Reaching out in an attempt to limit the damage of new accounting for intercompany swaps, which banks have used to hedge risk at least in the near term, the Securities Industry Association (SIA) requested a grandfather clause last week for transactions prior to this year. If the transactions are not grandfathered, banks will have to unwind them, and some fear that could result in a flood of swap contracts in the market.

SIA sent a letter stating its view to the Financial Accounting Standards Board, which had already rejected the idea when deliberating on its new standard to account for derivatives, FAS 133.

"These transactions were entered into in good faith and they shouldn’t be penalized," said a source at a large Wall Street bank.

Large banks routinely will have one part of the bank enter into a hedge with its own trading desk, with the intent of eventually unloading the risk to a third party. However, that intent can be difficult to verify, and the risk can appear to stay within the bank seeking to hedge it–one FASB staffer described the transactions as "shifting (risk) from your left pocket to your right."

The standard setter and the Securities and Exchange Commission, which enforces the accounting standards, have both issued guidance requiring the banking community to unwind intercompany hedges, with the exception of those done for foreign currency exposure–or the swap doesn’t qualify as a hedge. However, the SEC said intercompany transactions entered into prior to the start of this year could be grandfathered.

In February, the Derivatives Implementation Group (DIG), an independent group tackling FAS 133 implementation issues, concluded those swaps should not be grandfathered.

SIA’s letter, addressed to Robert Wilkins, a project manager at FASB and the standard setter’s representative at DIG, and FASB’s chairman and technical director, requests that the issue and DIG’s conclusion be reconsidered.

The letter notes "financial institutions acted in good faith in applying the deals under current accounting literature" and "the inordinate costs that would be imposed upon firms having to replace large numbers of existing hedges with third party transactions"

Kristine Smith, vice president of accounting policy at Lehman Brothers and one of the crafters of SIA’s letter, explained that banks see risk as "fungible." Instead of offsetting each defined risk with a derivatives transaction, risks can be aggregated and hedged with a third party as a whole or cut up into pieces. At least, that has been the practice, which presents a considerable obstacle in unwinding the transactions.

"It will be costly to companies and difficult because you’ll need to cancel the existing basket of trades and enter into a one-to-one trade for every trade done before, and entities have hundreds if not thousands of these on their books," she said. She said banks would have to retransact the volume of trades entered into before Jan. 1, 1999, to achieve direct offsets, needlessly grossing up the books, or cancel out the trades altogether. Lehman Brothers alone has $30 billion of debt swapped to fixed on an intercompany basis, according to Smith.

FASB’s project manager for the DIG, Robert Wilkins, said last week that the SIA’s letter was not received in time to give it the required weeklong analysis to bring it up at last week’s board meeting.