A dramatic decline of stock prices in a market. Crashes are driven by panic as much as by underlying economic factors


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    F I N A N C I A L C R I S I S complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system.

    A Short History


    Global financial crisis l.jpg
    Global Financial Crisis complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system.

    • The global financial crisis of 2008 is the

    • worst of its kind since the Great

    • Depression

    • Began with failures of large financial

    • institutions in the United States

    • Rapidly evolved into a global crisis

    • resulting in a number of European bank failures


    Crisis l.jpg
    Crisis complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system.

    • Usually, some financial institutions or

    • assets suddenly lose a large part of

    • their value

    • – Banking Panics (and recessions)

    • – Stock market crashes

    • – Bursting of financial bubles

    • – Currency crisis

    • – Sovereign defaults


    Result l.jpg
    Result complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system.

    • Commercial banks suffer a sudden rush of withdrawals

    • by depositors, this is called a bank run

    • – September 7, 2008:

    • • Two United States Government sponsored enterprises

    • (GSEs), Fannie Mae (Federal National Mortgage

    • Association) and Freddie Mac (Federal Home Loan

    • Mortgage Corporation), into conservatorship run by

    • FHFA

    • – September 14, 2008

    • • Lehman Brothers files for bankruptcy.

    • • Sale of Merrill Lynch to Bank of America

    • – September 16, 2008

    • • AIG faces severe liquidity crunch

    • • Financial institutions lost a large part of their value in

    • coming days and weeks


    Causes l.jpg
    Causes complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system.

    • • Leveraged Investment

    • • Asset-Liability Mismatch

    • • Regulatory Failures

    • • Fraud

      – Medford

    • • Contangion

    • • Self-fulfilling Prophecy

    • Sub-prime Mortgage


    Before l.jpg
    Before complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system.

    • 1 year ago RBS paid $100 billion for ABN Amro.

    • For this amount it could now buy:

    • Citibank $22.5 billion

    • Morgan Stanley $10.5 billion

    • Goldman Sachs $21 billion

    • Merrill Lynch $12.3 billion

    • Deutsche Bank $13 billion

    • Barclays $12.7 billion

    • And still have $8 billion change......with which it would

    • be able to pick up GM, Ford, Chrysler and the Honda F1 Team.


    Causes of financial crisis l.jpg
    CAUSES OF FINANCIAL CRISIS complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system.

    • Strategic Complementarities in Financial Markets

      • Successful investment requires each investor in financial market to guess what other investors will do

        • John Keynes compared Financial markets to a “Beauty Contest Game”

        • Mr. George Soros an Analyst , has called this need to guess the intentions of other “Reflexivity”


    Banking l.jpg
    Banking complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system.

    • The banking industry can be divided in several ways, commonly beginning with wholesale vs. retail banking

    • Retail, or commercial banks, provide various services to individuals and families:

      • Depository services such as checking and savings accounts and CDs

      • Financing in the form of credit cards, auto loans, student loans, and home mortgages

      • Less common services like currency exchange and merchant banking

    • Most individuals deal with commercial banks their whole lives

    • These banks are well-known brands like Bank One, Wells Fargo, Bank of America, and Citibank


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    Investment Banking Overview complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system.

    • The private side is further divided into product and industry elements:

      • Product groups specialize in a certain service or instrument, such as M&A, bonds, common and preferred stock, etc. – these groups run transactions

      • Industry groups cover all client firms which operate in a certain field, like mining, health care, or telecommunications – they are relationship managers and assist management with multiple needs

    • The industry is broadly segmented into “buy side” and “sell side:”

      • The sell side of banking includes any firm which structures transactions or issues instruments

      • The buy side describes the firms which buy (i.e. invest in) such issues, like insurance companies, pension funds, and other asset managers all the way down to retail brokers


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    Non Banks complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system.

    • Non-bank financial institutions:

      • Include: Large non-bank financial institutions like AIG, G.E. Financial, Transamerica, MBIA, and others

      • Key industries like insurance & reinsurance, asset management, and leasing, which also offer a deal atmosphere and high finance experience while being more approachable than the bulge bracket banks

    • The financial information industry:

      • Banks rely on several outside providers for much of their analysis and information, like Moody’s, S&P, Fitch, Reuters, Factset, Disclosure, KMV, and others


    The act l.jpg
    THE ACT complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system.

    In 1933, in the wake of the 1929 stock market crash and during a nationwide commercial bank failure and the Great Depression, two members of Congress put their names on what is known today as the Glass-Steagall Act (GSA). This act separated investment and commercial banking activities.


    The other act l.jpg
    THE OTHER ACT complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system.

    In November of 1999 Congress repealed the GSA with the establishment of the Gramm-Leach-Bliley Act, which eliminated the GSA restrictions against affiliations between commercial and investment banks. Furthermore, the Gramm-Leach-Bliley Act allows banking institutions to provide a broader range of services, including underwriting and other dealing activities.


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    Hedging complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system.

    • What does it mean to "hedge"?

    • To "hedge" means to manage risk. Any given money manager may make an allocation/investment that could be described as speculative; if this same manager simultaneously makes an allocation to an allocation/investment specifically designed to balance or counter-act any negative performance from his speculative position then this would be his hedging position.There are many types of perceivable risk - Market, Interest rate, Inflation, Sectoral, Regional, Currency, etc. Hedge fund managers utilise the complete arsenal of financial weapons (holding cash, short selling, buying selling or swapping options, futures, commodity and/or currency futures, etc.) and are expert in concocting hedging positions for most conceivable risks.


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    Fair Value complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system.

    • Measurement

    • Definition of Fair Value

    • Fair value is the price that would be received to

    • sell an asset or paid to transfer a liability in an orderly

    • transaction between market participants at the measurement

    • date.

    • The asset or liability

    • A fair value measurement is for a particular asset

    • or liability. Therefore, the measurement should consider

    • attributes specific to the asset or liability, for example,

    • the condition and/or location of the asset or liability

    • and restrictions, if any, on the sale or use of the asset at the measurement date


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    Rules (Some of ) complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system.

    • FAS

      133, 149, 155, 157, 159

    • Au

      312 Risk, 314 Entity, 318 Performance-Risk, 326 Evidence, 332 Derivatives


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    Gambling on Derivatives complex and largely unregulated financial instruments that have grown into a $12 trillion market, pose new and enormous risks to the global financial system.

    Hedging Risk or Courting Disaster?


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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 Crunch 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

    The 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 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 (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 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

    • 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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    Derivatives 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

    • 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 Futures 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

    Definition

    • forward 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.


    Options l.jpg
    Options 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

    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


    Swaps l.jpg
    Swaps 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

    DEFINITIONAn 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.


    Interest only strips l.jpg
    Interest only strips 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

    Definition

    • A security with cash flows based entirely on the monthly interest payments received from a mortgage pool


    Principal only strip l.jpg
    Principal-only strip 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

    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 securities 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

    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.


    Ginnie mae l.jpg
    Ginnie Mae 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

    Definition

    • A security issued by the Government National Mortgage Association.


    Freddie mac l.jpg
    Freddie Mac 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

    Definition

    • A security issued by the Federal Home Loan Mortgage Corporation and secured by a pool of conventional home mortgages.


    Collateralized mortgage obligation cmo l.jpg
    Collateralized mortgage obligation (CMO) 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

    • 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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    Securitization 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

    Definition

    • The process of aggregating similar instruments, such as loans or mortgages, into a negotiable security.


    Securitization40 l.jpg
    Securitization 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

    • 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


    Securitization41 l.jpg
    Securitization 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

    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


    Credit default swap l.jpg
    Credit default swap 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

    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.


    Sallie mae l.jpg
    Sallie Mae 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

    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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    CDO 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

    Definition

    Collateralized debt obligations (CDOs) are a type of structuredasset-backed security (ABS) whose value and payments are derived from a portfolio of fixed-income underlying assets. CDOs are assigned different risk classes, or tranches, whereby "senior" tranches are considered the safest securities. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupon payments (and interest rates) or lower prices to compensate for additional default risk.


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    December 28, 2007 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

    Sallie Mae Sells Securities to Try to Pay Off Derivatives

    By REUTERS

    Sallie 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 332 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 Auditing DerivativeInstruments 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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    Assertions 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

    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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    Assertions 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

    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 to

      assets, and liabilities are the obligations of the entity.

    • iii. Completeness. All assets, liabilities, and equity interests that

      should have been recorded have been recorded.

    • iv. Valuation and allocation. Assets, liabilities, and equity interests

      are included in the financial statements at appropriate amounts

      and any resulting valuation or allocation adjustments are appropriately

      recorded.


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    Assertions 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

    c. Assertions about presentation and disclosure:

    • i. Occurrence and rights and obligations. Disclosed events and

      transactions have occurred and pertain to the entity.

    • ii. Completeness. All disclosures that should have been included in

      the financial statements have been included.

    • iii. Classification and understandability. Financial information is appropriately

      presented and described and disclosures are clearly

      expressed.

    • iv. Accuracy and valuation. Financial and other information are disclosed

      fairly and at appropriate amounts


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    Derivative Instruments Included in the 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 Scope 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 to Plan and Perform Auditing Procedures

    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 principles

    for assertions about derivatives, which might require that the

    auditor have special knowledge because of the complexity of those principles.

    In addition, a derivative may have complex features that require

    the auditor to have special knowledge to evaluate the measurement

    and disclosure of the derivative in conformity with generally accepted

    accounting principles. For example, features embedded in contracts or

    agreements 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 and

    securities, including the appropriateness of various types of valuation

    models and the reasonableness of key factors and assumptions, which

    may require knowledge of valuation concepts.


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    Assessing inherent risk and control risk for assertions about derivatives

    used in hedging activities, which may require an understanding

    of general risk management concepts and typical asset/liability management strategies


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    Audit Risk and Materiality about derivativesAU 312

    Requires 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 Assessment about derivatives

    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 of about derivatives

    inherent 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 Tools about derivatives


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    COSO and Derivatives about 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 Used 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 Reference Tool Management

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

    • 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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    Utilizing the COSO Framework Control Principles in Derivatives Management

    • 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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    Utilizing the COSO Framework Control Principles in Derivatives Management

    • 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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    Utilizing the COSO Framework Control Principles in Derivatives Management

    • 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 Principles 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 Derivatives


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    Overview of Fiscal Responses to the Crisis Derivatives

    • 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 Systemic Risk Derivatives

    • 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 Accounting DerivativesStandards

    • 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 Action Derivatives


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    Hedge Funds Derivatives

    • 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 Swaps Derivatives

    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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    FIX IT Derivatives

    • Adoption of Strengthened Standards

      • Vulnerability of Financial System

        • Contagion

        • Volatility

    • Role of Rating Agencies


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    FIX (contd) Derivatives

    • Restructuring the Financial System

      • Liberalization of interest rates

      • Reduction of controls on credit

      • Encouraging the development of secondary market for government securities

      • Allowing free entry of private banks


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    FINANCIAL BAIL OUT PACKAGE Derivatives

    • Sound Corporate Governance stabilize & strengthen good capital markets

      Benefit of Corporate Governance:

      • Protect Shareholder rights

      • Robust growth of corporate sectors

      • Enables corporations to realize Corporate objectives

      • Demonstrate to the wider public about the business


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    FIX ( contd ) Derivatives

    • Legal infrastructure must be made

      • Bank secrecy laws should be improved

      • Financial supervision & Bankruptcy

      • Deposit insurance scheme is needed


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    ROLE OF ACCOUNTING Derivatives

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    QUESTIONS????? Derivatives